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The IRS Is Not Obligated to Pursue Your Whistleblower Claim

Posted in Uncategorized, tagged , , , , , , on October 10, 2012 | 1 Comment »

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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IRS Rules That State Law Doesn’t Dictate Whether Two Properties Are Like Kind

Posted in Uncategorized, tagged , , , , , , on September 24, 2012 | 2 Comments »

Under the tax law, taxpayers are afforded favorable treatment when instead of selling appreciated property, they “exchange” it for other property; the idea being that the taxpayer has not cashed out its investment in the property, but rather simply changed the form of the investment.

Specifically, Section 1031(a) of the Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

Stated simply, a taxpayer recognizes no gain if instead of selling appreciated property, they exchange it for property that is “like kind.” And this, as you can imagine, is where issues arise. What is “like kind” property? The regulations offer scant guidance:

Section 1.1031(a)-1(b) of the regulations provides that the words “like kind” have reference to the nature or character of the property and not to its grade or quality. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.

This much is clear, however: This like-kind requirement precludes a taxpayer from exchanging real property for personal property, or vice versa.

As a result, over the years numerous court cases have sought to answer the question of whether Property A was “like kind” to Property B by looking to state law classifications. For example, in Commissioner v. Crichton[i], the 5th Circuit determined that a mineral right was real property under Louisiana state law and thus of like kind to other real property. Similarly, in Peabody Natural Resources Co. v. Commissioner[ii], the Tax Court determined that under New Mexico law, coal supply contracts constituted real property interests and were of like kind to the relinquished gold mine.

These decisions have led some practitioners to question whether state law classifications are in fact determinative in concluding whether two properties are of like kind. Last Friday, in PLR 201238027, the IRS clarified that state law classifications, while relevant, are not determinative of whether properties are of like kind. Rather, all facts and circumstances should be considered.

In the Ruling, the IRS presented four scenarios. In each of the four scenarios, similar properties were exchanged for one another. Under state law, however, the properties were classified differently. For example, in Case 1, a natural gas pipeline in State A (constructed along a right of way on real property) that was classified as personal property in State A was exchanged for a State B natural gas pipeline that was  constructed along a right of way on real property and that was classified as real property in State B. (The right of ways associated with the exchanged pipelines in State A and State B are also exchanged.)

The IRS declined to base its decision as to the like kind nature of the properties solely on their respective state law classifications. Instead, the Service looked to certain informative sections of the Code to glean how they classified property as personal or real, specifically, Sections 48, 263A, and 1245:

For example, § 1.263A-8(c)(1) of the regulations provides, in part, that real property includes land, unsevered natural products of land, buildings, and inherently permanent structures. Section 1.263A-8(c)(3) describes “inherently permanent structures” as including “property that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time, such as swimming pools, roads, bridges, tunnels . . . telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment. . . .”

Section 1.48-1(c) of the regulations provides in part, that for purposes of § 1.48-1, the term “tangible personal property” means any tangible property except land and improvements, including structural components of such buildings or structures. It further provides that “production machinery, printing presses, transportation and office equipment. . . contained in or attached to a building constitutes tangible personal property for purposes of the credit allowed by section 38.”  

Finally, § 1245(a)(3) provides that “§ 1245 property” is any property which is or has been subject to depreciation under § 167 and which is either personal property or other tangible property used as an integral part of certain activities, including manufacturing.  

Acknowledging that relying solely on state law classifications could yield absurd results – for example, in Case 1 where identical pipelines are exchanged but their respective states classify them as personal and real property, respectively, treating the properties as not being like kind would make little sense – the IRS concluded the basic nature and character of the property involved should override the state law treatment.

Applying these concepts to Case 1, since both pipelines were inherently permanent structures that were affixed to real property that will remain for an indefinite period of time, they both qualified as real property under the definition found at Regulation Section 1.263A-8(c)(1). Thus, the exchange of one pipe line for the other qualified as a like kind exchange under the meaning of Section 1031.

