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Way back near the end of May, which feels like a very long time ago, we published a couple of pages of overview on how to classify ownership interests in activities as passive vs. non-passive.  Somewhere in that article I promised to mention how real estate interests can qualify as non-passive activities.

This determination is key in the proper treatment of income and losses both for the purposes of the limitations under the passive activity loss rules and also for the inclusion in the calculation of the new Net Investment Income tax.

For an activity to be considered non-passive, the owner must materially participate in that activity and generally meet one of seven tests enumerated in Reg. Section 1.469-5T, explained previously.  Despite those requirements, rental activities are per se passive, that is, automatically treated as passive regardless of the level of the owner’s participation.  There are a couple of exceptions to that default which we mentioned in the earlier article for self-rental activities, holding a working interest in an oil and gas property, and where a grouping election would be allowed with a non-rental activity in only specific circumstances. However, the most frequently used (and risky) exception to the default treatment of real estate income or loss as passive is when an election is made for a real estate professionals.

Special rules are provided under IRC §469(c)(7) for rental activities commonly referred to as the real estate professional rules.  If the test is met, the rental activity of a real estate professional is treated as non-passive.  Treatment as non-passive is advantageous when a real estate rental activity is generating losses that can be used to offset other income such as interest, dividends and wages.  Conversely, the passive losses would not reduce other passive real estate income for purposes of the net investment income tax.  Planning to make this election should be well thought out in that it may not always be desirable to treat net rental real estate income or loss as non-passive and the election itself may invite increased IRS scrutiny.

Am I a real estate professional?

The real estate professional must satisfy two tests:

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

At first glance, the test seems relatively easy to satisfy until you realize that for an activity to be counted towards the first and second test, the owner must materially participate in each activity to treat the income or losses as non-passive.  If there are interests in several real estate activities, this may be difficult to satisfy.  To help satisfy the material participation for each activity, a special grouping election can be made under Reg. Section 1.469-9 to treat all interests in rental estate as one activity. Once made, the election is binding for all future years the taxpayer is a qualifying real estate professional and is revocable only if there is a material change in facts and circumstances.  In case you missed the election, one can be filed with an amended return under Rev. Proc. 2011-34.

The rental estate activity is owned by a trust.  Can the trust be a real estate professional?

The Code nor the regulations address how material participation rules can be satisfied for taxpayers who are trust, estate or personal service corporations.  Under IRC §469(c)(7)(B) the requisite amount of service hours must be performed in real property trades or businesses, the performance of which the IRS has previously stated must be by a taxpayer who is a natural person and has the capability for physically performing such services.  In looking to case law for guidance, the U.S, Tax court in a recent decision, held that a trust taxpayer could meet the material participation standards through the performance of its trustees and thus qualify for the real estate professional exception under §469(c)(7). [Frank Aragona Trust, (2014) 142 TC No. 9.] In the case, the taxpayer was a trust that owned rental real estate properties and engaged in other real-estate activities.  The court ultimately rejected the IRS’ argument that a trust is incapable of performing personal services.  Rather, the Tax Court held that the trust is an arrangement whereby trustees have a fiduciary responsibility to manage assets for the benefit of the trust’s beneficiaries and therefore worked performed by an individual as part of their trustee duties are personal services for purposes of satisfying the section 469(c)(7) exception.

The trust was formed by a grantor who, after his death, was succeeded as trustee by his five children and one independent trustee.  All six trustees acted as a management board for the trust and made all major decisions regarding the trust’s property. In addition, a disregarded LLC, wholly owned by the trust, managed the trust’s rental real-estate properties.  The LLC employed several people, some of whom were the trustees.  The court ruled that not only were the activities performed by the individuals in their duties as trustee included as personal services performed in a real-estate trade or business, but also their time spent as employees of the LLC managing the rental real estate properties.

Because the requisite hours in real-property trades were met and the trust materially participated in the real property businesses, the trust met the exception to the per se passive treatment of rental real estate activities and was able to treat the income and losses from the activities as non-passive.

