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When the calendar turns to mid-March and tax season makes the leap from annoying to soul-crushing, I spend more time than I should daydreaming about goin’ all Walter White and breaking bad, only instead of cooking meth, I’d use my well-honed number-crunching skills to become an underground bookie.

Oh, what a life it would be. Instead of spending March Madness in a tiny office cranking out tax returns, I’d spend it in a giant war room complete with wall-to-wall flat screens, building my riches on the failed dreams of student athletes. I’d work the phone better than Gordon Gecko, avoiding detection by using subversive colloquialisms like “unit” and “juice.” I’d threaten to break thumbs with impunity. And I’d make money. Lots and lots of money. Because the house never loses.

The house doesn’t lose because it is (generally) indifferent to who the bettors favor. Not to get into Gambling 101, but if you bet $100 on the Seahawks + 2 ½ in the Super Bowl, you won $100, But if you bet $100 on the Broncos to cover the 2 ½ points (sucker), you lost $110. The $10 the loser pays over and above the wagered amount is the “vig.”

Thanks to the vig, bookies generally don’t care who people are betting on, as long as the bets are fairly even on both sides. And of course, bookies have the advantage of being able to move the line to make sure this happens.

When it comes to horse racing — which in my bookie fantasy world, I will  occasionally dabble in but not invest heavily – the house has an added level of protection in the form of “parimutuel wagering.” It works like so:

The entire amount wagered on a particular race is referred to as the betting pool or “handle.” The pool can then be managed to ensure that the track receives a share of the betting pool regardless of the winning horse. This share of the betting pool that the track keeps for itself is often referred to as the “takeout,” and the percentage is driven by state law, but generally ranges from 15% to 25%.

The takeout is then used to defray the track’s expenses, including purse money for the winning horses, taxes, licenses, and fees. The takeout can also be used, if needed, to cover any shortfall in the amount necessary to pay off winning bettors. To the extent any excess takeout remains after covering these two classes of obligations, the track has profit.

Once the betting pool has been reduced by the takeout, the balance is generally used to pay off any winning wagers, with the excess, once again, representing profits. Great business model, isn’t it?

Yesterday, an enterprising CPA with a raging gambling habit threatened to strike a blow for bettors everywhere when he took on the IRS in the Tax Court and argued that the portion of his wagers attributable to the “takeout” were deductible without limitation. But before we can understand the significance of the case, we need to understand some basics about the taxation of gambling.

Treatment of Gambling Expenses, In General

Section 165(d) provides that “losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.” Generally, any winnings are reported on page 1 of the Form 1040, while the losses (but only to the extent of winnings) must be claimed as itemized deductions. Thus, if a bettor is one of the 66% of Americans who don’t itemize their deductions, they would effectively be whipsawed – they would be forced to recognize the gambling income, but would receive no benefit from the losses.

Section 162, however, generally allows a deduction for “all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.”

Putting these two provisions together, many bettors have taken the position that if their gambling activities are so frequent, continuous and substantial as to rise to the level of an unhealthy addiction a Section 162 trade or business, then gambling losses are deductible as Section 162 business expenses, and are not subject to the loss limitations imposed by Section 165(d). In their view, if the gambling activity constitutes a business, because the losses (along with the gains) should be reported on Schedule C, rather than itemized deductions, the losses should be permitted in full.

The courts have repeatedly shot this theory down, holding that even a professional gambler who properly reports his activity on Schedule C may only deduct losses to the extent of gains.

In a very important 2011 decision out of the Tax Court, however, the court held that while gambling losses are limited to the extent of gambling winnings, any non-loss expenses of a professional gambler engaged in a trade or business – items like automobile expenses, travel, subscriptions and handicapping data – are not subject to the Section 165(d) limitation. Thus, a professional gambler could reduce his winnings to zero by his losses, and then further deduct any non-loss business expenses, generating a net loss from the activity. (See Mayo v. Commissioner, 136 T.C. 81 (2011).)

And that brings us back to our gambling CPA.  In Lakhani v. Commissioner, 142 T.C. 8 (2014), settled yesterday, an accountant/prolific track bettor made the compelling argument that his portion of the track’s “takeout expenses” represented non-loss business expenses rather than gambling losses, and were thus deductible without limitation. The taxpayer posited that by extracting takeout from the taxpayer’s wagers and using those funds to pay the track’s operating expenses, the track was acting in the capacity of a fiduciary. The taxpayer further likened the process to that of an employer who collects payroll taxes from his employees and remits them to the IRS and state agencies. Stated in another manner, the taxpayer argued that he was paying the operating expenses of the track, with the track acting as a conduit by collecting the takeout and using the funds.

Based on this position, the taxpayer argued that he was entitled to non-loss gambling business deductions in excess of $250,000 between 2005 and 2009.

The IRS disagreed with the taxpayer’s argument, countering that because the takeout is paid from the pool remaining from losing bets, “it is inseparable from the wagering transactions,” and thus constitutes wagering losses that are subject to the limits of Section 165(d). Furthermore, the Service argued that the taxpayer could not deduct business expenses for amounts paid from the takeout by the track for taxes, fees, and licenses, etc… because these were expenses owed by the track, not the individual bettor.