[i] 122 F.2d 181 (5th Cir. 1941).

[ii] 126 T.C. 261 (2006).

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IRS Won’t Audit Compliance With the Individual Insurance Mandate

Posted in Uncategorized, tagged , , , , , , , , on September 12, 2012 | 2 Comments »

From CNBC:

The Internal Revenue Service on Tuesday assured congressional lawmakers that agents would play no role in enforcing the controversial requirement that Americans buy insurance under President Barack Obama’s health care overhaul. IRS revenue agents will not be involved. There will not be audits,” IRS Deputy Commissioner Steven Miller told a subcommittee of the tax-writing Ways and Means Committee in the Republican-controlled House of Representatives.

Thank goodness. This frees up agents to go about their normal activities, which according to the Tax Court, consists primarily of not substantiating their tax deductions and improperly claiming hobby losses.

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Wells Fargo Denied Deduction in District Court, Immediately Raises All ATM Fees to $17 to Make Up Difference*

Posted in Uncategorized, tagged , , , , , , , , , on August 16, 2012 | 1 Comment »

Citation: Wells Fargo & Company v. U.S, (DC MN 8/10/2012) 110 AFTR 2d ¶ 2012-5188

Gather round children, whilst I tell a tale of the most widely-read but poorly-written book of all time, 50 Shades of Grey the Internal Revenue Code.

Our story is set in the destitute great state of California.  Our central figure is the national banking chain of Wells Fargo. Like all corporations operating in California, Wells Fargo pays taxes each year for the privilege of doing business within the state.  The tax is based on the income earned in Year 1, but is paid for the privilege of doing business within the state in Year 2.  Importantly, the tax is actually paid in Year 1 in the form of estimated payments.

Under California state law as it has existed since 1972, the tax Wells Fargo pays based on its Year 1 income for the privilege of doing business in Year 2 is not refundable. To illustrate, even if Wells Fargo pulled out of California on Day 1 of Year 2, it is still required to pay the tax for the right to conduct business in Year 2.

As an accrual basis taxpayer, this led Wells Fargo to believe that it could safely accrue the state tax deduction at the end of Year 1, as it would have satisfied the “all-events” test at that time.

As a reminder, meeting the all-events test is required under I.R.C. § 461 in order for an accrual basis taxpayer to deduct a liability. The all events test requires an accrual basis taxpayer to jump through three hoops:

1. The fact of the liability must be fixed. In simple terms, this means that whatever event that is necessary to give rise to Well Fargo’s requirement to make payment has occurred by the end of Year 1.

2. The amount can be determined with reasonable accuracy, and

3. Economic performance has occurred.

Wells Fargo, quite naturally, took the position that all three prongs of the all-events test were met. The fact of the liability was fixed at the end of Year 1, it argued, because the amount due could not be refunded in Year 2, regardless of whether or not Wells Fargo conducted business within California. Furthermore, the amount of the liability could be determined with reasonable accuracy, as the liability was based on Year 1, rather than Year 2 income. And finally, economic performance had occurred, because under Regulation Section § 1.461-4(g)(6), economic performance occurs with respect to a liability for taxes as it is paid, which Wells Fargo did during Year 1 in the form of estimated payments.

Unfortunately for Wells Fargo, their deduction was not to be. And why not? Because of an arcane remnant left over the in the statute at I.R.C. § 461(d). Section 461(d) provides:

In the case of a taxpayer whose taxable income is computed under an accrual method of accounting, to the extent that the time for accruing taxes is earlier than it would be but for any action of any taxing jurisdiction taken after December 31, 1960, then, under regulations prescribed by the Secretary, such taxes shall be treated as accruing at the time they would have accrued but for such action by such taxing jurisdiction.

