Archive for May, 2011

As we discussed here, real estate “professionals” get advantageous tax treatment under Section 469. While rental activities are de facto passive — meaning losses from such activities can only be deducted against passive income — losses generated by real estate professionals are not subject to these limitations. As we discussed in that previous post:

In order to qualify as a real estate professional, a taxpayer needs to pass two tests under Sec. 469(c)(7)(B), 

(1)  more than one half of the personal services performed by the taxpayer in all trades or businesses for the tax year must be performed in real estate trades or businesses in which the taxpayer materially participates (you must spend more hours on real estate activities than non-real estate activities), and

 (2) the taxpayer must perform more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. (you must spend more than 750 hours in each real estate activity, unless you elect to group them in which case you must spend more than 750 hours on the combined real estate activities)

In discussing the hurdles in meeting these tests, we added:

The second test of Section 469(c)(7) – requiring the taxpayer to spend more than 750 hours per year in real property trades or business in which the taxpayer materially participates — poses a serious challenge. Absent an election to group the activities under Sec. 469(c)(7)(A), you will have to spend more than 750 hours in each rental activity.

Ordinarily, this election to group the activities — thereby reducing the taxpayer’s requirement to spend 750 hours in the combined activities, rather than each individual activity — is made by filing a statement with the taxpayer’s original income tax return for the taxable year. In the event the taxpayer failed to timely file the election, they would need to file a ruling request asking for 9100 relief and pay the appropriate user fee.

In several weeks, the IRS will publish Rev. Proc. 2011-34, which simplifies the procedure to receive late relief for an election to aggregate rental activities for qualifying taxpayers, while also allowing a taxpayer to retroactively aggregate their rental activities. In order to use the Rev. Proc., a real estate professional must meet the following requirements:

1. The taxpayer failed to make an election solely because the taxpayer failed to timely meet the requirements in §1.469-9(g);

2. The taxpayer filed consistently with having made an election on any return that would have been affected if the taxpayer had timely made the election. 

3.  The taxpayer timely filed each return that would have been affected by the election if it had been timely made. The taxpayer will be treated as having timely filed a required tax or information return if the return is filed within 6 months after its due date, excluding extensions;

4. The taxpayer has reasonable cause for its failure to meet the requirements in § 1.469-9(g).

Assuming these requirements are met, the taxpayer must do the following in order to be granted late relief:

  • Attach the statement required by § 1.469-9(g)(3) to an amended return for the most recent tax year and mail the amended return to the IRS service center where the taxpayer will file its current year tax return.
  • The statement must contain the information required on the original election under § 1.469-9(g)(3) and must explain the reason for the failure to file a timely election.
  • The statement must identify the taxable year for which it seeks to make the late election.
  • Finally, the statement must state at the top of the document “FILED PURSUANT TO REV. PROC. 2011-34.”

Any taxpayer receiving relief under this revenue procedure is treated as having made a timely election to treat all interests in rental real estate as a single rental real estate activity as of the taxable year for which the late election was requested.

Clearly, this will reduce the administrative burden of requesting a formal private letter ruling, but more importantly, it will allow taxpayers who failed t0 timely file the election to retroactively treat their rental activities as aggregated. This election to aggregate may well make the difference between qualifying and not qualifying as a real estate professional under the second mechanical test of Section 469(c)(7).

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Just when I’d convinced myself that Ryan Howard was the embodient of taking a paycheck while providing no value,  I stumbled upon this report from TRAC, an IRS monitoring and data gathering group based out of Syracuse University,which provides the following:

A year and a half ago, in the fall of 2009, the Internal Revenue Service created a special new unit to examine “high wealth individuals” and the extent to which they were complying with the tax laws.

In an October 2009 speech announcing the new program, IRS Commissioner Douglas Shulman said that the purpose of the Global High Wealth Industry Group (GHWIG) was to “centralize and focus the IRS compliance expertise” on “high wealth individuals and their related entities.”