The Tax Court sided with the IRS, holding that the taxpayer’s share of the takeout expenses represented wagering losses that could only be deducted to the extent of winnings under Section 165(d). In reaching this conclusion, the court differentiated between an employer remitting payroll taxes on the behalf of an employee and a track using takeout funds to pay its operating expenses.

The employee, the court stated, is ultimately responsible for his share of the payroll taxes on his wages, and it is the remittance of these taxes by the employer that discharges the employee of this obligation. To the contrary, at no point are the expenses of the track imposed on the individual bettor; they are always obligations of the track. The tracks use of the takeout to pay its expenses, the court stated, does not discharge any obligation of the bettor.

As a result, the court concluded that because the track’s expenses were never an obligation or expense of the bettor, the takeout could not qualify as the bettor’s business expense. Instead, the takeout represented an additional gambling loss by the taxpayer, and could only be deducted – when added to his other losses – to the extent of his winnings.

follow along on twitter @nittigrittytax

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Earlier today, House Ways and Means Committee Chairman Dave Camp released his long-awaited and highly anticipated proposal for tax reform. The proposal promised to present the most thorough, sweeping changes to the law since the 1986 Act, and it didn’t disappoint.

Before we begin our analysis of the plan let me start by saying that while I clearly admire Chairman Camp for his tireless push to simplify the industry in which I ply my trade, I’d be remiss if I didn’t point out the irony that in the tax world, even a proposal for “simplification” stretches to nearly 1,000 pages.

Because there’s so much to take in, we’ll be separating our analysis into two parts

Part 1: Proposal for individual tax reform

Part II: Proposal for business tax reform

Let’s get to it with Part 1, Chairman Camp’s proposal for individual tax reform.

Streamlining of Individual Income Tax Rates

Current Law

Effective January 1, 2013, we now have seven income tax rates that are applied against so-called “ordinary income,” (i.e. income from wages, business income, interest, etc…): 10%, 15%, 25%, 28%, 33%, 35%, and a top rate of 39.6%. If you’ve ever wondered how efficient this type of structure is, consider that in 2013, the 35% rate was only applied on single taxpayers with incomes in excess of $398,351 but less than $400,000. Yes, we had a tax bracket that was $1,649 wide.

Because our tax system is a progressive one, taxpayers don’t pay a flat rate of tax on all earned income; rather, as income increases, so does the tax rate applied to the income. Thus, when someone proclaims that they are in the “39.6% bracket,” that does not mean they paid 39.6% on all of their income; rather, it means they paid 39.6% on their last dollar of income. It also means that they are likely insufferable.

No matter how you slice it, a system with seven brackets – and a high of nearly 40% — is far from ideal.

Camp Solution

Camp’s proposal would consolidate the current seven brackets into three, consisting of 10%, 25%, and 35% rates. Generally, the new 10% rate would replace the old 10% and 15% brackets, meaning it would cover all income earned up to approximately $73,800 if married, $36,900 if single (for simplicy’s sake, from this point on I will refer to married versus single thresholds or limitations like so: $73,800/$36,900).

The new 25% bracket would replace the former 25%, 28%, 33% and 35% brackets, meaning single taxpayers with taxable income between $36,900 and $400,000 would pay a 25% rate on that income, while married taxpayers with taxable income between $73,800 and $450,000 would pay a 25% rate on that income.

If you happen to earn taxable income in excess of $450,000/$400,000, then you will pay a rate of 35% on the excess, as opposed to 39.6% under current law.

Excluded from this top rate of 35% — meaning it would be taxed at a top rate of 25% — would be any income earned from “domestic manufacturing activities,” which is defined as “any lease, rental, license, sale, exchange, or other disposition of tangible personal property that is manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States, or (2) construction of real property in the United States as part of the active conduct of a construction trade or business.”

Click here to read the rest on Forbes

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While the debate format that has ruined sports entertainment [ESPN: All Yelling, All the Time!]  obsesses over the inane and inherently unanswerable question of, “Has Kevin Durant surpassed LeBron?” the Oklahoma City Thunder forward and aspiring first-time MVP has managed to keep his attention right where it belongs: on his tax returns.

News came out this week that Durant – who has been lighting up the NBA at a 31.5 points-per-game clip this season – is suing his accountant for perpetrating some untoward shenanigans on Durant’s tax returns.

The suit alleges that California-based accountant Joel Lynn Elliot deducted expenses for Durant’s personal travel and personal chef on the five-time All-Star’s tax returns. This, of course, is a big no-no, because Section 262 of the Internal Revenue Code provides that “no deduction shall be allowed for any personal, living or family expenses.” Unless, of course, the personal expenses are specifically allowable for policy reasons, such as the deduction for mortgage interest and real estate taxes.

