Posts Tagged ‘court’

Last week we discussed the Tax Court’s unfavorable ruling  in Amerisouth, in which the court deconstructed a cost segregation study performed on an apartment building. In our eyes, the most damning implication of the court’s decision was the requirement that all component assets of an apartment building be analyzed on whether they were essential to the operation or maintenance to a standard apartment building, rather than a generic shell building, thus forcing certain assets such as gas lines and kitchen sinks into a 27.5 year life.

The cost segregation community, however, has not shared our concern that Amerisouth was potentially a game changer; instead, the consensus has been that had the preparer of the cost segregation properly documented their findings and been adequately prepared to defend their reclassifications in front of the IRS, this harsh result could have been avoided. Below is a response sent from WS+B’s preferred cost segregation consultants —  Ernst & Morris Consultants Group — to all of its clients and partners, which reaffirms what we’ve been hearing elsewhere: The decision in Amerisouth was more a product of a sloppy study than a shift in the court’s approach to cost segregation:

To our valued clients,

On  Monday, March 12, 2012 the United States Tax Court released T.C. Memo 2012-67 regarding AmeriSouth XXXII, LTD. v. Commissioner  that has generated several emails to us from CPA’s around the country asking what’s our opinion on this case.  

AmeriSouth XXXII, LTD. purchased the Garden House Apartments in Mesquite Texas back in 2003 for 10.25 million and then spent another 2.0 million renovating the property. Garden House Apartments were originally constructed in 1970 and contain 366 units on 16 acres.  The taxpayer then hired MS Consultants to perform a Cost Segregation (CS) study. The study reclassified 3.4 million of the purchase price and subsequent renovations to 15 and 5-year MACRS property. The IRS disagreed with the taxpayer’s allocations, so the taxpayer filed a petition to challenge the IRS. The taxpayer then sold the property and discontinued further discussions with not only the IRS but with their legal counsel as well. In a rare move, the IRS allowed the taxpayer’s attorneys to be removed from the case since the taxpayer stopped all communications, so AmeriSouth was left to represent themselves in Court as they failed to file a post trial brief.

After reading the entire case, it’s obvious that the CS provider did a very poor job of defending his work in front of the IRS. They claimed the overhead incoming electric power lines as well as portions of the incoming utilities as 15-year MACRS property that the taxpayer did not own. Taking the costs associated with clearing and grubbing the site as 15 year depreciable property, qualifying the stove hood that they called a microwave exhaust, taking base molding along with many other mistakes obviously did not lend much credibility to the study. The CS provider claims that they had work papers but they were never admitted as evidence-wonder why?? In this case, it’s obvious that the CS provider did not provide enough evidence to prove that their allocations were valid and their report did not pass IRS scrutiny. The circumstances behind this case enabled the IRS to provide their positions with no rebuttal from the taxpayer. I’m sure the results would have been different if the taxpayer was more cooperative with the IRS.

As with every T.C. Memo, this case involves special circumstances between the taxpayer and the IRS. We will take these issues under consideration going forward. We do not anticipate changing how we perform CS studies for apartments. We emphasize to our clients the importance of having a qualified CS professional perform an engineering based study. Over the last few years during these tough economic times, some of our competitors started offering buy one study, get one free. The old saying of “you get what you pay for” definitely applies to this situation.

Every one of our studies provide a full narrative report, a set of cross referenced work papers and the support that we bring by defending our study for as long as it takes, at no charge. Feel free to visit the client testimonials regarding the defense of our work @ our website, www.costseg.com . Any questions or comments on this case or any CS issues you might have, please don’t hesitate to contact me @ 1-800-COST-SEG.

Thank you,

Michael P. Morris

Managing Director

Ernst & Morris Consulting Group, Inc.

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Today is March 15th, which means the last thing we should be writing about is a corporate tax issue. But let’s be honest, many of the more complex corporate returns get extended until September 15th, meaning the corporate filing season is really just starting as opposed to coming to an end.  

As tax-paying entities, C corporations present many issues that are unique when compared to the flow-through regimes of Subchapters K (partnerships) and S (S corporations). When these issues are not properly identified and addressed, the result is often real dollars to clients in the form of a tax deficiency assessed by the IRS.

One of the issues that causes confusion among even the most experienced of advisers is the limitation on net operating losses for certain C corporations that have undergone an ownership shift under the meaning of I.R.C. § 382.

Q: Why is Section 382 important?

A: Because over the next six months, it will simply be reflexive to offset any federal corporate taxable income for 2011 with available net operating loss carryforwards. Should a Section 382 change have occurred under your nose, however, those losses may well be limited in their usefulness.

Q: Why does Section 382 exist? What’s the point?

A: Section 382 exists predominately for two reasons.