While the creation of this new group appeared to signal that the IRS was going to launch an aggressive effort to single out high wealth individuals for special attention, very timely agency data shows that so far this has not been the case. In fact, through the end of March 2011…GHWIG has only managed to audit a handful of tax returns in its first 18 months: two (2) in fiscal year 2010 and only eleven (11) during the first six months of FY 2011…

That’s right. Eleven. As a point of reference, in that same time span, the Large Business & International Division — responsible for audits of businesses with assets in excess of $10,000,000 — audited nearly 75,000 returns. While it sounds like the GHWIG has some catching up to do, they’ve got no plans to start burning the midnight oil anytime soon.

While it is likely the IRS is planning to expand its audit goals in the future, at least for now they are very skimpy. In its 12-month target for all of FY 2011, the agency called tor the audit of only 122 returns.

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In Weekend Warrior, T.C. Memo 2011-105(2011), the taxpayer was a successful C corporation engaged in the business of designing trailers for recreational vehicles. Business was growing fast, and upon the advice of a team of advisors, the sole shareholder of Weekend Warrior established an S corporation (Leading Edge) for the purpose of establishing an incentive plan for rank-and-file employees and centralizing management.

Weekend Warrior entered into a management agreement whereby Weekend Warrior would pay $4,175,000 during year 1 to Leading Edge to perform accounting, marketing, sales and purchasing, human resources, and product research and development functions for Weekend Warrior. 

Upon audit, the IRS disallowed Weekend Warrior’s  management fee expense. The Service argued that Leading Edge was a sham corporation and should be disregarded, as it had neither economic purpose nor substance, as its sole purpose was to provide a deduction to Weekend Warrior, reducing Weekend Warrior’s taxable C corporation income.

The Tax Court, disagreed with this contention, however, providing:

Leading Edge provided personnel services to Weekend Warrior. It maintained an investment account and bank accounts. It paid its employees by check, adopted a retirement plan, which respondent does not timely argue was a sham, kept books and records, and engaged Mr. Baily to appraise its stock. Leading Edge invested excess funds and at least from August 2003 through December 2004 purchased and sold stocks and received dividends. Corporate formalities were followed. Leading Edge filed Federal income tax and employment tax returns. We conclude Leading Edge carried on sufficient business activity to be recognized for Federal income tax purposes.

Undeterred, the IRS also argued that the management fee should be disallowed on the grounds that it was not an “ordinary and necessary” business expense of Weekend Warrior. On this position, the Tax Court agreed, denying Weekend Warrior’s $4,175,000 deduction based on the following:

Whether the fees were reasonable and necessary depends on what services Leading Edge actually performed (as opposed to what the management agreement provided it would perform). The record, however, is sparse as to the details of the parties’ actual relationship. Leading Edge issued no invoices to Weekend Warrior for 2003 and 2004. Of the four invoices that Leading Edge issued for 2002, two predate the incorporation of Leading Edge, raising questions regarding the genuineness of the other two invoices as well. The invoices contain only a general description “Management Fee”. The record is also sparse regarding the identity of the persons who allegedly supplied services on behalf of Leading Edge under the management agreement. Because the record is vague as to what specific services Leading Edge performed for Weekend Warrior under the management agreement and who exactly performed those services, we cannot conclude that the fees for those undefined and unquantified services were necessary or reasonable.

The lesson is obvious. As prior case law dictates,  a taxpayer may adopt any form he desires for the conduct of his business and the chosen form cannot be ignored merely because it results in a tax savings. However, an entity must have a valid business and economic purpose, and arrangements between entities must be formalized and real. As practitioners, we often concern ourselves with whether a party is paying  a discounted amount in a non-arms length transaction. As Weekend Warrior points out, we must be equally cognizant of whether the service provider is holding up their end of the bargain; providing a level of service that justifies the payment received.