The IRS soon came calling, and Durant will now have to amend his returns, pay the back taxes, and, very likely, interest and penalties. As a result, he is looking to recover $600,000 from Elliot. Interestingly enough, should Durant recover that amount from his CPA, the settlement payment would itself be taxable, because the tax law was written by a crazy person.

Durant’s first mistake, of course, was hiring a tax preparer  who goes by three names, as people who do so are generally only fit to serve as famous assassins, serial killers, or country music singers. That’s just science.

Follow along on twitter @Nittigrittytax

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Super Bowl parties are the worst, and that’s largely because people are the worst. I’m no literary buff, but I’m pretty sure that cramming a couple dozen yahoos into a living room for three hours so they can scream incoherently at an inanimate object was one of Dante’s levels of hell.

Things are even worse for us tax professionals. When the party winds down late Sunday night, we’re greeted with the reality that we’re mere hours away from starting another hellacious “busy season” work week, this one with a bit of a hangover.

The only thing that makes a Super Bowl party palatable — aside from the nachos – is having a rooting interest in one of the teams. Of course, if you hail from Colorado or Washington, your allegiances are firmly entrenched. But if you call one of the other 48 states homes, who should you root for?

To help the decision making process, I’ve put together this handy comparison that summarizes the salient issues that you, the sports fan-tax geek — need to know before deciding who deserves your love on Sunday night.  Think of the table as one of the Tax Court’s “factor tests,” while the Broncos may win the preponderance of the factors, you may weigh the factors based on your personal ideology and reach a different overall conclusion.

Superbowl-Nitti2(Click to enlarge)

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Sometimes in life, when faced with a given situation, we say things simply as a matter of reflex. For example:

“What an adorable baby!”

“You have a lovely home here.”

“You’re a great gal, I’ll call you sometime. Now can you help me find my pants?”

Things are no different in the tax world. As advisors, we keep an army of axioms always at the ready to be used in response to client queries. Take, for example, the client who contemplates the type of entity that should be used to hold a piece of real estate. For most tax practitioners, this would elicit the following Pavolovian reaction:

“You should NEVER put real estate inside a corporation.”

And while there are very few NEVERS in the tax world, this one is pretty darn accurate. But do you really understand why you should never put real estate into a corporation? It’s because, as the ensuing discussion will reflect, while real estate can go into a corporation tax-free, it can never come out tax free. In today’s Tax Geek Tuesday, let’s peel back the layers of the statute and find out why.

Case study:  A, an individual, owns a building with a basis of $400,000 and a fair market value of $1,000,000. B, another individual, owns business assets worth $1,000,000. A and B would like to form a business that will use both the business assets owned by B and the building owned by A.  The entity will be owned 50/50 by A and B. Should the entity be a C corporation,  S corporation, or partnership?

Transfers to Controlled Corporations, In General

Under the general tax principles of Section 1001, the transfer of appreciated property triggers gain for the difference between the amount realized on the transfer less the adjusted tax basis of the property. Thus, barring a statutory exception, if A were to transfer the building to a corporation in exchange for the corporation’s stock, A would recognize $600,000 of gain ($1,000,000 fair market value less A’s $400,000 tax basis).

Section 351 is one such exception to the general rule of gain recognition, however, as it allows you to contribute appreciated property to a corporation in exchange for the corporation’s stock without recognizing gain provided you “control” the corporation immediately after the transfer.

For these purposes, “control” is defined as 80% of the vote and value of the corporation, with a couple of important distinctions. First, you don’t have to acquire 80% of the corporation; you simply must own 80% immediately after. A taxpayer who already owns say, 85% of a corporation may continue to transfer appreciated property to the corporation, and the gain will be deferred under Section 351.

In addition, Section 351 allows for a group of transferors. If you contribute appreciated property to a corporation in exchange for, say 20% of the corporation’s stock, but simultaneous to the transfer, another two individuals transfer cash or property to the corporation in exchange for an additional 65% of the stock, all three transfers are covered by Section 351 because on a combined basis, the transferor group controls the corporation immediately after the transfer.

Section 357(c)

Problems arise when the property contributed to a corporation is subject to a liability. Under Section 357(c), if you transfer property to a corporation that is subject to a liability and the corporation assumes that liability as part of the transfer, the transfer triggers gain to the extent the liability exceeds the tax basis of the property.

This provision is particularly problematic when the subject property is real estate, where mortgages are the norm. If, for example, A’s property were subject to a $700,000 mortgage, the transfer of the property to a corporation in exchange for corporate stock would generate $300,000 ($700,000 debt relief less $400,000 tax basis) of gain to A, even if the transfer were otherwise tax-free under Section 351.

Basis and Holding Period

When Section 351 applies to a transfer of property to a corporation, the gain is not excluded, it is merely deferred. This is accomplished through two statutory provisions that provide basis rules that ensure that any gain inherent in the building will be recognized if either you dispose of the corporation’s stock or the corporation disposes of the building.

Under Section 358, you must take a basis in the stock received equal to the basis in the property you transferred to the corporation. This is often referred to as a “substituted basis,” because the basis in the property received is determined in reference to the basis in the property relinquished.