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A new chapter was added to the ongoing dispute as to whether student athletes should be compensated for (i) the part they play in helping their respective schools generate millions of dollars in revenue from ticket sales and the use of their individual player likenesses, and (ii) the predominant amount of time that is spent as an athlete as opposed to a student.  It is a deeper issue than simply framing it as “pay for play”, but that discussion is one for another day …

What is important for our purposes is that the National Labor Relations Board (“NLRB” or the “Board”) recently ruled Northwestern University’s scholarship football players (differentiated from walk-on players) are “employees” under the National Labor Relations Act (the “Act”), and as such, have the right to unionize for collective bargaining purposes.

The Board’s ruling will be appealed, so the practical application of this unionization right and the resulting sub-issues from the decision will be delayed as of this writing.  However, there are theoretical tax matters that will play a part in the debate, and that could emerge if student-athletes are in-fact deemed “employees”.  Furthermore, the reasoning that the NLRB used to reach its conclusion that student-athletes are “employees” may also be the basis for which student-athletes would be taxed.

Without going into extensive detail, the NLRB determined that the Northwestern football players receive the substantial economic benefit of a scholarship in exchange for performing football-related services, under what amounts to be a contract-for-hire.  Additionally, the Board made note of the extensive amount of control that the football coaching staff and University have over the players, and that if team rules are broken, scholarships can be revoked:

  • NCAA rules prohibit players from receiving additional compensation or otherwise profit from their athletic ability and/or reputation, so scholarship players are dependent on their scholarships to pay for basic necessitates, including food and shelter;
  • Players devote 40-60 hours per week for football, depending on whether it is in-season versus the off-season, despite the NCAA’s prescribed limitation of 20 hours per week once the academic  year begins;
  • Coaches control living arrangements, outside employment, the ability to drive personal vehicles, travel arrangements off-campus, social media, use of alcohol or drugs, and gambling;
  • Players also are sometimes unable to take courses in certain academic quarters because they conflict with scheduled team practices.

At this point it is not entirely clear what student-athletes would be taxed on because if the decision is ultimately affirmed, there could be conflicting definitions and concepts in the tax code with respect to “gross income”, “compensation for services” and “qualified scholarships.”

For income tax purposes, “gross income” means all income from whatever source it is derived, and this includes compensation for services.  Until now student-athletes have not been considered employees, which is essentially why their scholarship (or parts of) have not previously been taxed.  But the NLRB went to great lengths to detail how the Northwestern football players currently receive compensation for playing football (the reason it saw fit to classify them as employees).  On that same basis, the IRS would likely take the position that the granted scholarships are compensation for services, and are thus taxable income to the student-athletes.  Whether the current statutory language would have to be amended or exclusions would have to be created to properly allow for this taxation is a secondary issue.

Yet there are other benefits the Northwestern football players have cited which they feel would outweigh the negative impact of taxes they might incur.  If the decision is upheld, players might be able to qualify for workers’ compensation benefits as a result of injuries suffered on the field.  Moreover, instead of coaches having unilateral control over the schedules and rules players must abide by at the risk of losing scholarships, the union the players could form would bargain with the university over “working conditions”.  This would be similar to the way in which the NFL and MLB players’ unions bargain for benefits of their respective players.

However, rights that are bargained for by this theoretical union could lead to further questions for the university.  For example, if players successfully bargained for health benefits, Title IX (which demands equal treatment of male and female athletes) might require equivalent benefits to all of the other athletic programs on campus.  Conversely, bargained-for benefits such as safer football helmets or equipment would not necessitate comparable action on the part of the school.

The NLRB ruling in the Northwestern case is restricted to private universities, meaning efforts by student-athletes of state schools would be governed by each state’s laws on unions of public employees.  However, this decision is an initial step in what will be a lengthy process that ultimately could re-shape the National Collegiate Athletics Association (“NCAA”) … and tax issues will most certainly have a substantial impact along the way.

CJ Stroh, Esq.

