Archive for March, 2011

Rare is the court decision where a taxpayer is permitted to deduct a theft loss without someone at least being accused of a crime. Today, in Herrington v. Commissioner, T.C. Memo 2011-73, the court allowed just such a deduction in a decision likely to change some views around the tax community as to what constitutes a “theft.”

In Herrington, the taxpayer was in an extremely abusive relationship, often facing violence and intimidation at the hands of her boyfriend. She was coerced by her boyfriend into opening two sandwich shops which were home to video poker machines.

The boyfriend took charge of the finances of the business, cutting checks to himself without alerting the taxpayer as to the amount and reason. While she knew he was withdrawing money from the business at his every whim, the taxpayer never knew when it was coming. In the two years at issue, the boyfriend took $114,000 and $96,000, respectively, out of the business for his own benefit.

The Tax Court was left to determine whether the amounts could be deducted as theft losses.

As a reminder, an individual may deduct theft losses incurred in a trade or business under Section 165. Generally, whether a theft loss has occurred depends upon the law of the state where the loss was sustained. In Herrington, however, the boyfriend was never accused, let alone charged, with theft.

The court, citing previous case law, maintained that the deduction for theft losses does not depend upon “whether the perpetrator is convicted or prosecuted or even whether the taxpayer chooses to move against the perpetrator.” (emphasis added) Instead, the taxpayer need only to provde that a theft occurred under the relevant state law, which it did in this case under Louisiana law.

The IRS argued that the boyfriend’s withdraws could not be thefts since the taxpayer never objected to the transfers, and Louisiana law provides  that a theft cannot occur if the victim actively consents to the theft. The Tax Court, however, concluded that the taxpayer gave only “passive consent,” which was induced by force and threats of violence. For these reasons, the court placed little significance on the fact that the taxpayer never reported the thefts to the authorities, and allowed the theft losses in full.

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Allow myself to reference…myself.

A few weeks ago, after the IRS provided the Section 280F  luxury auto depreciation limits for 2011 in Rev. Proc. 2011-21, the esteemed authors of this here blog hypothesized that the introduction of 100% bonus depreciation could create quite an anomalous result in years 2-6 for those taxpayers electing to maximize their first year auto depreciation

Long story short, we questioned whether in years 2-6, taxpayers would be limited to zero depreciation, since in each of these years they would be limited to the lesser of the Section 280F limits or the amount otherwise allowable under MACRS for that year. As we discussed in our original post:

Remember, in this hypothetical, we elected under Section 168 to apply the first year bonus depreciation rules. So under MACRS, all the allowable depreciation is taken in year 1, with nothing remaining for subsequent years. The fact that Section 280F limits the year 1 depreciation has no bearing on what the depreciation would be for years 2-6 under the normal rules. As a result, in those years, you would receive no depreciation deduction, before finally depreciating the entire remaining basis of the car in year 7 under Section 280F’s catch-up rule.

Today, the IRS issued Rev. Proc. 2011-26 and confirmed our belief. The procedure provides that if you decide to take the 100% first year bonus depreciation on a luxury auto, any cost unrecovered in year 1 is not deductible until year 7. For example, if you spent $20,000 on your new ride in December 2010 and chose to take the 100% bonus depreciation subject to the S280F limits, you would deduct $11,060 in year 1. The remaining $8,940 of unrecovered basis would not be deductible until 2016, the year after the end of the MACRS 5-year period.

Acknowledging this bizarre result, the IRS did offer up a safe harbor, which is about as easy to follow as Chinese arithmetic. It works as follows:

For the following steps, assume a $20,000 luxury auto placed in service during 2010, depreciable over 5 years MACRS.

1. In year 1, you deduct the lesser of your cost or the S280F first year depreciation limit ($11,060 in our example above),

2. In year 2, you must determine your remaining depreciable basis as if you took the 50% bonus depreciation, rather than the 100% bonus depreciation, in year 1.  This depreciation would be $12,000 in our example (50% * $20,000 cost =$10,000 plus first year MACRS depreciation of 20% of the remaining $10,000 basis.)

3. You then subtract the amount determined in Step 2 by the depreciation actually taken in Step 1 ($12,000-$11,060=$940.) This result, if positive, is not deductible until the year after the MACRS period expires, or 2016 in our example.