In turn, Section 362 provides that the corporation must take a basis in the building equal to your basis in the building. This is often referred to as a “carryover basis,” because the corporation’s basis in the property remains unchanged from that which you held in the property.

Going back to our case study, if A and B simultaneously transfer property to a corporation in exchange for 50% of the corporation’s stock, Section 351 applies to the transfer. Despite the fact that A’s building has a fair market value of $1,000,000 and a tax basis of $400,000, no gain is recognized. 

Under Section 358, A takes a basis of $400,000 in the corporate stock received. Because the total value of the corporation’s assets is $2,000,000, A’s 50% stock ownership is presumably worth $1,000,000. If A sells the stock for its value of $1,000,000, A will recognize $600,000 of gain, the amount that was deferred when A transferred the building to the corporation.

Under Section 362, the corporation takes a basis in the building of $400,000. If the corporation sells the building for its value of $1,000,000, the corporation will recognize the $600,000 of gain deferred on the contribution.

Distributions and Liquidations of C Corporations, In General

The big problem with placing real estate in a corporation does not present itself until it’s time to get the property out, whether as a sale or distribution.

Sale

As mentioned above, if the corporation sells the building, courtesy of the basis mechanics of Section 362, the sale will generate $600,000 of gain. This gain will be taxed at the corporate level at a maximum federal rate of 35%, resulting in $210,000 of corporate-level tax.

The tax inefficiency is only exacerbated if A would like to get his hands on the remaining $790,000 ($1,000,000 less $210,000 tax liability) of purchase price.  If the corporation liquidates and distributes the net cash to A, A would be required by Section 331 to recognize capital gain for the difference between the amount distributed and A’s basis in the stock. A would recognize $390,000 of gain ($790,000 distribution less $400,000 stock basis) upon the liquidation, and assuming the stock were held longer than one year, would pay tax on the liquidation at a maximum rate of 23.8%, resulting in an individual tax bill of $93,000.

Thus, by selling the property in a C corporation and withdrawing the after-tax cash, A will incur a total tax liability in excess of $300,000.

Current Distribution

Alternatively, A may simply have second thoughts about dropping the building into a corporation, and wish to unwind the transaction. If the corporation transfers the building to A in a non-liquidating distribution, Section 311(b) governs the taxability of the transfer. Under this provision, when a corporation distributes appreciated property to a shareholder, the corporation recognizes gain as if it had sold the property for its fair market value. Thus, the distribution would trigger $600,000 of gain to the corporation — just as it did with a sale — which would be taxed at a maximum federal rate of 35%.

And just as seen with a sale, A isn’t through paying tax yet. Under Section 301, A must treat the fair market value of the distributed property as dividend income (to the extent of any corporate E&P, which will include the $600,000 of gain) where it will be taxed at a maximum rate of 23.8%.

Liquidating Distribution

Things are equally painful if the corporation distributes the property to A in a liquidating distribution. Under Section 336, when a corporation transfers appreciated property in a liquidating distribution, the corporation recognizes gain as if the property were sold for its fair market value. Thus, the corporation would once again recognize gain of $600,000, just as it did in the sale and current distribution examples, and once again pay corporate level tax of $210,000.

Under Section 331, A is treated as having received payment for his corporate stock equal to the fair market value of the distributed property ($1,000,000) less the corporate tax liability assumed by A in the liquidation ($210,000). A receives $790,000 of payment in exchange for his stock with a $400,000 basis, resulting in long-term capital gain of $390,000 that is taxed at a maximum of 23.8%. As you may have noticed, these are the exact same tax consequences that would arise if the corporation had simply sold the building for cash and distributed the after-tax proceeds.

Summary

In summary, while A can get his building into the corporation without triggering the $600,000 of appreciation, he cannot get it out of the corporation — by sale or distribution — without incurring a tax liability of approximately $300,000. For this reason, a C corporation is not the ideal entity choice for A and his building.

Application to S Corporations

Section 351 applies equally to C and S corporations. Unfortunately, Sections 311(b) and 336 also apply equally to an S corporation. This means that if the S corporation distributes the property to A in either a non-liquidating or liquidating distribution, the S corporation will be treated as if it sold the property for its fair market value of $1,000,000, triggering $600,000 of corporate level gain.

Of course, S corporations – at least S corporations that are not subject to the built-in-gains tax (future Tax Geek Tuesday idea!) – do not generally pay tax at the corporate level. Instead, the $600,000 of gain will flow through to A who will pay tax on the income at the individual level, and the gain will increase his basis from $400,000 to $1,000,000 under Section 1367(a)(1). As a result, the distribution will not be taxed a second time at the shareholder level. If the distribution were of the non-liquidating variety, A would simply reduce his $1,000,000 stock basis by the $1,000,000 value of the building. If the property were distributed in a liquidating distribution, under Section 331 A would be treated as having received property worth $1,000,000 in exchange for stock with a basis of $1,000,000, resulting in no further gain or loss. .

