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Archive for October, 2011

Following up on our previous post, those squares at the IRS have once again killed the collective buzz of an otherwise law-abiding medicinal marijuana facility and its clients:

When is a valid business expense deduction not a valid business expense deduction?  When you are running one of the country’s largest, most successful medical marijuana dispensaries, that’s when.  You see, back in 1982, Code Sec. 280E was added to the Internal Revenue Code.  We all remember the “war on drugs”, right?  Well, Congress decided that one way to crack down on drug traffickers was to disallow them any deductions incurred in the process of drug trafficking.  Specifically, Code Sec. 280E provides:

 No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business  . . . consists of trafficking in controlled substances . . . which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

 Now, I don’t know how compliant your average, run of the mill drug trafficker is with his or her tax filing obligations, but this would be quite a bitter pill to swallow (pun intended).

Fast forward to 2011.  Many states have now passed legislation that makes the use of medical marijuana legal.  At the forefront of this movement was the State of California, home of the Harborside Health Center.  Recently, the IRS used Sec. 280E to deny Harborside a deduction for many general business deductions.  As you can imagine, this generated quite a tax obligation, one that may put the company (and likely many other dispensaries like them) out of business. 

Stay tuned for further developments, as this is likely to be an evolving issue as more and more states look at medical marijuana legislation.  The full article can be found here.

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Pop quiz, hotshot. Can a taxpayer deduct mortgage interest on a home that’s never actually built?

Well, if you’d bothered to read my title, you’d already know the answer. And that answer, according to the Tax Court’s decision today in Rose v. Commissioner, T.C. Summary Opinion, 2011-117, is a resounding “yes.”

Facts

  • In 2006, Mr. Rose (Rose) purchased land and a home on beachfront property in Florida for $1,575,000. Rose didn’t want the house; he wanted to build his own. Thus, as part of the contract, the existing house was torn down prior to Rose’s purchase.
  • To purchase the property, Rose took out a $1,260,000 mortgage.
  • Florida required a lengthy permit application process before Rose could build on beachfront property. Before an application could even be submitted, Rose was required to perform survey work and provide core samples to the State.
  • To further the application process, Rose put together a team of architects, engineers, and designers who prepared and submitted the construction and site plans.
  • In early 2008, a full two years after Rose purchased the land, his permit to build was approved. Unfortunately, by that time the local real estate and lending markets had crashed, and Rose couldn’t obtain the necessary financing.
  • As a result, the house was never built, and Rose sold the raw land in 2009, taking a $850,000 bath.

On his 2006 and 2007 tax returns, Rose deducted the interest on the 2006 mortgage to purchase the raw land as “qualified residence interest.” The IRS disallowed the deductions, posing the logical argument that a home cannot qualify as a qualified residence — and thus mortgage interest can never be deducted — if it’s never built.  

 The Tax Court disagreed, siding with Rose and allowing the mortgage deductions.

 Relevant Law

Qualified residence interest is any interest that is paid or accrued during the taxable year on acquisition debt or home equity debt. Acquisition debt is any debt secured by the qualified residence of the taxpayer and incurred in acquiring, constructing, or substantially improving the qualified residence.

Section 163(h)(4)(A)(i) defines a qualified residence as the principal residence of the taxpayer and “one other residence of the taxpayer which is selected by the taxpayer.”

 Pursuant to section 1.163-10T(p)(5), a taxpayer may treat a residence that is “under construction” as his or her second residence for up to 24 months “commencing on or after the date that construction is begun”.

Tax Court Decision

To determine if Rose’s 2006 and 2007 mortgage interest was deductible, the Tax Court had to determine whether “construction” had begun with regards to Rose’s planned Florida home. In reaching its decision, the Tax Court held that Rose’s construction activity began even before he owned the land.

For all practical purposes, petitioners were responsible for the demolition work, and it came about as a direct result of their purchasing the property. The fact that petitioners did not hold legal title to the property at the time that the work occurred does not negate its relevance to our inquiry… Therefore, we find that by causing an entire house to be demolished and by clearing the lot so that it would be suitable for a new residence, petitioners undertook significant steps in the process of constructing their vacation house, as early as January 2006.

The court also determined that Rose’s two-year effort as part of the permit application process constituted continued “construction” on the home.

The work petitioners were required to complete before filing the application was extensive and required the labor of multiple building and design professionals. Petitioners undertook significant work in preparing to obtain a construction permit, and that work was a necessary component of the overall process of construction. We hold that the property was “under construction” as a residence during 2006 and 2007.

Lastly, the Tax Court was left to decide whether Rose’s failure to ever build the house negated the mortgage interest deductions in 2006 and 2007. Reaching the logical conclusion, the court held that it didn’t, as in 2006 and 2007, Rose would not be aware that the home would eventually fail to be built.

Section 1.163-10T(p)(5)(i) and (ii) allows qualified residence interest to be deducted for the 24-month period following the commencement of construction. In the event the residence under construction has not been completed and is not ready for occupancy by the end of the 24-month period, the residence under construction ceases to qualify after that 24-month period ends. If petitioners intended to claim the deduction for interest during the construction period, they had to claim it on their returns for the years immediately following the commencement of construction in January 2006…[in those years], it would be impossible for petitioners or the Internal Revenue Service to have known that the proposed residence would never become ready for occupancy.

