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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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The WSJ Debates Carried Interest

Posted in Uncategorized, tagged , , , , , , on May 14, 2012 | Leave a Comment »

My father-in-law came to visit this week, and over Friday night pizza, the conversation turned to politics; specifically, Mitt Romney’s much-ballyhooed 13.9% effective tax rate in 2010.

Being a tax guy, I wanted my father-in-law to understand exactly why Romney’s rate was so low given his $21,000,000 of AGI, which required a primer on the taxation of carried interest. [For your own primer, click here.]

As the discussion advanced, my father-in-law understandably struggled to understand why the profits received by private equity fund managers on their carried interest were taxed any differently than, say, the wages he earned over his 40-year career working for an insurance carrier.

Even after I advanced the standard arguments for a 15% rate on carried interest — the equity fund manager’s risk, the uncertainty of the profit stream, the “sweat equity” element, etc… — my father-in-law’s opinion remained blissfully simple:

“It still sounds like compensation to me.”

Now, my father-in-law is a staunch Republican in every way, shape and form. But yet, he failed to see how a 15% tax rate is justified on the income received by fund managers to do what they do: manage funds. Of course, my father-in-law is not the final arbitrator on such matters: after all, this is the same man who once advised me to buy a house located squarely within the Delaware River’s floodplain.

So perhaps you should decide for yourself. To facilitate your decision-making process, the Wall Street Journal has published this point/counterpoint on the carried interest tax issue, with Michael Graetz, a professor of tax law at Columbia Law School, arguing for carried interest to be taxed as ordinary income, while David Tuerck, executive director of the Beacon Hill Institute and a professor and chairman of the economics department at Suffolk University in Boston, argues that the preferential capital gains rates should be preserved.

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Avoiding The Trap on Employer-Owned Life Insurance Contracts

Posted in Uncategorized, tagged , , , , , , on May 9, 2012 | 3 Comments »

On corporate tax returns, it’s second nature to disallow any deductions for “officer’s life insurance premiums” expensed on the corporation’s books. But why do we do it?

Under I.R.C. § 101, life insurance proceeds paid upon the death of an insured to the beneficiary are generally excludable from the beneficiary’s income. Thus, when a corporation takes out a life insurance policy on one if its key employees — and the corporation is both the owner and beneficiary of the policy – the proceeds paid to the corporation upon the death of the employee are generally tax-exempt.

Because I.R.C. § 101 serves to exclude life insurance proceeds from income, I.R.C. § 264 prevents a second tax benefit by disallowing a deduction for any premiums paid on a policy on which the payor is the beneficiary. That way, the taxpayer doesn’t get a deduction for premiums AND tax-exempt proceeds when the policy is paid out.

But did you know that for policies issued after August 17, 2006, the proceeds from corporate owned life insurance policies may be taxable to the corporation upon receipt? Unless certain notice and consent requirements are met, I.R.C. § 101(j) provides that life insurance premiums paid to a corporation upon the death of an employee will be excludable from income only to the extent of any premiums or other amounts paid for the policy. Proceeds in excess of such costs will be taxable to the corporation.

In order for the entire amount of life insurance proceeds to be tax-exempt to the beneficiary corporation, the employee must:

1. Be notified in writing that the applicable policyholder (employer) intends to insure the employee’s life and of the maximum face amount of the policy at the time of issue,

2. Must provide written consent to being insured and that the coverage may continue after the insured terminates employment, and

3. Must be informed in writing that the applicable policyholder (employer) will be a beneficiary of any proceeds payable upon the death of the employee.

In addition, every applicable policyholder corporation owning one or more employer-owned life insurance contracts issued after August 17, 2006 must file a Form 8925 for each year such contracts are owned, showing:

1. The number of employees at the end of the year and the number of those employees insured under employer-owned life insurance contracts;

2. The total amount of insurance in force under such contracts at the end of the year;

3. The name, address, TIN, and type of business of the applicable policyholder; and

4. That the applicable policyholder has a valid consent for each insured employee or the number of insured employees for which no consent has been obtained.