Even with the favorable single-level taxation afforded S corporations, however, because of Section 331 A cannot take the property out of the corporation without incurring a tax bill of nearly $150,000 ($600,000 flow-through gain * 23.8% rate on LTCG or 25% rate on unrecaptured Section 1250 gain).

Application to Partnerships

So, what is it that makes partnerships such an attractive entity choice for holding real estate? For starters, just like corporations, appreciated property can be contributed to a partnership in exchange for a partnership interest without the recognition of gain. This is accomplished by virtue of Section 721, which works just like Section 351, only without as many restrictive rules.

For example, while Section 351 requires the transferor or a group of transferors to own more than 80% of the corporation immediately after the transfer in order to obtain tax-free treatment, Section 721 carries no such ownership requirement. Instead, an individual can transfer appreciated property to a partnership in exchange for as little as a 1% interest without triggering any gain.

Like Section 351, Section 721 is a deferral provision rather than an exclusion provision. Moreover, there are basis rules in Section 722 and 723 that mirror those previously discussed in Sections 358 and 362. Under these rules, when a partner transfers property to a partnership in exchange for an interest in the partnership, the partner takes a substituted basis in the partnership interest equal to his basis in the property contributed, and the partnership takes a carryover basis in the contributed property equal to the partner’s basis in the property.

Applying Section 721, 722 and 723 to our case study, A recognizes no gain on the transfer of property with a basis of $400,000 and a fair market value of $1,000,000 in exchange for a 50% interest in the partnership. A takes a basis of $400,000 in the partnership interest received, and the partnership takes a $400,000 basis in the real estate.

Liability Relief

It is much less likely that transferring mortgaged property to a partnership will create gain, because there is no parallel to Section 357(c) in subchapter K. Instead, a transferor of mortgaged property to a partnership must apply the principles of Sections 731 and 752 to determine if gain is recognized on the transfer, and as shown below, gain can be avoided in the partnership context where it would be required in subchapter C.

Section 752 provides that a partner increases his basis in the partnership interest for his share of the partnership liabilities. Conversely, if a partner’s share of the partnership’s liability decreases, the reduction is treated as a distribution of cash to the partner. Why do we care?

Because Section 731 provides that a partner will only recognize gain on a distribution if the cash (or liability relief) distributed exceeds the partner’s basis in the partnership interest.

Combiningg these rules with the partner basis rules of Section 722, it becomes much less likely that a partner contributing leveraged property to a partnership will recognize gain.

To illustrate, assume the property A contributes to the partnership has a basis of $400,000, a fair market value of $1,700,000, and is subject to a $700,000 mortgage. If the property were transferred to a corporation, Section 357(c) would apply and A would be required to recognize $300,000 of gain on the transfer for the excess of the liability over the tax basis of the property.

The partnership rules yield a different result. Under Section 722, A takes an initial basis in the partnership interest of $400,000. Then, under Section 752, A increases his basis to reflect his 50% share of the $700,000 liability that now belongs to the partnership, or $350,000, raising A’s basis to $750,000. Finally, because A has been personally relieved of 100% of the liability upon transferring it to the partnership, this debt relief is treated as a distribution of cash to A by Section 752. Under Section 731, A must reduce his outside basis by the deemed distribution of $700,000. As a result, A’s final outside basis is $50,000 ($750,000 – $700,000).

Because the deemed distribution of $700,000 did not exceed A’s basis immediately before the distribution, no gain is recognized by A on the transfer.

Distributions and Liquidations of Partnerships, In General

While appreciated property can go into a corporation free from tax, as shown above, it can’t come out without the corporation being required to recognize gain as if the property were sold for its fair market value. Partnership law, however, provides deferral rules governing both the contribution of property to a partnership as well as the distribution of appreciated property from a partnership.

Sections 731 and 732 combine to provide that when a partnership distributes property to a partner in a current distribution, generally no gain or loss is recognized by either the partnership or the partner. Instead, the partner simply takes a basis in the distributed property equal to the lesser of:

  • The partnership’s basis in the distributed property, or
  • The partner’s outside basis in his partnership interest.

This nonrecognition treatment is extended to liquidating distributions as well. If a partnership transfers property to a partner in liquidation of the partnership, no gain is recognized by either the partnership or the partner; rather, the partner simply takes a basis in the property equal to the partner’s remaining basis in the partnership interest, after reduction for any cash received or debt relief.

And this is why partnerships are the vehicle of choice for holding real estate. Put a building in a C corporation, and it’s not getting out – either by sale or distribution – without triggering two levels of tax. Contribute the property to an S corporation instead, and the property can’t come out without triggering corporate-level gain. But place appreciated real estate into a partnership, and you receive the gift of flexibility; you can always undo your previous decision and distribute the building without recognizing gain at either the partnership or individual level.

Assume A and B transfer their respective properties to a partnership, and the value of the building increases from $1,000,000 to $2,000,000 while the tax basis of the building decreases from $400,000 to $300,000. Assume further that A’s basis in his partnership interest has also decreased from $400,000 to $250,000.