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In order to deduct travel expenses, an individual taxpayer must show:

1) that the expenses are ordinary and necessary,

2) that the taxpayer is away from home on business when he incurred the expense, and 

3) the expense was incurred in pursuit of a trade or business.

The key words among those requirements are “away from home,” a seemingly straightforward phrase whose interpretation has spawned a lengthy case history. You see, in the eyes of the IRS, your tax home is not necessarily the same as the place where host your weekly Bunco game, receive your cherished subscription to Cracked, and store that ’69 Mustang you’ve been meaning to fix up.

The Tax Court has previously interpreted a taxpayer’s “home” under Section 162 to mean his principal place of employment and not where his personal residence is located. Mitchell v. Commissioner, 74 T.C. 578 (1980) The court also recognizes an exception to this general rule in situations where the taxpayer is away from his home on a temporary rather than indefinite or permanent basis.

In  Scroggins v. Commissioner, T.C. Memo 2011-103 (2011), the taxpayer (Scroggins) and his wife lived in Georgia, but worked primarily in California. Using the taxpayer’s ATM and banking activity, the IRS argued that Scroggins spent the majority of the years at issue in California, a sufficient amount of time to make California his tax home.

The Tax Court agreed, and denied all of Scroggins travel, lodging, and meals expenses related to his time in California. In reaching its decision, the court noted that because Scroggins particular line of business (medical consultant) could not be supported locally in Georgia but rather required a metropolis with large hospitals , it was “reasonably known to Mr. Scroggins that he would be employed for a very long time away from Georgia.” Also noting that Scroggins lack of local working relationships meant he had no business reason for his tax home to be in Georgia, the Tax Court concluded that Scroggins tax home was indeed in California.

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This from WS+B’s Trust and Estate expert, Hal Terr:

In the Estate of Erma V. Jorgensen (CA 9 5/4/2011), the Court of Appeals for the Ninth Circuit upheld the Tax Court’s decision and determined that the marketable securities the decedent transferred to two separate family limited partnerships (FLPs) were includible in her estate under IRC Code Section 2036.  In its decision, the Ninth Circuit noted that “transfers to family limited partnerships such as this are subject to heightened scrutiny, and, to be bona fide, must objectively demonstrate a legitimate and significant nontax reasons for the transfers.”  The Ninth Circuit agreed with the Tax Court’s decision that the “bona fide sale” exception did not apply to the gifts of partnership interests since there was no valid business purpose for the FLPs.  In addition, the Court concluded that there was an implied agreement at the time of the transfers that the decedent would retain the economic benefits of the property, even if the retained rights were not legally enforceable.

Ms. Jorgensen was a resident of California when she passed away on April 25, 2002.  Prior to her death, Ms. Jorgensen established two FLPs and funded with marketable securities.  Ms. Jorgensen made gifts of the limited partner interests to her children and grandchildren, and although the value of the gifts exceeded the then available annual exclusion of $10,000, she did not file any gift tax returns for these transfers.  A letter from Ms. Jorgensen’s attorney stated that the “purpose of the partnership formations was the hopefully the partnerships will qualify for the 35% discount.”  Neither partnership operated a business.  The management of the FLPs underlying marketable securities were not active.  In addition, Ms. Jorgensen wrote personal checks on the partnership accounts and the estate tax liability for Ms. Jorgensen’s estate was paid from funds from the FLPs.

Under IRC Section 2036(a)(1), an individual’s gross estate includes property he or she transfers during their lifetime if he or she retained for life the possession or enjoyment of the property or the right to the income from the property.   This requirement is met if there is an implied agreement among the parties to the transaction at the time of transfer that the transferor may retain the possession or enjoyment of, or the right to the income from, the transferred property.

The Ninth Circuit disagreed with the estate’s position that the personal checks written on the accounts of the partnerships were de minimis stating “we do not find it de minimis that the decedent personally wrote over $90,000 in checks on the accounts post-transfer, and the partnerships paid over $200,000 of her personal estate taxes from partnership funds.”