5. The remaining undepreciated basis of $8,000 is depreciated as if the taxpayer took the 50% depreciation in year 1 instead of 100% depreciation. So in years 2-6, the depreciation is equal to the lesser of the MACRS depreciation (32%*$10,000=$3,200 for year 2) or the S280F limit in place ($4,900 for year 2). In the event any basis reamins undepreciated after the end of the MACRS recovery period because of the S280F limitations, it would be recovered in year 7, along with the amount from Step 3.

Simple, right?

There are additional rules for what happens if Step 3 results in a negative number, but I don’t want anyone’s head to explode, like that guy  from The Running Man. The point is, unless you want to go five years without any depreciation deductions on your luxury auto, you may want to consider this safe harbor. It is adopted by simply applying this methodology in year 2 of the depreciable life of your luxury auto.

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While the Internal Revenue Code allows a taxpayer to deduct a loan that has become worthless, it differentiates between “nonbusiness” and “business” debts. What’s the significance?

While business bad debts are afforded ordinary loss treatment, nonbusiness bad debts are deductible only as short-term capital losses. In an economy where capital gains are difficult to come by, this disparity provides tremendous motivation to classify a worthless debt as a business debt, thereby avoiding a potentially unusable short-term capital loss.

Unfortunately, the relevant history has been largely unfriendly to individuals seeking ordinary loss treatment; it is rare to find a loan made by an individual classified as a “business” bad debt by the IRS or the courts.

Today, however, the Tax Court provided just such a victory for the taxpayer in Dagres v. Commissioner, 136 T.C. 12 (2011). 

In Dagres,  the taxpayer was the Manager Member of several LLCs. Each LLC was a general partner in a venture capital fund, which invested in start-up technology companies. The LLCs managed the investments of each VC fund, and in addition to the 1% capital interest each LLC held in the VC fund, they were also granted a 20% profits interest in exchange for their management services.

In addition, Dagres was also an employee of a related corporation that provided services on behalf of the LLCs. While Dagres earned a sizable salary as an employee, the income from his share of the 20% profits interest he received for manging the LLCs was nearly 20 times larger.

During his career, Dagres fostered numerous business relationships that helped him identify potential investments. One of his primary referral sources suffered greatly when the technology bubble burst in the early 2000’s, and he came to Dagres for help. Dagres obliged, loaning the business associate $5 million. As consideration for the note, the debtor agreed to continue referring any potential investment opportunities exclusively to Dagres.

When the loan went bad, Dagres deducted the worthless piece as a business bad debt. The court agreed, acknowledging that even though Dagres was partially an investor (as a member in LLCs owning a 1% capital interest in the VC funds), and partially an employee, he made the loan neither in his capacity as an investor nor an employee, but rather in order to protect the main source of his income: the 20% profits interest he received for managing the investments of the VC fund.

The profits interest, according to the court, was not indicative of an investment, but rather as compensation granted to the LLCs for managing the VC funds’ investments, a trade or business that was attributed to Dagres as the managing member.

It should be interesting to see if the IRS appeals, but in the interim, Dagres provides a rare example of an individual taxpayer not engaged in the business of making loans being granted ordinary loss treatment because the dominant motivation for the loan was to secure his income from a related trade or business.

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If you purchased a home in 2009 and received the $8,000 homebuyer’s credit, there is a requirement that the home must remain your principal residence for 36 months, or else the credit will be “recaptured” in the year of disposal (or the year the home ceases to be your primary residence.)

So if you sold your home in 2010 (or 2011 for that matter), you may think you owe the IRS a cool $8,000. Well, slow down there, maestro.

Under Section 36(f)(3), if the principal residence was sold to a person who isn’t related to the taxpayer, recapture is limited to the amount of gain (if any) on the sale. For this purpose, gain is determined by reducing the residence’s adjusted basis by the amount of the credit.

Example: Taxpayer, a first-time homebuyer, purchases a home for $300,000 in 2009 and claims a $8,000 first-time homebuyer credit.  In 2010, the taxpayer sells his home for $320,000 in 2011. He has no adjustments to basis. The taxpayer must recapture the previously taken credit of $8,000 for 2010.

Example 2: Assume that the taxpayer in Example 1 sold his home to an unrelated person for $270,000 in 2010. He has no adjustments to basis. Taxpayer recognizes a loss of $30,000 ($270,000 amount realized minus $300,000 basis). Taxpayer need not pay an additional tax of $8,000 for 2010 since the taxpayer recognized a loss on the sale.

In today’s real estate market, it is very possible that a taxpayer who sells a home in 2010 or 2011 that was purchased in 2009 will in fact recognize a loss on the sale. If that’s the case, you can at least take solace in the fact that you don’t owe the IRS an additional $8,000.