If the partnership distributes the building to A, neither A nor the partnership will recognize any gain on the distribution, despite the fact that the building’s fair market value of $2,000,000 greatly exceeds its tax basis of $300,000. Upon the distribution, A will take a basis in the building equal to the lesser of:

  • The partnership’s basis in the building of $300,000, or
  • A’s basis in his partnership interest of $250,000.

Thus, A reduces his basis in the partnership from $250,000 to zero and takes a $250,000 basis in the building.

If instead, the partnership liquidates and distributes the building to A in liquidation of his 50% interest, neither the partnership nor A will recognize gain. Instead, A will simply take a basis in the distributed building equal to A’s basis in the partnership interest, or $250,000.

Of course, these favorable distribution rules also operate on deferral principles; should A turn around and sell the property, the pre-distribution appreciation inherent in the building will be triggered by virtue or A’s modified carryover basis in the building. This still represents a tremendous advantage over the corporate regime, which forces the hand of the shareholder upon distribution by requiring the corporation to recognize all appreciation at the time of distribution. And that, above all other reasons, is why partnerships have become the entity of choice for holding real estate.

Got an idea for a future Tax Geek Tuesday? Send it along to anitti@withum.com or on twitter @nittigrittytax

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Guillermo Arguello worked for Guggenheim Investments, a conglomerate of entities of uncertain purpose. Mr. Guggenheim struck up a business relationship with another corporation, Netrostar, that was intended to be symbiotic: Guggenheim Investments would share customer lists and provide financing, while Netrostar would provide web development work to the Guggenheim entities.

Times got tough at Netrostar, and Arguello, who performed some small bookkeeping services for the company, was asked to help bail it out.

First, Arguello spent $24,000 on a used Alfa Romeo that was needed — for some odd reason — to keep Netrostar alive, and sold it to the company in exchange for a note.

In addition, Arguello cosigned Netrostar credit card debt in excess of $35,000.

At the end of 2007, Arguello was still owed $21,000 on the Alfa Romeo note, and he was justifiably getting antsy with his precarious position as creditor of a dying corporation. As a result, Mr. Guggenheim worked up an agreement by which Netrostar would pay Arguello an additional $2,000 towards the note, and then Arguello would “forgive” the remaining $19,000 balance in exchange for his release as cosigner of the credit card debt.

On his 2007 tax return, Arguello claimed a worthless debt deduction of $19,000. The IRS promptly denied the debt, arguing that it had not become worthless during 2007.

Relevant Law

Under Section 166, a taxpayer is entitled to a deduction for a debt, business or nonbusiness, that becomes wholly or partially worthless during the taxable year. There is no standard test for determining worthlessness; whether and when a ebt becomes worthless depends on all the facts and circumstances.[i] In general, the year of worthlessness must be established by identifiable events constituting reasonable grounds for abandoning any hope of recovery.[ii]

The Tax Court concluded that Arguello’s receivable from Netrostar did not become worthless during 2007, primarily because the debt was not forgiven due to Netrostar’s inability to pay, but rather in exchange for getting Arguello off the hook for this co-signed credit card debt:

We cannot assume, and do not find, that as of the close of 2007, Netrostar’s financial condition, although shaky, prompted petitioner to relinquish his rights to collect the balance on the note. The evidence shows, and we find, that the debt was extinguished not so much on account of Netrostar’s ability or inability to pay, but rather pursuant to an arrangement that allowed petitioner to avoid potential liabilities in connection with the credit card accounts.

The court summarized its decision thusly:  “A debt is not worthless where the creditor for considerations satisfactory to himself voluntarily releases a solvent debtor from liability.”

The takeaway lesson, of course, is that in today’s economy, where debts are being forgiven left and right, when you are on the creditor side there is a distinction between a debt becoming uncollectible and simply forgiving the debt in exchange for some form of noncash consideration. Under the tax law, the debtor must establish that the debt has become wholly or partially worthless in order to secure a bad debt deduction.


[i] Dallmeyer v. Commissioner, 14 T.C. 1282, 1291 (1950).

[ii] See Crown v. Commissioner, 77 T.C. 582, 598 (1981).

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Like me, Richard Cohen is a CPA who hails from the Garden State. Unlike me, Richard Cohen just lost millions of dollars at the hands of an apathetic IRS.

Cohen’s wife served as an executrix for an estate which held uncashed dividend checks from a public corporation. Due to some shenanigans, Cohen started to suspect that the corporation was retaining the proceeds from these uncashed dividend checks without including the amounts in taxable income.

In pursuit of hard evidence, Cohen requested information from the State comptroller under the Freedom of Information Law, and also reviewed allegations in pleadings from a civil case against the corporation. Cohen’s findings only buoyed his belief that the corporation was up to no good; with the amount of improperly retained unclaimed assets possibly reaching into the hundreds of millions.