A few weeks ago, in PLR  201217017, the IRS ruled that a corporation met the notice and consent requirements even where the corporation failed to acquire separate documentation prior to purchasing life insurance contracts on each shareholder/employee that explicitly satisfied the items detailed in I.R.C. § 101(j).

Instead, the corporation required each shareholder/employee to fill out insurance applications that indicated that the corporation was to be the owner and beneficiary of the policy, as well as the amount of coverage being obtained, while also requiring the shareholder/employees to sign an agreement dictating that if the shareholder terminates his ownership  interest, the shareholder has the right to purchase the policy from the corporation.

The IRS concluded that between the application and the agreement signed by the participating shareholder/employees, the notice and consent requirements had been met and I.R.C. § 101(j) was satisfied. Thus, proceeds received by the corporation upon the death of any of the insured’s will be tax-free under I.R.C. § 101.

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Senate Poised to Vote On Buffett Rule. In Other News, Golden Corral Patrons Agree That Buffets Rule

Posted in Uncategorized, tagged , , , , , , , on April 16, 2012 | Leave a Comment »

As the filing deadline draws mercifully closer, the nation’s tax geeks are finally free to go on a Robert Downey-sized bender turn their attention to what promises to be the most  tax-driven presidential election in recent memory.

Right on cue, the Senate will be spending this evening voting on the first iteration of the Democratic-sponsored Buffett Rule, which would require taxpayers earning over $1,000,000 to pay a minimum 30% effective tax rate. The vote is being dismissed as largely symbolic, because as I discussed previously, the Buffett Rule is much more of a mechanism for the current administration to cast roles in the upcoming election — A vote for Obama is a vote for fairness, puppies, and rainbows! A vote for Romney is a vote for rich white guys, unjust tax breaks, and Aspen ski homes! — than it is reflective of potentially impactful legislation.  

On the Republican side of the campaign trail, Mitt Romney has at long last started to show his hand regarding where he will make up the increase to the federal deficit caused by his proposed 20% across the board reduction of the current tax rates.  From the Wall Street Journal:

Mr. Romney, the presumptive Republican nominee for president, said he would eliminate or limit for high-earners the mortgage interest deduction for second homes, and likely would do the same for the state income tax deduction and state property tax deduction.

Ok, that should raise some revenue. But historically, Republicans have been fiercely protective of their home mortgage interest deduction. It’ll be interesting to see how those claims evolve should Romney’s party members push back the way I imagine they will.

Of course, increased tax revenue is only one way to skin the deficit cat. What about spending cuts?

He also said he would look to the Department of Education and the Department of Housing and Urban Development for budget cuts. Mr. Romney said he would either consolidate the education department with another agency or make it “a heck of a lot smaller.” “I’m not going to get rid of it entirely,” he said.

He also vowed to stand up to teachers unions and warned that unions would funnel dues to Mr. Obama’s reelection campaign. “The unions will put in hundreds of millions of dollars,” Mr. Romney said. “There’s nothing like it on our side,” he said, and he encouraged attendees to get their friends to donate, as well.

Now there’s a policy I can get behind. At the risk of sounding unpopular, if there’s one thing I’m sure of  it’s that educators are paid far too much. Personally, I’m sick of watching these kindergarten teachers cruise around in their Ferraris during spring break while I’m stuck in the office, counting their millions and preparing their tax returns.

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Is the Buffett Rule A Red Herring?

Posted in Uncategorized, tagged , , , , , , , , , on April 12, 2012 | 3 Comments »

President Obama is hitting the road to renew his push for a “Buffett Rule” that would require taxpayers earning over $1,000,000 to pay an effective tax rate of at least 30%. The timing is no accident, as the Senate is poised to vote on the Buffett Rule on Monday.

In recent months — or at least since it was revealed that the Buffett Rule would put nary a dent in the federal deficit — the Obama administration has repositioned the rule as being in the interest of fairness, rather than a significant revenue generator.