That’s a bit confusing, so allow me to clarify: this rule provides that if a state changes its tax laws after 1960 — and, as a result of that change, the accrual date of the payment of state taxes is moved up to an earlier year — then the change in the state tax laws is ignored for purposes of federal tax law. In other words, it is the state law that was in place in 1960 that governs the timing of a deduction for federal income tax purposes. If that state law is changed post-1960 to a allow for a more favorable, accelerated deduction, the change is ignored. As the District Court explained in reaching its decision, “Time stands still in this tiny corner of the federal tax world.”

Now, that provision on its own wouldn’t be problematic. But as indicated above, the general rule that the tax paid by California corporations such as Wells Fargo in Year 1 for the right to do business in Year 2 was not refundable didn’t come to be until 1972. Prior to 1972, if a business pulled out of California in Year 2, it could be refunded the tax paid in Year 1, either in part or in full.

In other words: Before 1972 = California state law said the Year 1 tax could be refunded.

                                After 1972 = California state law said the Year 1 tax could not be refunded.

And for some reason no one can explain, the Internal Revenue Code continues to provide that when determining whether a liability to pay California taxes is fixed at the end of Year 1, it is the state law in effect in 1960 that governs, despite the rather relevant fact that we currently reside in the year 2012.

Faced with these facts and the language in I.R.C. § 461(h), the District Court had no choice but to hold that the all-events test had not been met at the end of Year 1. Because under the state law in place in 1960, if Wells Fargo left California  on Day 1 of Year 2 it would receive a refund of the entire liability, the Year 2 liability was not fixed at the end of Year 1. The fact that a new law had been in place for 40 years providing that the Year 1 tax was not refundable was irrelevant.

The lesson? Cut us tax people some slack. When you ask us a question and we don’t feel comfortable giving an off-the-cuff answer, it’s not an indication that we’re not knowledgeable. Rather, our trepidation is the the result of being burned enough by outdated or inexplicable sections of the Code and regulations to know that we’d better check things out before we commit to a response.

*second thing may not have happened.

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Prince of Bel Air Denied Ordinary Loss (Alternate Title: Lying on Your Loan Application Might Bite You in the Ass)

Posted in Uncategorized, tagged , , , , , on July 12, 2012 | 1 Comment »

Remember the good ol’ days when the real estate market was so prosperous, every schlub on the street was buying land, building a spec home and selling for a tidy profit?

Those days are long gone, but pity those who built their spec home right before the crash, who instead of walking away with a pile of money were rewarded for their efforts with a large loss and financial ruin.

To soften the blow, many of these unfortunate investors will argue that they were in the trade or business of constructing spec homes — even when they only had one build on their resume  –  so as to deduct the loss as ordinary on their income tax return.

The IRS, of course, will argue the opposite: that the spec house was not constructed for sale in “the ordinary course of business” and thus was a capital asset, limiting the taxpayer to a capital loss that can only offset capital gains, plus an extra $3,000.

Now understand this: determining whether a piece of developed property is inventory — thus generating an ordinary loss — or an investment — generating capital loss — is not an open and shut analysis. This is, as much as any analysis in the tax law, an inquiry that is dependent on the facts and circumstances of each case.

Throughout the years, the courts have produced an impressive volume of case law on this “dealer versus investor” issue, and as a byproduct, a list of factors have evolved to aid in the analysis. While typically, the argument centers on the other, income, side of the equation —  with taxpayers pleading for capital gain treatment while the IRS pushes for ordinary income — these factors prove equally helpful in determining the character of a loss resulting from an isolated sale of developed real estate.

Consider the case of Darron (not a misspelling) Bennett, a self-described “serial entrepreneur” who decided to try his hand at developing a home in Carlton Banks’ hood – the Bel Air neighborhood of Beverly Hills.

In 1997, an old friend roped Bennett into taking a piece of raw land located in Bel Air off his hands. Bennett called Nevada home at the time, but he would spend 85% of his time at the Bel Air site handling the “design side” of the home construction.