From prior case law, some of the guidelines that help meet the bona-fide exception for transfer of FLP interests are as follows:

Create the FLP using a valid written agreement under state law.  (Estate of Kimbell v. United States, 91 AFTR 2d, 585);

  1. Document the non-tax reasons for establishing the partnership;
  2. Separate partnership assets from personal assets.  Clients should attain a separate tax identification number for the partnership, establish a separate bank account for the FLP, and maintain proper books and records.  (Estate of Harper v. Commissioner, 83 TCM 164);
  3. Transfer the title of assets contributed to the FLP as soon as reasonably possible. (Estate of Harper v. Commissioner, 83 TCM 1641);
  4. Do not contribute the bulk of the transferor’s assets to the FLP.  Personal residences, automobiles and other personal items should not be used for funding an FLP.  (Estate of Strangi v. Commissioner, 85 TCM 1331)
  5. The general partner(s) should manage the FLP pursuant to their fiduciary duty mandated under state law.  Generally the investment philosophy of the FLP should not mimic that of the general partner.  (Estate of Kimbell v. United States, 91 AFTR 2d, 585);
  6. Make sure all distributions from the FLP are performed on a pro-rata basis as outlined in the partnership operating agreement.  (Estate of Thompson v. Commissioner, 84 TCM 374);
  7. Engage in transactions with non-related parties, rather than exclusively with family members.  (Estate of Thompson v. Commissioner, 84 TCM 374);
  8. Ensure that the FLP will be a going concern after the death of the original partner.

In the current case, we learn that the mere funding of the partnership with long held marketable securities will not overcome the “bona fide sale” exception.   There should be some active management of the marketable securities transferred and input should be received from the other partners of the FLPs on the investment of partnership funds.  In addition, the Courts are finding that the payment of decedent’s estate tax from partnership funds implies that the decedent had full control of the partnership’s underlying assets and as such, never surrendered the use, enjoyment and possession of the assets.

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And more from Mr. Terr…

In Estate of Gertrude H. Saunders et al. v. Commissioner; 136 T.C. No. 18; No. 10957-09 (28 Apr 2011), the Tax Court rejected a claim by an estate that litigation could potentially cost the estate $30 million.   As demonstrated by various expert reports submitted on behalf of the estate, the value of the claim was too uncertain to be deducted based on estimates as of the date of death.

IRC Code Section 2053(a) allows various deductions in computing the taxable estate of a decedent, including claims against the estate.  IRS Reg. 20-2053-1(b)(3) permits a deduction for a claim that is “ascertainable with reasonable certainty, and will be paid.”  In the Estate of Smith (CA 5 12/15/1999), the Fifth Circuit allowed a deduction for the date-of-death appraised value of a claim outstanding at the decedent’s death even though the claim was later settled for a lesser amount.  Although the Tax Court agreed with the IRS that the deduction should be limited to the settled amount, the Fifth Circuit ruled in favor of the taxpayer that the deduction could not be based on a post-death settlement amount.

In Estate of Gertrude H. Saunders, the claim in question was on the contingent liability of the decedent’s pre-deceased husband.   The decedent’s husband was being sued for attorney malpractice at the time of his passing by a former client.  The former client’s estate sued for $90 million and to settle the pre-deceased husband’s estate, the Estate of Gertrude Saunders agreed with the IRS that Gertrude would be responsible for any judgment or settlement of the malpractice case.   Ms. Saunders passed away before the case went to trial and the estate claimed a $30 million deduction for the malpractice claim.

In 2007, a jury found in favor of the plaintiff, however, did not award any damages.  Upon settlement of the case, the Estate of Saunders paid $250,000 in attorney fees to the plaintiff’s estate attorney and waived its right to $289,000 of costs awarded in the state court judgment.