But let’s call the Buffett Rule what it is: political posturing. It’s got no chance to pass the Republican led House, but it can still play a significant role in the November elections. Because — truth be told — the Buffett rule is a whole lot less about Warren Buffett than it is about President Obama’s chief competition come this fall, Mitt Romney.

It’s Romney, after all, who upon making public his tax returns in January, revealed that he paid an effective tax rate of a mere 13.9% on $21,600,000 in adjusted gross income. Now granted, Obama first announced his plans for a Buffett Rule in August of 2011, months before Romney’s admission, but the Obama administration is not populated with dummies, no matter what Rush Limbaugh might think. They had identified Romney as their most likely threat, and they knew that — as a man who made millions as a private equity fund manager — Romney was benefitting greatly from the preferential rates currently afforded investment income long before he released his returns.

When billionaire Warren Buffet famously announced that he pays a lower tax rate than his secretary, he did the president a tremendous favor. By handing Obama a poster child for his war against the perceived inequities of the current tax regime, Buffett allowed Obama to build a campaign against Mitt Romney without ever having to say Romney’s name.

If it hadn’t been made clear already, the president’s recent road show will tell the nation that the tax system is broken. Many people, both Democrat and Republican, will agree that a man earning $21,000,000 should not pay tax at a lower rate than a school teacher. They will view Mitt Romney as the enemy; the embodiment of this broken system, and many will find it difficult to relate to,  and vote for him, come November.

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The Supreme Court Set to Determine the Fate of Obamacare

Posted in Uncategorized, tagged , , , , , , , , , , on March 26, 2012 | 5 Comments »

The U.S. Supreme Court is typically charged with determining the victor of the country’s most important debates, such as Roe v. Wade, religion v. science or, which shape marshmallow should be added to boxes of Lucky Charms. So when the high court goes slumming, setting aside three days to hear debate with potentially major implications on the tax law, it’s incumbent upon every CPA to stand up and take notice.

Of course, it’s a rather busy time of year, and given the pile of Form 1040s overwhelming your desk, the events transpiring in D.C. are probably the least of your concerns. So as a bit of a public service, we’ve put together the following “heads up” for our industry peers, hopefully giving you the information you’ll need when your clients inevitably ask you for your take on the Supreme Court’s review of “Obamacare.” You can thank us after the 17th.

Q: What’s Obamacare? It sounds like a charitable organization to which I don’t contribute.  

A: On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act, a 2700-page bill that took aim squarely at the country’s health care practices. The reform would extend health insurance to an additional 32 million Americans while revamping one of the nation’s largest industries: prohibiting insurance companies from denying coverage due to preexisting conditions, expanding the Medicaid threshold to 133% of the poverty line, and eliminating the ability of insurers to cap an insured’s ”lifetime limit” of benefits.

Q: I didn’t hear anything about tax in there, so why do I care?

A: The Act also contained several major tax provisions, one of which set off a firestorm of debate regarding its constitutionality. Beginning in 2014, I.R.C. § 5000A will require taxpayers to purchase or retain health insurance that qualifies as minimum essential coverage, and to report this information on their federal tax returns, subject to certain codified exceptions. If the taxpayer fails to maintain adequate insurance, a monthly “penalty” is imposed equal to the greater of a flat dollar amount (phased in starting at $95 in 2014) or a percentage of the taxpayer‘s income (phased in starting at 1% in 2014).

Q: Where does the ”constitutionality” come in?  

A: Twenty-eight states have filed suit seeking to overturn this individual insurance mandate, challenging whether Congress is overstepping its taxing powers by imposing a penalty on individuals for failing to obtain insurance. In 2010, a Virginia federal court ruled the individual mandate unconstitutional, striking it from the Patient Protection Act but allowing the rest of the act to stand. The case was later overturned on appeal.

In early 2011, however, a Florida district court also held the individual insurance mandate unconstitutional, but refused to sever the provision from the rest of the Act, rending the entire Act unconstitutional. This time, on appeal, the verdict stood, but the appeals court disagreed on the severability of the individual mandate, allowing the rest of the Act to remain. The Department of Justice asked the Supreme Court to hear the case, which brings us to today.