1. In the context of an outright sale of corporate stock to new owners, Congress believes the new owners should not be able to “traffic” in NOLs and acquire losses that can be used to offset income previously earned by the buyer.

2. In the context of a change in corporate ownership created by the issuance of stock to new investors, Congress believes that new “controlling” owners should not have unfettered access to losses that were generated by the previous controlling shareholders

Q: OK, makes sense. So when does a corporation have a Section 382 change?

A: A Section 382 ownership change occurs when a loss corporation undergoes an ownership shift in which the stock ownership percentage (by value) of 5-percent shareholders has increased by more than 50 percentage points over such shareholders’ lowest ownership percentages within the testing period.

Q: I recognize all the words you just wrote, but I have no idea what that sentence means. Can we approach this differently?

A: Sure. There are a lot of moving parts in that definition, so breaking it down into its components is essential to developing an understanding of the mechanics of Section 382. Fire away.  

Q: What’s a loss corporation?

A: A loss corporation is any corporation entitled to use a NOL or generating an NOL for the tax year in which an ownership shift occurs. If a corporation is currently not generating a NOL and has no NOL carryforwards, then it can have all the ownership turnover in the world and Section 382 is not an issue.

Q: What is an ownership shift?

A:  Ownership shifts can take the form of sales of stock by existing shareholders, or issuances of new stock from the corporation to new or existing shareholders. Without ownership shifts, a corporation can generate unlimited NOLs without risk of Section 382 applying.

Q: Got it. So I need a corporation with losses and changes in the shareholders’ ownership. What if I have a bunch of shareholders with tiny interests?

A: The transfers of stock your concerned with involve 5-percent shareholders. While this definition can become confusing when evaluating public companies, in general a 5% shareholder is any shareholder that owns — directly or indirectly through attribution — 5% of the stock of the loss corporation. All of the shareholders who own less than 5% in a corporation are aggregated together and treated as one 5% shareholder.[i]

Q: Do I have to test every time a 5% shareholder buys, sells, or is issued additional stock?

A: Yes. However, the transfers of stock involving 5% shareholders must only be evaluated throughout a testing period. The testing period is the shorter of 1) three years, 2) the period of time since the corporation became a loss corporation, or 3) the period of time since a previous Section 382 change occurred.

Q: You lost me there. Can you show me what you mean?

A: Example: X Co. generated NOLs from 2003 through 2011. Thus, X Co. is a loss corporation. X Co. previously underwent a Section 382 change on May 3, 2008. On December 1, 2010, A, who owns 70% of X Co.’s stock, sells his stock to B, who was  not  previously a shareholder.

A is a 5-percent shareholder, and his sale of stock to B constitutes an ownership shift. X Co. must test its cumulative changes during the testing period. The testing period ends on December 1, 2010, and begins on the later of 1) December 1, 2007 (three years prior to the ownership shift); 2) January 1, 2003 (the date X Co. became a loss corporation); or 3) May 3, 2008 (the date of X Co.’s most recent Section 382 change resulting in a limitation). Thus, the testing period is from May 3, 2008-December 1, 2010.

Q: OK, but what exactly am I testing for?

A: To have an ownership change that limits your NOLs, there needs to be a cumulative increase in the ownership interest of 5-percent shareholders of at least 50 percent during the testing period. There are three common misconceptions surrounding this requirement that often result in inaccurate Section 382 computations:

  • The 50-percent increase is based on absolute values. If A’s ownership increases from 20% to 40%, even though his ownership interest has increased by 100% over his previous interest, it is not an absolute 50% increase. If ,however, A’s ownership increases from 20% to 75%, then A’s ownership has increased by 55-percent for purposes of Section 382.
  • The measure of the change is based on value, rather than pure percentage of stock held. This complicates matters greatly, as the value of the corporation must be known at each testing date in order to determine each 5-percent shareholder’s share of the total value. For a publicly traded corporation, value can be determined by merely glancing at the stock ticker. But for all other corporations, particularly those that may have multiple classes of stock outstanding with varying liquidation rights, the determination of the total enterprise value — and each 5-percent shareholder’s piece of that value on the testing date — often presents the biggest hurdle in measuring whether a Section 382 change has occurred.
  • The 50-percent increase is measured by comparing the percentage of value held by a 5-percent shareholder on a testing date to the lowest percentage owned by the shareholder throughout the testing period. Thus, if during a testing period A’s ownership of X Co. goes from 20% to 30%, and then from 30% to 45%, A’s increase for the second change is 25% (45% compared to 20%), rather than 15%. Even worse, the cumulative increases of the 5-percent shareholders are not offset by any decreases in interest by a 5-percent shareholder.

Q: Once I’ve confirmed I have a 50-percent change, what do I do next?