In 1999, Bennett refinanced the property for $2,500,000, and on his loan documentation he indicated that he would occupy the home as his primary residence. One year later, he’d refinance again, this time indicating that he would not occupy the home as his primary residence.

In 2001, Bennett sold the unfinished home for $4,000,000, realizing a loss of $1,300,000 that Bennett deducted as an ordinary loss on his 2001 Form 1040.

The IRS denied the loss, arguing in the alternative that:

1. The house was intended to be Bennett’s primary residence, so any loss on the home was an unallowable personal loss under Section 165(c), or

2. The house was a capital asset — not a business asset — and thus the resulting loss was capital.

The Tax Court made short work of the first argument, holding that there was no evidence that Bennett intended to occupy the home as his primary residence. While he indicated on his loan application that he would do so, the court acknowledged that it is common practice for borrowers to fudge those applications in search of better lending terms, so the court disregarded this minor slip-up on Bennett’s part.

With regards to the second argument, a full-blown analysis was required. The following factors, developed by the Ninth Circuit, were used to determine if the Bel Air home was an investment property or inventory:

  1. The nature of the acquisition of the property,
  2. The frequency and continuity of sales over an extended period,
  3. The nature and the extent of the taxpayer’s business, and
  4. The activity of the seller about the property.

The Tax Court ultimately concluded that the Bel Air home was not built for sale in the ordinary course of business to customers, and thus generated capital, rather than ordinary loss. Relevant points for each factor were as follows:

1. The nature of the acquisition of the property:

The court decided this factor in favor of Bennett, concluding that because the home was not to be used as a primary residence, and because Bennett had enlisted the help of an architect/builder to help develop a saleable property, the Bel Air home was meant to be sold.

 2. The frequency and continuity of sales over an extended period:

While previous courts have held that very few sales can still reach the level of a trade or business, the Tax Court refused to do so in this case, deciding this factor against Bennett. There was no preexisting arrangement at the time Bennett acquired the property to quickly resell it, a fact that distinguished Bennett’s facts from previous taxpayer-friendly decisions.

3. The nature and the extent of the taxpayer’s business:

The fact that Bennett did not previously, or subsequently, engage in real estate development — exacerbated by the fact that he improperly reported the activity from the Bel Air property throughout the years on his tax return — convinced the court to decide against Bennett on this factor.

4. The activity of the seller about the property:

Bennett did himself no favors here. He hired a friend as his realtor. He never tried to advertise the property or prepare for the sale of the property. In fact, Bennett testified that he was “just trying to be rid of the property.” Add these up, and the court was obligated to decide against him here, and ultimately conclude that the property was not held for sale in the ordinary course of business.

What’s the lesson? If you’re one of the unfortunate souls still trying to unload a spec home you built pre-2008 and you’re angling to take an ordinary loss, you need to know the factors, and behave accordingly. Run it like a business, keeping books and records. Try like hell to sell the property through advertising, hiring unrelated brokers, etc… And for god’s sake, don’t admit you were “just trying to get rid of it.”

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Weekend Roundup

Posted in Uncategorized, tagged , , , , , , on July 9, 2012 | Leave a Comment »

A few things you may have missed while partaking in a great American tradition: losing a few fingers to an M-80 left over from the 4th of July.

R&B singer Rihanna rencently accused her accountants of making off with “tens of millions” of her hard-earned dollars. Don’t weep too hard for her, however, as her mentor Jay-Z reportedly paid her back with some cash he found in the pocket of a rarely-worn pair of jeans.  

Looking for work? The Supreme Court’s decision to uphold the individual insurance mandate may single-handedly put a halt to those rising unemployment numbers. First comes the news that the IRS will need to add thousands of workers to manage the numerous tax law changes found in the Patient Protection Act. And if you fancy yourself more of the artistic type, feel free to chip in and help pen the 13,000 pages of regulations it’s going to take to enforce the new law.