Q: So what’s the Supreme Court going to decide?

A: Over the next three days, the U.S. Supreme Court will begin its review of Obamacare, an unprecedented act in the sense that it is the first time the high court has considered striking down a president’ signature legislation in the midst of his re-election campaign.  Here’s how the next few days are expected to shake out:

Today: Before the discussion of constitutionality can even get off the ground, the Supreme Court must determine whether the “penalty” under I.R.C. § 5000A for filing to obtain insurance is a “tax” or a “penalty.” If it’s truly a tax, then the current debate might be over before it gets started, courtesy of this old-timey law as explained by Bloomberg:

A 145-year-old law, the Anti-Injunction Act, says courts can’t rule on the legality of federal taxes until they are imposed. For the no-insurance penalty in the 2010 health care law, which takes effect in stages, that comes in 2015. The justices may decide it’s too soon to rule on the health law’s constitutionality.

In other words, if the penalty under I.R.C. § 5001A is held to constitute a tax, the Supreme Court might be barred from deciding the constitutionality of the insurance tax until it is actually imposed beginning in 2015.

Tomorrow: Assuming today’s hearings don’t render the remaining debate moot, tomorrow is likely to contain the most spirited arguments, as the Supreme Court will hear debate on whether the Constitution allows the government to require Americans to either get insurance, or pay a penalty.

Q: What will each side be arguing?

A: Similar to the state courts, the argument is likely to consist of the following positions:

On one side, detractors of the Patient Protection Act will insist that Congress has no authority to order someone to give up their own desire not to buy a commercial product and force them into a market they do not want to enter. The federal government, on the other hand, will defend the new law as being allowable under the Commerce Clause, the Necessary and Proper Clause, and the taxation power of the General Welfare Clause.

Q: What’s left to hear on Wednesday?

A: Wednesday could actually have far-reaching effects on the tax world. The court will hear debate about what should happen to the rest of Obamacare should the individual insurance mandate be found unconstitutional. If the Supreme Court were to strike down the entire Patient and Protection Act because the individual insurance mandate was found unconstitutional, the remaining tax provisions would die with it. As a reminder, some of the other significant tax provisions found in the Patient Protection and Affordable Care Act include the following:

  •  Starting in 2014, pursuant to I.R.C. § 4980H,  applicable large employers must provide minimum essential coverage to each full-time employee and their dependents. Failure to comply with the employer mandate will result in a penalty equal to one-twelfth of $3,000 for each month multiplied by the applicable number of full-time employees. In general, an “applicable large employer” is any employer with a work force in excess of fifty full-time employees.
  • Higher Medicare taxes will be imposed upon wealthy taxpayers beginning in 2013. Section 3101(b)(2)will be amended to include an additional tax of 0.9 percent on all income in excess of $200,000 or $250,000 for joint filers.
  • 2013 will also add to the Code I.R.C. § 1411, which creates a 3.8 percent Medicare tax on investment income in excess of $250,000 for joint filers, $125,000 for married filing separately, and $200,000 ―in any other case.

We’ll do our best to keep you apprised of any big developments.

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Tax Court: S Corporation Shareholder Must Reduce Basis For Loss He Failed To Take

Posted in Uncategorized, tagged , , , , , , , on March 22, 2012 | 1 Comment »

Who’s up for a little S Corporation 101?

Well, I’m doing it anyway. S corporations generally don’t pay tax. Instead, the corporation’s taxable income or loss is divvied up and allocated to its shareholders, who report the income on their Form 1040.[i]

S corporation shareholders are required to maintain their “basis” in their S corporation stock. This is done primarily for three reasons: to determine gain or loss on the sale of the stock, to determine the taxability of S corporation distributions[ii], and lastly, to determine the maximum amount of S corporation loss allowable on the shareholder’s individual income tax return. It is this final reason we concern ourselves with today.