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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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Imagine you’ve spent the past decade pouring your blood, sweat and incapacitated neighbor’s social security checks into your wholly owned C corporation. Your business has evolved into a raging success, and it’s nearly all attributable to your efforts. New clients sign on because of you. Suppliers negotiate on favorable terms because of you. Your corporation has a strong name in the marketplace, and it’s all because of you.

Now the time has come to sell your beloved business, and you and the buyer agree on an asset sale. The purchase price will be $1,000,000 for everything: the inventory, the fixed assets, and the intangible assets, including the trade name and customer list.

In such a fact pattern, determining who is actually selling the intangibles is critical. If the corporation is the seller, the entire purchase price will go into the corporation where it will be subject to two levels of income tax: once when the corporation recognizes a gain on the asset sale, and a second time when the proceeds are distributed and the shareholder recognizes dividend income. Making matters worse, because C corporations do not benefit from a preferential rate on long-term capital gains, all of the corporate level income is taxed at the same rate, reaching a high of 35%.

If, on the other hand, the argument can be made that the shareholder — you — are the  owner and seller of the intangible value, well…now we’re getting somewhere. Keeping that cash out of the corporation accomplishes two things. First, the proceeds allocable to the intangibles will only be taxed once; at the individual level. Second, because an individual does benefit from the preferential tax rate afforded long-term capital gains, the proceeds will be taxed at 15%, resulting in as much as a 20% tax savings when compared to the current maximum corporate rate of 35%.

Can it be done? Can an individual shareholder of a corporation be deemed to own — and sell — the intangible assets of a corporation?

The answer is yes, and today the Tax Court added a fourth key authority  to the oft-cited triumvirate of Norwalk,[i] Martin Ice Cream,[ii] and MacDonald[iii] by holding in H&M Inc. v. Commissioner,[iv] that when a corporation’s intangible value is entirely attributable to the services of a shareholder/employee, unless the shareholder/employee has effectively transferred the intangible value to the corporation by entering into a covenant not to compete, the shareholder/employee will be deemed to the be the owner of those intangible assets, and is free to sell them in his individual capacity.

In H&M Inc., Harold Schmeets was the sole shareholder of the plaintiff corporation and apparently, the biggest wheel of the North Dakota insurance industry:

Despite the competitive market, Schmeets stood out among insurance agents in the area. He had experience in all insurance lines and all facets of running an insurance agency, including accounting, management, and employee training. He also had experience in a specialized area of insurance called bonding,1 and his agency was the only agency in the area, aside from the bank’s, that did this kind of work. There was convincing testimony that in the area around Harvey no one knew insurance better than Schmeets, and even some of his competitors called him the “King of Insurance.” We also find that when people came to Harvey Insurance to buy insurance, they were buying it from Harold Schmeets, and that he had far more name recognition as an individual than Harvey Insurance did as a firm.

Why anyone would want to give up the prestige that comes with being coined “King of Insurance” in North Dakota is beyond me, but Schmeets eventually decided it was time to sell. He’d had a long-standing relationship with a local bank, and ultimately decided to sell the assets of H&M Inc. to the bank in exchange for $20,000, payable over a period of years.

While Schmeets did not claim to have sold any intangible value directly, he did enter into a compensation package with the bank, as he took over as manager of their insurance practice for a six-year term.

On its tax return for the year of sale, H&M Inc. reported the required amount of the $20,000 proceeds under the installment method. On his personal return, Schmeets reported the compensation income earned for services provided to the buyer.

The IRS, however, took issue with this treatment, arguing that $20,000 was not nearly equal to the fair market value of the acquired assets of H&M Inc., particularly when considering the substantial goodwill created by employing the “King of Insurance.”

Instead, the Service argued that a portion of the compensation payments made by the buyer to Schmeets properly represented additional purchase price for the corporation’s assets. As such, this portion should be taxed first at the corporate level and again when distributed to Schmeets.