Maine Governor calls the IRS the “new Gestapo,” which I believe is a mildly popular form of  soup that is commonly served cold.

AIG is suing the IRS for a $30.2 million tax refund dating back to 1991. Of course, AIG is owned 61% by the U.S government, so essentially, the U.S. is suing the U.S., with any trial presumably taking place at the nexus of the universe.

Lets be honest, after the holiday week, we’re all kind of easing our way back into this Monday. This should help.

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Section 83(b) Elections, Examined

Posted in Uncategorized, tagged , , , , , , , on June 26, 2012 | 4 Comments »

The IRS will soon be publishing Revenue Procedure 2002-29, which will add some clarity to the risks of making a I.R.C. § 83(b) election while also providing some helpful sample language. Let’s get right to the Q&A:

Q: Remind me what I.R.C. §  83 says?

A: That’s really not a question, it’s more of a directive, but fine. We’ve covered it here and here, but in general, I.R.C. § 83 provides that if you provide services for someone (whether past, present, or future) and that person compensates you by paying you in property, the excess of the FMV of the property over the amount you paid to acquire it is taxed as compensation income.

Example 1: You provide services for your employer. Your employer, in turn, pays you in unrestricted, freely transferable stock valued at $100 and requires you to pay $0 to obtain the stock. Under I.R.C. § 83, you will recognize ordinary income of $100 upon the receipt of the stock.

Q: So then what’s a Section 83(b) election?

A: Here’s the catch. Under I.R.C. § 83, the service provider (you) are only taxed on the property you receive when that property is EITHER:

1. no longer subject to a substantial risk of forfeiture, or

2. freely transferable.

This is a concept that confuses many tax advisers. Property must be subject to BOTH conditions in order for the recipient to defer the recognition of taxable income. The moment the property either becomes transferable or no longer subject to a substantial risk of forfeiture, the recipient must recognize taxable income.

Q: So you get to defer the income? Isn’t that a good thing?

A: Contrary to popular opinion, income deferral — like Radiohead and Johnny Depp  – isn’t always great. Here’s the thing…under the general rule of I.R.C. § 83, when the property becomes either freely transferable or no longer subject to a substantial risk of forfeiture, the service recipient (you) will be taxed on the FMV of the property at that time. Thus, if the value has increased substantially from the date it was first granted to you until the date the restrictions lapse, you will pay for your deferral with an increased income recognition.

Example 2: If the $100 in stock in Example 1 was subject to a substantial risk of forfeiture — i.e., you were required to remain employed for 2 years in order to “vest” in the property — you would not be taxed upon receipt of the $100 in stock in year 1. Instead, your income would be deferred until you vested in year 3. At that point, if the value of the stock had increased to $400, you would be required to recognize $400 of compensation income, as opposed to the $100 in the previous example.

Q: So where does the election come in?

A: Section 83(b) and Treas. Reg. § 1.83-2(a) permit the service provider (you) to elect to include the excess of the FMV of the property at the time of transfer over the amount paid for the property as compensation for services at the time of the transfer, rather than when the restrictions lapse. Thus, in Example 2, even though the stock did not vest until year 3, you could elect under I.R.C. § 83(b) to include the $100 in income in year 1.

Q: Why would you choose to accelerate income?

A: Because in some situations, as illustrated above, if you don’t make the election, you will recognize more ordinary income when the property vests if the FMV of the property increases. In other words, when you make an I.R.C. § 83(b) election, you are betting that the value of your nonvested property will increase. By making the election, you are capping your ordinary income at the FMV on the date of transfer. Any subsequent appreciation will only be recognized upon a subsequent disposition of the property, likely as capital gain.

Q: You said something in the intro about risks. What’s the downside?

A: The downside is obvious, and quite painful. If you make an I.R.C. § 83(b) election to include the FMV of restricted property in income at the date of grant and the value subsequently decreases, well…then you just voluntarily accelerated more income than necessary. It is, as I said, a gamble.