At that point, Cohen filed a whistleblower claim with the IRS on Form 211, Application for Award for Original Information. As you may or may not know, Section 7623 provides that an individual who provides information that leads the IRS to pursue an administrative or judicial action against a taxpayer is entitled to receive an award equal to a percentage of the tax dollars collected by the IRS. [Ed note: pick the right taxpayer, and you can get paid $100 million, even if you're a convicted criminal].

Despite the fact that Cohen felt the IRS had a strong case against the corporation, a mere two weeks after he filed his application he was notified by the IRS that no action was commenced and no tax dollars recovered from the corporation; thus, Cohen was not entitled to an award.

Understandably frustrated, Cohen sued the IRS, presenting the Tax Court with an issue of first impression: Could the court force the IRS to pursue a case against the corporation, so that Cohen would be eligible for a future whistleblower award?

Interpreting the statute literally, the Tax Court held against Cohen and declined to compel the IRS to reopen the whistleblower case. In reaching its decision, the court noted that Section 7623 requires a condition precedent to the issuance of a whistleblower award: the IRS must first commence an administrative or judicial action against the accused taxpayer, and tax dollars must ultimately be collected.

In this case, because the IRS did not see fit to pursue the corporation for its alleged unclaimed assets, no award could be given. Equally as important, the Tax Court established a precedent for future whistleblower decision by concluding that it lacked the authority to direct the IRS to pursue a case; rather, it’s jurisdiction was limited to determining whether an award should be given after a case has been pursued and tax revenue collected.

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The Obama administration addresses the math behind Mitt Romney’s $1 trillion $5 trillion tax cut. Wait…what?

Nation’s pastors agree to take a Sunday off from decrying same-sex marriage; taunt IRS instead.

From the WSJ: Be advised, the last chance to undo a Roth IRC conversion is October 15, 2012.

Xzibit — of “Pimp My Ride” fame — owes the IRS $130,000 for 2011. Weird, I would have thought that a guy who installs custom fish tanks into Honda Civics would understand the need for conservative spending and sound investment.

Could the U.S. really do away with corporate interest deductions?

Often ignored in the presidential campaigning is the growing problem of violence in the suburbs:

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One hundred thousand views in a little over a year. That’s not too shabby. Though a closer inspection of this site’s hits reveals that many of our guests have stopped by unintentionally, and by the looks of it, left considerably disappointed. Below is a list of the Top 6 search terms that have led internet users to Double Taxation since its inception:

Canyonero: 886 (The fact that nearly 1,000 people came here because they were searching for the fictional SUV endorsed by The Simpsons’ Krusty the Clown warms my heart and renews my faith in humanity.)

Power Rangers Porn: 620 (For obvious reasons, this instantly renews my disgust for humanity)

Double Taxation: 606 (Picking a good blog title is key. Search engine optimization!)

Power Ranger Porn: 391 (You should all be ashamed of yourselves. Perverts.)

Tax Law Changes for 2013: 270 (I’m not sure what it says about the content of this site that it took until our fifth search term to yield a result that I actually wrote about.)

Things get slightly more comforting when we look at the most-read posts in our 16-month history:

Tax Planning for the 2013 Law Changes 3,038
IRS Clarifies Interplay Between Luxury Auto Depreciation   Limits and 100% Bonus Depreciation, Long National Nightmare Finally Over   2,403
IRS Issues Luxury Audit Limits, Fails To Acknowledge   Potential Problem 1,873
Power Ranger Porn, Google Rip-Offs, and Homicidal   Accountants: Just Another Day in the Tax Court 1,591
Presidental Candidate Tax Comparison: Update 1,345

Two things can be gleaned from this data:

1. People really seem to care about luxury audit for some reason, and

2. If you want to get page hits, here’s a simple yet full-proof business plan for any blog:

Phase 1: Put “porn” in title

Phase 2: ?????

Phase 3: PROFIT!

On the tax front, in advance of tonight’s presidential debate, Mitt Romney has finally started to cave to continuing pressure to share some details regarding his tax proposals; particularly, how he plans to keep his 20% acr0ss-the-board rate cuts revenue-neutral while not shifting the tax burden away from the rich and towards the middle class. In a speech given this week, Romney indicated that he might cap deductible itemized deductions at $17,000 per individual.

There are still a number of details missing — particularly whether the $17,000 would be doubled for MFJ and how the cap would handle credits — but according to Bloomberg, this cap is just the first in a three-part plan to achieve Romney’s tax goal of a cutting tax rates by 20% while remaining revenue neutral and progressive. From Bloomberg:

A second cap would apply to personal exemptions and a third cap would apply to the health care exclusion. The amount and details of the caps could be changed to meet Romney’s targets for revenue and distribution of the tax burden. The aide emphasized that the three-cap idea is only one option being considered.

While devoid of the details necessary to formulate any meaningful conclusion, it’s hard to see how this is a step in the right direction in achieving progressive, revenue-neutrual tax reform while also cutting rates. A study conducted by the Tax Policy Center earlier this year concluded that Romney would have to eliminate all deductions for those taxpayers earning in excess of $200,000 before limiting those deductions to a lesser extent to those earning below the threshold in order to pay for his tax cuts in a progressive manner. Clearly this proposal does not accomplish those goals, as it allows those earning over $200,000 to retain some of their deductions, while providing the same limitation to those earning below the threshold.