Schmeets countered by arguing that like the taxpayers in Martin Ice Cream and MacDonald, he personally owned any intangible value of the corporation. The Tax Court agreed:

The insurance business in Harvey is “extremely personal,” and the development of Harvey Insurance’s business before the sale was due to Schmeets’s ability to form relationships with customers and keep big insurance companies interested in a small insurance market. He grew relationships with large insurance companies that other brokers in the area didn’t.And we specifically find that when customers came to his agency, they came to buy from him–it was his name and his reputation that brought them there. We also find he had no agreement with H & M at the time of its sale that prevented him from taking his relationships, reputation, and skill elsewhere, which was precisely what he did when he began working for the bank’s renamed insurance agency…We therefore find that payments to Schmeets were not disguised purchase price payments to H & M.

What Can We Learn?

There is obviously a significant tax advantage to selling goodwill at the shareholder level as opposed to the corporate level; namely, the advantageous 15% LTCG tax rate and the single level of taxation. In order to successfully argue the position, however, the case law has taught us that certain facts must be present.

Most importantly, the success of the corporation must be directly traceable to the activities, skills, and relationships of the shareholder/employee. But this is only half the battle. In addition, the shareholder/employee must not have entered into a covenant not to compete or long-term employment agreement with the corporation, as this will effectively cause their personal relationships to become property of the corporation.

Lastly, while the Tax Court was lenient in H&M, Inc. with the corporation’s lack of attention to detail when crafting its purchase agreement, future taxpayers may not be so lucky. To safeguard against an IRS attack, a shareholder wishing to take the position that they personally own the intangible value of the corporation should enter into two agreements: one in which the corporation agrees to sell its hard assets, and a second that is entered into directly between the buyer and the shareholder, in which the buyer purchases the intangible assets directly from the shareholder who created them.


[i] TC Memo 1998-279

[ii] 110 T.C. 189

[iii]  T.C. 720

[iv] T.C. Memo 2012-290

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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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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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Coming on the heels of my Friday post regarding the impending expiration of the COD exclusion for mortgages secured by a taxpayer’s primary residence, Roger McEowen of Iowa State University published this wonderful 5-page chart detailing 1) those provisions set to expire at 12.31.2012 as part of the sunset of the Bush tax cuts, 2) those provisions set to expire at 12.31.2012 unrelated to the Bush tax cuts and 3) those provisions that previously expired at 12.31.2011 and may be candidates for a Lazarus-like revival. With year-end planning just around the corner, it’s a must read.

Hat tip: Joe Kristan at Roth & Co.

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If you are one of the 97% of Americans whose home is worth significantly less than when they purchased it, you’ve likely been seeking out some type of debt modification with your lender. Or perhaps things have gotten so bad that you’re contemplating a foreclosure or short sale.

Here’s the thing: anytime a mortgage is modified (i.e., reduced), the borrower is required to recognize cancellation of indebtedness (COD) income under Section 61(a)(12). Similarly, if a property is sold at foreclosure or in a short sale and the underlying mortgage is recourse (meaning the borrower has personal responsibility for any excess loan deficiency remaining after the sale), then to the extent the remaining deficiency is forgiven, the borrower will again recognize COD income.

In the foreclosure or short sale context, this COD income is NOT treated as gain from the sale of the property, and thus is not eligible for exclusion under Section 121 (allowing a $500,000 exclusion for MFJ taxpayers who have owned/used the home as their principal residence for 2 of prior 5 years).

When the sh*t hit the fan in the real estate market in 2006 Congress recognized that something had to be done, as it seemed patently unfair to tax homeowners on COD income when they couldn’t even afford to service the underlying mortgage. And while exclusions to COD income have always existed under Section 108, prior to 2007 those exclusions were only of use to a homeowner if the homeowner were insolvent or bankrupt.

As a result, in 2007 Congress enacted Section 108(a)(1)(E), which provides that a taxpayer that is neither insolvent nor in bankruptcy can still exclude up to $2,000,000 of COD income related to the discharge (in whole or in part) of qualified principal residence indebtedness. This exclusion applies where a taxpayer restructures his or her acquisition debt on a principal residence, loses his or her principal residence in a foreclosure, or sells a principal residence in a short sale.