Q: Any other risks?

A: There sure are. Say you don’t actually vest in the property; for example, you don’t put in the two years required to vest in the stock in the illustration above. The regulations provide that you don’t get a deduction for the amount you voluntarily took into income; rather, you may recognize a loss equal to the amount paid for the property less any amount realized on the sale.

To illustrate just how painful this can be, assume you made the election to include the stock worth $100 in income in year 1, expecting the value to increase before you vested in year 3. You decide to leave the company in year 2, however, and never vest, forfeiting the property back to your employer for no consideration. Your loss is limited to $0 (the amount you paid for the stock), even though you included $100 in taxable income. Ouch.

Q: When/How do I make the election?

A: An election made under I.R.C. §  83(b) must be filed with the Internal Revenue Service no later than 30 days after the date that the property is transferred to the service provider. This is done so as not to give you the benefit of too much in the way of hindsight as to the change in value of the restricted property.

The election is made by filing a copy of a written statement with the Internal Revenue Service office with which you file your return. In addition, you’re required to submit a copy of such statement with your income tax return for the taxable year in which such property was transferred. The statement must be signed by the person making the election and must indicate the election is being made under I.R.C. §  83(b). The statement must include the following information: the name, address and taxpayer identification number of the taxpayer; a description of each property with respect to which the election is being made; the date or dates on which the property was transferred and the taxable year for which such election is being made; the nature of the restriction or restrictions to which the property is subject; the fair market value at the time of transfer of each property with respect to which the election is being made; the amount, if any, paid for such property; and a statement to the effect that copies have been furnished to other persons as provided in Treas. Reg. § 1.83-2(d).

Q: So what did Revenue Procedure 2012-29 add?

A: Not much.  The RP added some clarity, but mostly provided sample language that can be used in making the election, likely because the IRS has read your Facebook status updates and realized that rudimentary writing skills have gone the way of the dodo.

For text of the sample election, click RP 2012-29.

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IRS Provides Guidance for Partnership COD/Partner Insolvency

Posted in Uncategorized, tagged , , , , , on May 29, 2012 | 1 Comment »

Late last week, the IRS announced that it will be publishing Revenue Ruling 2012-14, which will provide guidance for determining the amount of a partnership’s nonrecourse liabilities a partner is permitted to include in his measurement of insolvency for purposes of applying the exception to cancellation of indebtedness income found at I.R.C. § 108(a)(1)(B).

That’s quite the mouthful, so let’s break it down into more easily digestible parts so we can understand why Revenue Ruling 2012-14 may be important:

  • Section 61(a)(12) provides that gross income includes income from the discharge of indebtedness. This is a natural and logical result, because being forgiven of a debt is an accession to wealth; if someone loans you $100 and you don’t pay it back, you’re $100 richer and should therefore recognize taxable income. As the economy and real estate values have tanked in the past few years, many taxpayers have been unable to service their loans or mortgages, bringing the COD rules to the forefront of the tax law.
  • Section 108(a)(1)(B) provides an exclusion to the general rule found in I.R.C. § 61, generally excluding discharged indebtedness from a taxpayer’s gross income if the discharge occurs when the taxpayer is insolvent. Section 108(a)(3) limits the amount of income excluded by reason of I.R.C. § 108(a)(1)(B) to the amount by which the taxpayer is insolvent.

What’s the point of the insolvency exclusion? Believe it or not, Congress can, at times, be rational. If a taxpayer cannot service his debt, it seems rather silly to tack on a tax bill for the amount of any forgiven loans. A taxpayer who owes more than they own should be given the opportunity to receive a “fresh start;” one that wouldn’t be possible if the forgiven debt was included in taxable income. Of course, that only makes sense if the taxpayer is insolvent at the time of the debt discharge. If the taxpayer is solvent, they presumably would have the ability to pay the tax associated with the debt discharge.