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Beginning with tax years starting January 1, 2010, corporations with assets in exess of $100,000,000 are required to complete Schedule UTP with its tax return. Schedule UTP discloses information regarding certain “uncertain tax positions” the corporation may have taken on its tax return and for which it established a reserve in their financial statements (or didn’t establish a reserve because the taxpayer expects to litigate the position.)

Today, the IRS issued Frequently Asked Questions on their website to supplement the draft instructions to Schedule UTP, and clarify the interplay between:

1) The standard for determining whether a tax position requires inclusion in Schedule UTP, and

2) The standard for determining whehter a tax position requires a reserve be established FIN 48 purposes on the audited financial statements.

See the FAQ here.

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Below is an interesting write-up of a recent case impacting estate planning and the use of Qualified Personal Residence Trusts from one of WS+B’s Estate and Trust experts, Hal Terr.

Last week, the Tax Court ruled in favor of the taxpayer in the Estate of Sylvia Riese v. Commissioner (TC Memo 2011-60), holding that the taxpayer could avoid inclusion of a residence previously gifted to trusts for the benefit of her children through the use of a Qualified Personal Residence Trust (QPRT) from the value of her estate.

The decedent had a significant fortune and engaged estate planning advisors to reduce the value of her taxable estate.  The decedent’s attorney suggested the use of a QPRT to transfer her personal residence at a reduced transfer tax cost and during the planning of the QPRT, the attorney explained to the decedent that if she was to occupy the residence after the QPRT term she would need to pay fair market rent to the beneficiaries of the trust.  When the QPRT term ended in April 2003, the trustees of the QPRT contacted the attorney for assistance on how to determine fair market value rent for the residence.  However, during the time after the QPRT trust term ended the decedent died and no payments of rent were actually made.

Under IRC 2036, the value of the gross estate includes all property that a decedent has transferred (except in case of a bona fide sale for an adequate and full consideration) under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not end before his death—

 (1) the possession or enjoyment of, or the right to the income from, the property, or

(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom

The IRS argued that under IRC 2036, the decedent retained possession and enjoyment of the residence without adequate consideration and as such the residence should be taxable in the decedent’s estate.   

However, the Tax Court was persuaded by the good faith testimony of the estate planning attorney and the trustees that they fully intended to determine the rent by the end of the year.  In addition, this good faith intention was supported by the fact that the discussion of the requirement for the payment of rent occurred during the implementation of the QPRT and after the decedent’s passing. 

Planning Tip: Due to the recent increase in the lifetime gift exemption to $5 million and depressed residential values, QPRTs have become a popular estate planning transfer technique for wealthy individuals.  What can be learned from the court’s decision? 

First, in the event of an untimely death, even the best planning can be undermined by poor execution.  If there is an expectation of use of the residence by the grantor after the QPRT term, have the attorney draft a rental agreement when the QPRT trust agreement is signed.  As the term of the QPRT trust nears the end, gather evidence to determine the actual fair market value rent that should be charged for the use of the residence.  When the trust term ends and the grantor is residing in the residence, the grantor should actually pay rent each month and show the transfer of cash between the grantor and owner of the residence.  With these steps, individuals may be able to avoid the extensive professional fees incurred by the Estate of Sylvia Riese  to prevent the inclusion of the residence in the decedent’s estate.

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Section 162 allows a deduction for all ordinary and necessary expenses in carrying on a trade or business. Since a taxpayer may be in the trade or business of being an employee, an employee can deduct those business expenses that are not reimbursed by the employer as a Schedule A itemized deduction. Seems simple enough, right?

Today, the Tax Court decided De Werff v. Commissioner, T.C. Summary Opinion 2011-29, which reminds us that an employee is not entitled to an unreimbursed employee expense — even if they meet the “ordinary and necessary” tests and the substantiation requirements of Section 274 — if the employee was entitled to reimbursement from the employer (see Orvis v. Commissioner, 788 F.2d 1406 (9th Cir. 1986).

In 2004, De Werff deducted food, travel, vehicle and parking expenses incurred in her role as an employee. For each expense, the court held that the since the employer’s reimbursement policy would have repaid De Werff for her expenses had she documented and submitted the claims, the expenses were not allowable as unreimbursed employee expenses under the case law cited above.

The lesson to be learned? An employee cannot covert a business expense of her company into one of her own simply by failing to seek reimbursement.  Instead, as De Werff clearly illustrates, in this scenario everyone loses, and the deduction simply disappears.

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