Unlike a C corporation, a shareholder’s stock basis in an S corporation is not static. Because of the “flow through” nature of S corporations, a shareholder’s basis must constantly be adjusted to prevent the corporation’s income from being taxed twice.[iii]

In general, a shareholder’s basis in his S corporation stock is increased for:

  • Capital contributions
  • Items of income (including tax exempt income)

And decreased for:

  • Distributions
  • Items of loss and deduction (including non-deductible expenses like M&E)[iv]

For any tax year, a shareholder’s allocable share of the S corporation’s loss can only be deducted to the extent of the shareholder’s basis in his stock, after accounting for the increases listed above.[v] To the extent a loss is limited under this rule, it is “suspended” and carried forward, where it is treated as a new loss in the succeeding year and is again subject to the basis limitation rule.

Today, the Tax Court tackled a seemingly simple, yet interesting issue. What if a shareholder neglects to deduct a loss they are entitled to. Must they reduce their stock basis for the loss, even though they received no tax benefit from the loss?

Let’s apply some round numbers to make it easier to follow. In 1995, A set up S Co. with a $50,000 capital contribution. During 1995 and 1996, A was allocated $200,000 of loss from S Co. which reduced his basis to $0 as of the end of 1996. Because the loss exceeded A’s positive basis of $50,000, A only received the benefit of $50,000 of loss during those two years, with the remaining $150,000 of loss suspended as of December 31, 1996.

In 1997, A contributed $250,000 to S Co. S Co. allocated a $50,000 loss to A in  1997, which he deducted on his Form 1040. A, however, failed to deduct the prior year suspended loss of $150,000, despite the fact that his capital contribution gave him ample basis to do so. As a result, A did not decrease his basis for the suspended loss, leaving him with $200,000 of stock basis as of December 31, 1997.

Fast forward five years. From 1998-2003, A continued to reflect this “extra” $150,000 in his basis, which stood at $300,000 on January 1, 2003. In 2003, S Co. allocated a $275,000 loss to A, which he deducted in full on his return.

The IRS disallowed $125,000 of the loss, arguing that A’s stock basis was required to be reduced by $150,000 of additional losses in 1998 — even though A did not deduct the loss on his return, as he was entitled to. Because under this calculation, A would have only $150,000 of stock basis on January 1, 2003 ($300,000 according to A less $150,000 downward adjustment from 1998), S Co.’s 2003 loss of $275,000 was limited to A’s stock basis of $150,000.

In defense of his stock basis calculation, A argued that I.R.C. § 1367 requires basis reduction only for losses that the S corporation shareholder reports on his or her tax return and claims as a deduction when calculating tax liability.

The Tax Court disagreed and sided with the IRS, holding that a shareholder is required to reduce his basis in S corporation stock for his allocable share of the S corporation’s loss, even if the shareholder did not deduct the loss on his Form 1040. From the court:

The class of losses described in section 1366(a)(1)(A)[S corporation losses] is not limited to losses that were actually claimed as a deduction by the shareholder on the shareholder’s tax return. Therefore, the basis reduction rule in section 1367(a)(2)(B) is not limited, as the Barneses contend, to losses that were actually claimed as a deduction on a return.

As a result, A was denied $150,000 of loss on his 2003 tax return. Of course, A would have been entitled to amend his 1996 return to take the $150,000 loss he was entitled to during that year, if it weren’t closed by statute. Ouch.

[i] S corporation shareholders are generally required to be individuals, but see I.R.C. § 1361 for the rules regarding certain qualifying trusts.

[ii] See I.R.C. § 1368 and our previous post here

[iii] To illustrate, assume Mr. A contributed $100 to S Co. in exchange for all of its stock. S Co then earns $20 in year 1, which is not taxed at the S corporation level, but rather flows through to Mr. A and is taxed on his Form 1040. Presumably, the value of S Co. is now $120. If Mr. A sells the stock for $120, were he not required to adjust his basis in the S Co. stock, he would recognize $20 on the sale ($120 sales price – $100 basis). By increasing Mr. A’s stock basis by the $20 of income recognized by S Co., Mr. A recognizes no gain on the sale of the S Co. stock ($120 sales price – $120 basis). Thus, the $20 earned by S Co. is only taxed once.