  • Section 108(d)(3) of the Code defines “insolvent” as the excess of liabilities over the fair market value of assets. That section further provides that whether a taxpayer is insolvent, and the amount by which the taxpayer is insolvent, is determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.
  • Unfortunately, nowhere does I.R.C. § 108 actually define the term “liabilities,” causing a bit of confusion when trying to determine whether a taxpayer who has benefitted from the cancellation of indebtedness is in fact insolvent.
  • Confusing matters even more, while C and S corporations must determine insolvency at the entity level, forgiven partnership debt doesn’t work that way. Instead, the partnership recognizes the COD, and any exclusion, including the insolvency exclusion, must be determined at the partner level. This means that the determination of insolvency must also be determined at the partners level when partnership debt is forgiven.

Combine all of these bullets, and a natural question arises: how does a partner in a partnership account for the partnership’s liabilities in determining whether their individual liabilities exceed the FMV of their assets, making them insolvent?

Keep in mind, a partnership can have two types of liabilities, recourse and nonrecourse. Recourse liabilities are those that one or more partners is personally liable for, and the responsible partner should certainly include his share of the partnership’s recourse liabilities in the computation of his insolvency in the event a partnership debt is forgiven.

But what about nonrecourse debt? Nonrecourse debt, as opposed to recourse debt, is a partnership liability for which no partner is personally liable. In other words, if the partnership fails to pay the debt, tough luck for the lender. Nonrecourse debt is most commonly seen as a mortgage: the lender retains the right only to foreclose on the mortgaged property; they cannot pursue the partnership for any deficiency in the event the FMV of the nonrecourse debt plummets below the principal balance of the debt.

So if a partnership has nonrecourse debt forgiven, are the partners entitled to include any portion of the nonrecourse debt in their individual computations of insolvency?

The answer, according to Revenue Ruling 2012-14, is yes. Building on the principles established in Rev. Ruling. 92-53, the IRS held that a partner may include two pieces of a partnership nonrecourse debt in their individual computation of insolvency:

1) the amount of the debt equal to the FMV of the property (meaning it’s a wash from an insolvency standpoint), and

2) any debt in excess of the FMV of the property, but only to the extent it is forgiven, and the income resulting from the forgiveness is allocated to that partner.

The specific fact pattern in the ruling is as follows:

X and Holdco, a corporation, are equal partners in PRS, a partnership. In Year 1, PRS borrows $1,000,000 from Bank and signs a note payable to Bank for $1,000,000 that bears interest at a fixed market rate payable annually. The note is secured by real estate valued in excess of $1,000,000 that PRS acquires from Seller, in part with the proceeds of the note. The note is a nonrecourse liability within the meaning of § 1.752-1(a)(2) of the Income Tax Regulations. Neither PRS nor its partners (X and Holdco) are personally liable on the note. 

In Year 2, when the value of the real estate is $800,000 and the outstanding principal on the note is $1,000,000, Bank agrees to modify the terms of the note by reducing the note’s principal amount to $825,000. The PRS partnership agreement provides for income to be allocated equally to X and Holdco under § 704(b) and the regulations thereunder. X and Holdco share PRS nonrecourse liabilities equally under § 1.752-3. At the time of the modification of the note, X and Holdco have no assets or liabilities other than their partnership interests in PRS. PRS’s sole asset is the real estate subject to the note, and PRS’s sole liability is the note.

The IRS held that of the $1,000,000 note, X and Holdco may each consider the following portion of the liability as part of their liabilities for purposes of measuring insolvency:

 1. 50% of the $800,000 balance of the note equal to the FMV of the asset, or $400,000 each, and

2. The portion of the debt in excess of FMV that was forgiven, but only to the extent the COD income was allocated to X and Holdco, or 50% * $175,000 = $87,500 

Thus, for both X and Holdco, in computing each partner’s insolvency, they may include $487,500 of partnership liabilities, and $400,000 of FMV from the partnership (each partner’s share of the asset.)