The key, in my mind, is how the third cap would treat excludable health care benefits, as this preference largely benefits the middle class. Do away with the Section 105 exclusion, and you will likely be right back to shifting the burden of tax increases to those taxpayers earning less than $200,000.

What I do like about Romney’s proposal, however, is that he could avoid the morass of trying to eliminate deductions and preferences from the Code, as any attempt to do so would leave special interest groups fighting to the death for their particular provision. By instituting a cap,  you leave the mortgage interest deduction untouched, leave the state and local tax deduction, and leave the charitable contribution deduction in the Code, but cap their benefit. While this doesn’t neceessarily achieve the simplicity one seeks when base broadening, as it leaves those provisions in the Code, as we’ve discussed here before, sweeping Code reform isn’t particularly likely anyway.

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Yesterday, the Supreme Court of the United States denied certiorari to a tax case on an issue of first impression from the U.S. Court of Appeals for the Eighth Circuit — David E. Watson P.C. v. U.S., 668 F.3d 1008 (8th Cir., 2012).

You may remember Watson from our previous discussion here, or from this brilliantly written article in the Tax Adviser. Either way, Watson directly impacts tax advisors as it provides a long-awaited roadmap for quantifying a “reasonable compensation” amount for shareholder/employees in personal service S corporations.

Background

In late 2010, an Iowa district court held that David Watson, a partner with a CPA firm who paid himself only $24,000 in annual salary while taking out over $200,000 in annual distributions, had avoided payroll taxes by failing to pay himself reasonable compensation. Because Watson actually reported some compensation, however, the court was facing an issue of first impression: determining just what constituted “reasonable compensation” for Watson’s services. The resulting analysis provided the first court-approved roadmap for tax advisers to use in setting appropriate salary amounts for their S corporation shareholder-employee clients.

In setting Watson’s salary, the IRS engaged the services of a general engineer, who first sought to determine the health of Watson’s CPA firm. By analyzing financial ratios published by the Risk Management Association — particularly profits/sales and compensation/sales – the engineer found that Watson’s firm was very healthy, and that compared to similarly healthy firms, Watson’s compensation was unreasonably low.

The court then looked internally at Watson’s firm, noting that Watson was paid less than those subordinate to him. In fact, Watson’s salary was less than what the firm was paying recent college graduates.

Finally, to quantify the appropriate salary, the engineer utilized MAP surveys conducted by the AICPA, which indicated that the average non-owner director of a CPA firm the size of Watson’s would be paid $70,000. The engineer then grossed up this salary by 33% to account for Watson’s stake as a shareholder, resulting in “reasonable” compensation of $93,000 for each of 2002 and 2003.

The District Court agreed, citing Watson’s experience, expertise, and time devoted to his role as one of the primary earners at a well-established firm.

In February 2012, the Eighth Circuit Court of Appeals affirmed the District Court’s decision. Watson appealed once more to the Supreme Court, but saw that dream die yesterday.

With Watson apparently in the books as concluded tax law, now is an appropriate time to remind ourselves what we can take away from this important decision:

What Can We Learn?

Above all else, Watson established that the IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing. At a minimum, in setting the compensation of our S corporation shareholder-employee clients, we must consider the following:

1. Nature of the S Corporation’s Business. It is no coincidence that the majority of reasonable compensation cases involve a professional services corporation, such as law, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated primarily by the personal efforts of the employees, and as a result, a significant portion of the profits should be paid out in compensation rather than distributions.

2. Employee Qualifications, Training and Experience, Duties and Responsibilities, and Time and Effort Devoted to Business. A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. The greater the experience, responsibilities and effort of the shareholder-employee, the larger the salary that will be required.

3. Compensation Compared to That of Non-shareholder Employees or Amounts Paid in Prior Years.  Here, common sense rules the day. In Watson, a CPA with significant experience and expertise was  paid a smaller salary than recent college graduates. Clearly, this is not advisable.

4. What Comparable Businesses Pay for Similar Services. Tax advisors should review basic benchmarking tools such as monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared to industry norms.

5. Compensation as a Percentage of Corporate Sales or Profits. Tax advisors should utilize industry specific publications such as the MAP to determine the overall profitability of the corporation and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, comparisons should be made to similarly sized companies within the same geographic region. If the resulting ratios indicate that the S corporation is more profitable than its peers but paying less salary to the shareholder-employee, tax advisors should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norm provided for in the publications is likely necessary.

6. Compensation Compared With Distributions. While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that all profits be paid out as compensation. Though the District court in Watson recharacterized significant distributions as salary, it permitted Watson to withdraw significant distributions in both 2002 and 2003. Perhaps the court was content to recharacterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue. In doing so, the payroll tax savings on Watson’s remaining distributions amounted only to the 2.9% Medicare tax.

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