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Oftentimes in life, we say things merely because they appear to reflect conventional wisdom, regardless of whether we’ve ever actually independently verified their validity. Things like:

“Meryl Streep is the greatest actress of her generation.”

“He may enjoy lukewarm commercial success, but Beck is an extraordinarily talented musician.” 

“Anything bigger than a handful, and you’re risking a sprained thumb.”   

It’s no different in the tax world. For example, tax advisors almost universally offer up the following advice to clients seeking guidance on how to characterize the gain from the sale of assets or payments received as a result of a legal settlement:

“As long as you’ve got a bargained for, arms-length agreement with an unrelated party, the IRS won’t attack your allocation.”

Unfortunately, as Healthpoint, LTD., DFB Pharmaceuticals, Inc. v Commissioner, T.C. Memo 2011-241 reminded us today, just because we say it, doesn’t make it true. 

In Healthpoint,the taxpayer was a pharmaceutical partnership that manufactured and marketed a very successful drug; Accuzyme. A competitor came along and introduced Ethezyme, a drug that was marketed as a generic form of Accuzyme. Unfortunately, Ethezyme also contained a potentially harmful chemical that sickened patients. Once word got out, the damage wasn’t limited to the manufacturer of Ethezyme, however, as their marketing strategy had been rather successful. As a result, when the reputation of Ethezyme suffered, so did the reputation of Accuzyme, as in the eyes of the public, the drugs were one and the same. 

In response, Healthpoint filed two separate suits against the competitor, alleging false advertising, unfair competition, and trademark dilution. Healthpoint won the first suit, with a jury awarding the company $16,100,000. The jury allocated the damages as follows:

Actual damages: $5,000,000      Lost profits: $1,640,00     Punitive damages: $3,1745,000      Damage to goodwill: $6,349,000

While the second suit was in deliberation, the competitor filed an appeal with regards to the first suit. Healthpoint decided the best course of action was to pursue a settlement of both suits at once.

After much negotiation, the two parties agreed to settle, with Healthpoint receiving $16,300,000 between the two suits. Both parties had a vested interest in refraining from calling the bulk of the settlement punitive or compensatory damages: the competitor because an admission of wrongdoing would only further damage their already sullied reputation, and Healthpoint because any punitive or compensatory damages would generate ordinary income.

In light of these facts, a final settlement agreement was executed allocating the $16,300,000 as follows:

Lost profits: $1,800,000   Damage to goodwill: $14,5oo,00o

On its Form 1065 for the year of settlement, Healthpoint reported the $14,500,000 as long-term capital gain, and the $1,800,000 of lost profits as ordinary income. The IRS challenged the characterization, arguing that the allocation of the settlement income should follow the allocation provided for by the jury upon Healthpoint’s victory in the initial suit. This would effectively recharacterize $9,000,000 of the settlement payment from capital gain to ordinary income.

Healthpoint disagreed, repeating the long-held belief that the IRS and the Tax Court should respect the allocations provided for in the final, executed settlement agreement.

The Tax Court, likely to the surprise of many CPAs, sided with the IRS, choosing to ignore the executed settlement agreement between two unrelated parties. In reaching its decision, the court stated:

Where there is an express allocation in the settlement agreement between the parties, it will generally be followed in determining the allocation for Federal income tax purposes if the settlement agreement is entered into by the parties in an adversarial context at arm’s length and in good faith.

The Tax Court then backtracked by adding:

However, general adversity between the parties to a lawsuit is to be expected. If the parties were generally adverse but ultimately allocated the funds in a way that did not represent the claims they actually intended to settle, then we need not respect the allocations made in the settlement agreement.

The court determined that while Healthpoint and its competitor may had been adverse parties, they both benefitted from characterizing the bulk of the settlement payment as harm to goodwill rather than punitive or compensatory damages: the competitor could salvage its reputation; Healthpoint could benefit from the long-term capital gain rates. Because both parties wanted to avoid calling the settlement payment damages, the court held that the allocation could not be respected.

Instead, the Tax Court required that Healthpoint characterize the income in the same manner as was handed down by the jury in the first suit. As a result, over $9,000,000 of the $16,200,000 payment was treated as ordinary income.

What Can We Learn? The decision in Healthpoint will prove difficult for a majority of CPAs to get their arms around. If we are presented with a signed, fully executed settlement agreement between two unrelated parties that has been negotiated at an arm’s length, we will rarely  – if ever — dig any deeper than the document itself. In many cases, we are not even privy or party to the negotiations; rather, we are merely presented with the final agreement and charged with accurately presenting it on a tax return.

Well, in Healthpoint, not only did the court dig deeper than a CPA may feel necessary, the taxpayer was also held liable for a substantial underpayment penalty. In refusing to apply the “reasonable cause” exception, the court noted that Healthpoint’s tax adviser was not asked to opine on the propriety of the allocations in the agreement, nor did he participate actively in the negotiations.

This should serve as an eye-opener to tax advisers everywhere.  To best protect our clients from exposure to additional assessments of tax and the associated underpayment penalties, we may need to insist on being an active part of any negotiation that ultimately dictates the characterization of income on a client’s tax return.

In closing, Beck sucks.

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