For these purposes:

  • Qualified principal residence indebtedness is debt that meets the Section 163(h)(3)(B) definition of acquisition indebtedness for the residential interest expense rules but only with respect to the taxpayer’s principal residence (i.e., does not include second homes or vacation homes), and with a $2 million limit ($1 million for married filing separate taxpayers) on the aggregate amount of debt that can be treated as qualified principal residence indebtedness.
  • Acquisition indebtedness includes refinanced debt to the extent the refinancing does not exceed the amount of the refinanced acquisition indebtedness.
  • For purposes of these rules, a principal residence has the same meaning as under the Section 121 home sale gain exclusion rules.

Why do you care? Because as of today, this exclusion is set to expire on December 31, 2012. That means you have to ask yourself: How much do you trust Congress to get an extension done before year end? If you do, then by all means, take your time with your debt modification/foreclosure/short sale efforts. But if you don’t, you might want to get a sense of urgency about getting something done with your bank prior to year end, so you can take advantage of Section 108(a)(1)(e) while it’s here.

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There are three things you’ll find in almost annoying abudance in every mountain town: soul patches on the men, dreadlocks on the women, and weed. Lots and lots of weed.

In Colorado, however, you can’t limit the love of marijuana to the denizens of its ski towns. To wit: in Denver — where medical marijuana has been legal since 2000 — there are more dispensaries within the city limits than there are Starbucks in the entire state.

Now, with state tax revenues lagging and criminal justice costs rising, Colorado is turning to an unlikely, albeit logical, solution to its woes: weed for all.

This November, residents of Colorado will vote on Amendment 64, which would legalize and regulate marijuana sales just as it’s done for booze and cigarettes. The goal, quite obviously, is to raise tax revenue. Just how much tax revenue is anyone’s guess:

State analysts project somewhere between $5 million and $22 million a year. An economist whose study was funded by a pro-pot group projects a $60 million boost by 2017.

The cause of the confusion, of course, is because buying recreational marijuana is currently illegal, nobody can be certain what the market for legal weed will be. Muddling matters further, there is no guarantee that those currently buying illegal marijuana would shift their loyalties to legalized outlets. After all, if I learned nothing else from the film “Pineapple Express” — and I didn’t — it’s that the pot smoker-drug dealer bond is a strong one forged through loyalty, trust and PlayStation, and is unlikely to be cast aside so capriciously.

Should the legislation pass — and right now, it looks possible but not likely — it will be fascinating to sit back and watch the state-wide elation greeting free-market marijuana be quickly destroyed by the heavy hand of the IRS. As we’ve discussed before, the Service has used a little known Code section, Section 280E to be specific, to deny all of the tax deductions related to medicinal marijuana dispensaries, effectively taxing the business on 100% of their revenues.

The same section would apply equally to legal recreational sales, because marijuana will remain on the federal controlled substance list, and thus the IRS would be able to wield Section 280E to deny any and all deductions related to “trafficking” in the drug. With a string of recent successes in the Tax Court featuring medicinal dispensaries, the IRS would have a strengthened resolve to pursue recreational sellers of the drug, and likely tax them out of existence.

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I spent the weekend doing some mountain bike-assisted leaf peeping, as the fall colors are in “full splendor” mode right now in the Rockies:

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On to the tax stuff. For good or bad, there’s no bigger story in the tax world right now than the release of Mitt Romney’s 2011 tax returns. It’s a shame in a way, because it has to suck to publish your most sensitve personal information only to immediately have every hack (i.e., me) scrambling to their laptops to offer up their unsolicited opinions regarding your financial dealings on the internet. But such is the way of the world, so below are some links to other, more reputable sources and their thoughts on the Romney returns:

NY Times

Washington Post

The Atlantic

Forbes

Of course, as I’ve mentioned before, the bigger question is: will the information contained within those 300 pages of tax return really have an impact on election day? The Wall Street Journal has some theories.

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