As a result, both X and Holdco are insolvent to the extent of $87,500, and each may exclude the $87,500 of COD allocated to them from PRS under I.R.C. § 108(a)(1)(B).

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92-Year-Old Angel of Death Sentenced on Tax Evasion Charges

Posted in Uncategorized, tagged , , , , , on May 8, 2012 | 2 Comments »

It’s not uncommon for the IRS to have to do the law enforcement’s dirty work. Most famously, the Service brought down Al Capone when no one else had the gumption to get charges to stick.  Despite a lifetime defined by corruption and murder, it was tax evasion that eventually did in the notorious gangster. The IRS put an end to Capone’s criminal career by sentencing him to Alcatraz, where he would live out the remainder of his prime racketeering days while slowly going insane from syphilis-related symptoms. Good times.   

Fast forwarding to the present day, while a 92-year old retired school teacher would never be confused with a legendary criminal of Capone’s ilk, Sharlotte Hydorn shared one thing with Big Al: it again took the IRS to put an end to Hydorn’s  immoral — if not illegal — activities.

Several years ago, Hydorn attracted the attention of federal investigators by selling suicide kits out of her home. Hardened by watching her husband die of colon cancer, Hydorn longed to give “the terminally ill the option to decide how to die.”

Law enforcement was posed with a bit of a conundrum; technically, there is no federal law prohibiting assisted suicide. It’s obviously a bit of a public risk to have a non-medical professional playing the role of a capitalist Grim Reaper, however, so investigators were eager to find a way to put a stop to Hydorn’s activities.

Their answer — as it often is — was found in Hydorn’s tax returns. Apparently, assisted suicide is big business, because although Hydorn admitted to selling over 1,300 kits nationwide —  earning over $150,000 in the process —  she failed to pay taxes on any of the income.

As a result, the IRS convicted Hydorn of tax evasion charges, and she was sentenced to five years supervised probation. As part of her plea deal, Hydorn will not be charged in state court for any of the assisted suicide kit sales.

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Someone Wake Up Rush Limbaugh: Illegal Aliens Claimed $4.2 BILLION In Refundable Child Tax Credits in 2010

Posted in Uncategorized, tagged , , , , , , on May 7, 2012 | 2 Comments »

An email showed up in my inbox today with a link to the video below.

For those of you without the six minutes necessary to spend watching the video, it’s an investigation done by an Indianapolis news station purporting to blow the cover of a terrible conspiracy, in which illegal aliens are using their taxpayer identification numbers to generate large refunds by claiming the child tax credit for kids who aren’t even located in the U.S. The video is done in hilariously formulaic exposé fashion, complete with blurred faces, leading questions, and the disapproving, accusatory tone typically reserved for people who sell undercooked food or use the public library’s computer to masturbate to internet smut.  

Of course, the abuse of the child tax credit by illegal aliens is not new news, as the Treasury Inspector General for Tax Administration issued this report back in July of 2011 which highlighted just this abuse.

Yes, the problem is real. Yes, the IRS needs to stop the abuse. But it’s a logistical nightmare, because the problem stems from the fact that every person who is employed in the U.S. — citizen or not — is required by law to file a tax return. Under current law, those illegal aliens who cannot obtain a social security number can generally obtain an Individual Tax Identification Number (ITIN), and while the ITIN doesn’t enable a filer to claim an Earned Income Credit, they can claim an Additional Child Tax Credit, entitling the filer to a $1,000 refundable credit for each child.

Unless the IRS wants to devote significant resources to chasing down imaginary children of illegal aliens or verifying that the claimed children are in fact U.S. residents, the best course of action may be to revert the Child Tax Credit rules to their pre-”American Recovery and Reinvestment Act of 2009″ rules, when the additional child tax credit was limited to 15% of earned income in excess of $12,550.

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