[iv] I.R.C. § 1367

[v] The regulations at Treas. Reg. §1.1367-1(f) also require distributions to reduce stock basis before losses.

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NASA Employee Loses in Tax Court; [Insert "Even Rocket Scientists Can't Understand the Tax Code" Joke Here]

Posted in Uncategorized, tagged , , , , , , on March 21, 2012 | 2 Comments »

Donald Carl Barker is the rare man with three names who failed to fulfill his destiny of becoming a serial killer, Nascar driver, or high profile assassin, and instead actually did something useful with his life. Barker works for NASA, and he’s made it his personal mission to enable humans to one day colonize Mars, where we’ll create a utopian society where jet packs are abundant, high-fives replace cash as currency, and we’re free to marry our attractive cousins without judgment.

Barker has the education necessary to make his dreams a reality: a double bachelor of science in physics and psychology, a master’s degree in physics, psychology and math, another master’s degree in space architecture, and at the time of his appearance in front of the Tax Court, a half completed Ph.D. in geology. Kinda’ puts your Liberal Arts degree to shame, no?

Alas, in all that learning, Barker never garnered an understanding of the finer points of the Internal Revenue Code. In 2003, Barker launched a Schedule C “business” called Mars Advanced Exploration & Development, Inc. (MAXD), which was established to obtain funding for various technologies relating to exploring the Red Planet.

Over the next half decade, MAXD sporadically pursued its goals: submitting a funding proposal to NASA in 2003 (denied), applying for a patent in 2005 (also denied), and publishing a design study in 2008. Over that same span, it generated exactly zero dollars in revenue.

None of that kept Barker from deducting expenses in each year, including $7,500 in 2006. The IRS denied the expenses, arguing that MAXD never actually…you know…did anything, and thus wasn’t engaged in an active trade or business.

The Tax Court was left to decide whether MAXD’s activity did in fact rise to the level of a trade or business, necessitating a review of three factors previously established by the courts:[i]

(1) whether the taxpayer undertook the activity intending to earn a profit;

(2) whether the taxpayer is regularly and actively involved in the activity; and

(3) whether the taxpayer’s activity has actually commenced.

To determine whether Barker undertook the activity intending to earn a profit, the Tax Court analyzed the nine regulatory “hobby loss” factors,[ii] which quite frankly, we’ve beaten to death on this blog, discussing it here, here, here, and here. The factors are:    

1. The manner in which the taxpayer carries on the activity;  2. The expertise of the taxpayer or his advisers; 3. The time and effort expended by the taxpayer in carrying on the activity; 4. The expectation that the assets used in the activity may appreciate in value; 5. The success of the taxpayer in carrying on similar or dissimilar activities; 6. The taxpayers history of income or losses with respect to the activity; 7. The amount of occasional profits; 8. The financial status of the taxpayer; and 9.  Whether the activity lack elements of  personal pleasure or recreation.

In ruling that MAXD did not carry on a trade or business, the court held that Barker failed to keep accurate books and records, did not expend significant time on the activity during the year at issue, and was generating consistent losses that were offsetting Barker’s compensation income from his NASA job.

Next, the Tax Court addressed the second factor: whether Barker was regularly and actively involved in MAXD. Because Barker was working two jobs while also pursuing his Ph.D., the court found there was insufficient evidence to establish that Barker was involved with MAXD with any regularity.

With regards to the final factor, there remained no reason to determine whether MAXD had commenced its business,  since the court had already held that thre was no business. Thus, the Tax Court thus sided with the IRS, holding that Barker’s purported business expenses were not allowable.

Barker’s loss, however, is the American people’s gain. With this defeat behind him, Barker can refocus his efforts on helping NASA with its most daring and exciting project yet: blowing up the moon:

[i] Commissioner v. Groetzinger, 480 U.S. 23 (1987); McManus v. Commissioner, T.C. Memo. 1987-457, aff’d without published opinion, 865 F.2d 255 (4th Cir. 1988).