In its finding, the Tax Court stated it did not consider the post-death settlement of the malpractice case but rather focused on the various valuation reports provided by the estate.  One valuation report established the potential recovery against the estate to be $90 million and determined the likelihood of that recovery was a 25% to 50% chance.  Because of settlement possibility and other wide range of unknowns, the valuation was initially estimated at $30 million and then subsequently decreased to $25 million.  Another valuation expert provided an analysis and reduced the valuation for lack of assignability and estimated a net value of $19.3 million.  The IRS submitted a valuation report that determined that the claim was without merit, had “at most a 3% chance of recovery” and determined the value should be between $25,449 to $1,500,395.

The Tax Court determined that none of the experts for the estate could reasonably provide that the $30 million claimed on the estate tax return or any specific amount  would be paid as required by IRS regulations.   In his decision, Judge Cohen provided “Our review of the estate’s expert reports, standing alone, convinces us the value of the Stonehill claim against the Saunders estate is too uncertain to be ducted as of November 2004”.  The Tax Court concluded that the plaintiff’s claim against the estate was not deductible at the time of the decedent’s death and the amount actually paid during the administration of the estate was the amount that could be deducted.

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In general, both cash and accrual basis taxpayers must capitalize prepaid expenses that benefit the taxpayer beyond the end of the taxable year of payment. This is why you often see prepaid assets related to insurance contracts and similar expenses capitalized on the balance sheet; to be expensed as the benefits are enjoyed by the taxpayer.

Effective 1.1.2004, however, Treasury Regulation 1.263(a)-4 gave taxpayers a nice little planning opportunity by creating the “12-month rule.”

 The “12-month rule,” however, provides that a taxpayer does not have to capitalize prepaid expenses if the right or benefit doesn’t extend beyond the earlier of:

(1) 12 months after the first date on which the taxpayer realized the right or benefit, or

(2) the end of the tax year following the tax year in which the payment was made.

Consider the following examples:

On December 1, 2010, XCo pays a $10,000 insurance premium to obtain a property insurance policy with a one-year term that begins on February 1, 2011. Because the right or benefit attributable to the $10,000 payment extends beyond the end of the tax year following the year XCo makes the payment, the 12-month rule does not apply and XCo must capitalize the $10,000 payment.

Variation: Assume the same facts except that the policy has a term beginning on December 15, 2010. The 12-month rule now applies because the right or benefit attributable to the payment neither extends more than 12 months beyond December 15, 2010 (the first date the corporation realizes the benefit) or beyond the tax year following the year the payment is made. XCo need not capitalize the $10,000 payment.

Pretty nice, right? A taxpayer will significant qualifying prepaid assets can enjoy a one time favorable timing adjustment by changing their method of accounting to deduct these expenses.

As one taxpayer learned today, however, one of the key requirements for enjoying the benefits of IRS-granted opportunities like the 12-month rule is that the law actually be effective.

In Lattice v. Commissioner, T.C. Memo 2011-100,  the taxpayer, a corporation, could see the writing on the wall in 2002 that the 12-month rule was coming. Recent decisions by the appeals court in Zazinovich and US Freightways Corporation had permitted  the taxpayer to deduct certain short-term prepaid assets, and the IRS had issued both a Notice of Proposed Rulemaking and Industry Directive indicating that they too would soon adopt a 12-month rule permitting taxapayers to deduct certain prepaid expenses. 

However, in December 2002, the IRS asked taxpayers not to submit a change in accounting method to deduct these prepaid expenses until regulations were finalized.

Undeterred, the corporation filed a 3115 seeking to change its accounting method in 2002, and deducted its prepaid expenses on its 2002 return, generating a large NOL that it carried back to earlier years, generating sizable refunds.

The IRS denied the change in method, and then denied the deduction of the prepaid expenses, citing the lack of final regulations on the issue. The Tax Court agreed, holding that in order for the corporation to benefit from the 12-month rule, it would have to wait until the final regulations were promulgated in 2004.

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