[ii] Treas. Reg. §1.183-2(b).

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Republicans Push for Lower Tax Rates and Spending Cuts; Sun Rises in East

Posted in Uncategorized, tagged , , , , , , , , , on March 20, 2012 | 2 Comments »

House Republicans released a budget proposal today that would consolidate the six current individual income tax brackets into only two – a 10% and a 25% bracket — while also reducing the top corporate rate to 25% and eliminating taxes on U.S. companies’ overseas profits.

The proposal is part of  a larger election-year message signifying that Republicans — unlike their Democrat counterparts — have a plan to balance the federal budget in a way that does not necessitate tax increases.

As part of Congressman Paul Ryan’s plan, spending would be cut on Medicare, food stamps, college tuition grants, and other “safety net” programs. The plan would produce a 10-year deficit of only $3.13 trillion, less than half the deficit created by President Obama’s recently released budget.   

Equally as predictable, Democrats’ panned the proposal as screwing the poor to finance tax cuts for the rich.

Either way, from a tax perspective the proposal is as meaningful as rearranging the deck chairs on the Titanic, as neither side realistically expects the suggested reform to become law. Rather, the Republican plan is aimed towards establishing the party’s position on spending and taxes prior to the November election.

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Tax Masters Files for Bankruptcy; Cable News Scrambles to Fill Countless Hours of Advertising Time

Posted in Uncategorized, tagged , , , , , , , on March 20, 2012 | 8 Comments »

It is with an inordinate amount of joy that I relay the news that Tax Masters — the “tax resolution” company whose commercials offering to reduce or eliminate IRS deficiencies became a staple of late night television, giving rise to parodies by Saturday Night Live, among others — has filed for bankruptcy.

In this case, it’s not just our typical schadenfreude at work; we’ve had a bit of  a personal vendetta against the company since a good buddy of ours sheepishly confessed to us that he paid Tax Masters several thousand dollars to help with a large unpaid tax bill, only to get the runaround whenever he tried to gauge the company’s progress. The standard response coming out of Tax Masters was along the lines of “We’ll need another installment payment from you before we can continue to pursue your case,” causing him to eventually abandon hope of receiving the help he had paid for and leaving him $4,500 deeper in debt.

My problem with Tax Masters is that like the makers of the shake weight and Axe Body spray, they prey on the desperate, offering quick solutions to deep-rooted problems.

As any CPA knows, negotiating a successful Offer in Compromise can be a long, arduous, and most importantly, unpredictable process. The likelihood of success is largely dependent on the specific facts: the client’s financial picture and compliance history, the size of the deficiency, and the reasonableness of the offer. To wit: in 2010, the IRS received 57,000 OIC applications, but only 14,000 were accepted.

According to Tax Masters’ three-page bankruptcy filing, the company has less than $50,000 in assets and up to 5,000 creditors with claims nearing $10,000,000, many of whom our former clients like my friend who want to be made whole, but thanks to bankruptcy protection, will likely never see a dime. From Janet Novack at Forbes:

According to a report on Houston’s KHOU this morning, the bankruptcy filing “comes as the Texas Attorney General’s Office is set to begin a trial against the tax resolution firm for misleading consumers under Texas’ Deceptive Trade Practices Act.”

Texas sued TaxMasters in May 2010…alleging that TaxMasters misled consumers by offering an installment payment plan for its fees to prospective customers, without disclosing it wouldn’t start working on a case until it got all its money—even if that meant key Internal Revenue Service deadlines were missed. Last month, KHOU’s I-Team reported that consumer complaints about TaxMasters were continuing to pour into the state.

Coming on the heels of the untimely demise of JK Harris and Roni ”The Tax Lady” Deutch – two other “debt resolution” pitchmen — the Tax Masters’ bankruptcy offers a stern if painful reminder to taxpayers to steer clear of late night TV snake oil salesmen. If you find yourself owing the IRS back taxes, hire a lawyer, a CPA or an enrolled agent.

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