A: Once it has been determined that a Section 382 change has in fact occurred, an annual limitation must be determined on the utilization of the pre-change losses against taxable income. The limitation is generally equal to the long-term tax exempt rate in place during the month of change (issued by the IRS every month) multiplied by the value of the corporation immediately prior to the ownership change. The resulting amount represents the maximum amount of taxable income the corporation may offset in a post-change year with pre-change NOLs.

Example: X Co. underwent a Section 382 change on December 31, 2011. The value of the corporation was $1,000,000 prior to the change, and the long-term tax exempt rate was 5%. Thus, X Co.’s Section 382 limitation is $50,000. If X Co. recognizes $200,000 of taxable income in 2012, it may only use $50,000 of its pre-change NOLs to offset the $200,000 of taxable income.

Q: So I pretty much only need to be worried about big stock sales, right?

A: You weren’t listening, were you? A Section 382 change will not always be the result of an obvious 100% sale of a corporation’s stock; rather, they often are the end result of creeping changes over a period of time, or even situations where no new shareholders acquire interests in the corporation, but rather an existing shareholder greatly increases his ownership.

Example: A, B, C, and D each own 25% of X Co., a loss corporation. On January 10, 2009, A buys 10% of X Co. stock from D. On March 4, 2009, A buys all of B’s stock. Finally, on January 20, 2010, X Co. buys 20% of X Co. stock from C. An ownership change has occurred, because during the testing period ending January 20, 2010, A has increased his ownership in X Co. from 25% to 80%, a 55% increase. A’s increase is not offset by B, C, and D’s decrease in stock ownership.  

Q: I think I understand, thanks to your thoughtful explanation. You clearly deserve a large raise.

A: That’s’ really not a question, but thank you, I appreciate that. Truth be told, simply understanding that Section 382 exists is half the battle. Many tax advisers miss the issue entirely and utilize an NOL regardless of an underlying ownership change, inviting scrutiny from the IRS. While the hard part — the calculation — doesn’t begin until you’ve identified that your corporate client may be subject to Section 382, by simply undertaking the calculation, you’ve helped minimize risk for your clients.  

[i] If a 5-percent owner is an entity (i.e., a corporation, partnership or trust), the loss corporation is required to look through the entity (and through any higher-tier entity) in order to determine which owners of the entity are indirectly 5-percent shareholders of the loss corporation. It is the ownership of these ultimate 5-percent shareholders, including public groups, that is considered when determining whether a greater than 50 percentage point increase has occurred.

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My sophomore year in college, I shared a door room with this guy, Greg. Greg was the best roommate a 19-year old could ask for, for the simple fact that he was never around. Greg had a serious girlfriend, and whether out of affection for her or a distaste for Busch Light and Italian League soccer, he chose to spend all of his time at her dorm.

So which dorm room was Greg’s? The one he was assigned pursuant to school records, or the one where he brushed his teeth, kept his stuff, and slept 99 days out of 100?

Hell if I know; but then, it’s not my job to know. The same can’t be said for the members of the Tax Court, however, who recently had to determine which of a taxpayers’ two houses was their home. And all that was at stake was a $140,000 tax deficiency.

Marylou Stromme (Marylou) was a kind soul, this much is not open for debate. Marylou’s developmentally disabled older brother had spent much of his life institutionalized, motivating her to find a way to provide a better life for those similarly challenged. Her first step was to open a group home where patients could get better care than that found in congregate institutions.

The Stromme’s owned two homes, one on Lacasse Drive (Lacasse) and one on Emil Ave (Emil). For various reasons, the Strommes chose to convert the Emil property into the group home, performing extensive renovations and eventually housing up to six “clients.”

Marylou spent so much time at the Emil home, most of the surrounding neighbors assumed she lived there. She would often spend the night, recieve mail there, and perform basic upkeep. She would, however, return to the Lacasse home to be with her family and enjoyed the trappings of suburbia:

It was at the LaCasse Drive house that the Strommes held family get togethers and celebrated the safe return of another son from service in Iraq. LaCasse Drive house was also where they celebrated Thanksgiving and Christmas. Ms. Stromme found it a more restful place to recover from foot surgery.

In exchange for providing foster care, the State of Minnesota paid the Strommes $556,000 over 2005 and 2006. The Strommes excluded the payments from income. The IRS disagreed with this treatment, assessing over $140,000 in tax due, interest, and penalties.


Section 131 provides an exclusion from income for qualified foster care payments. To qualify for the exclusion, the payments must be:

1. Made pursuant to a foster care program of a state;

2. Paid by a State or political subdivision thereof, or a qualified agency; and;

3. Paid to a foster care provider for the care of a qualified foster individual in the foster care provider’s home.


At issue was the third requirement; specifically, the interpretation of the phrase “in the foster care provider’s home.” With no regulations and minimal relevant case law to reference, the Tax Court was left to determine what Congress intended with the use of the word “home.” Ultimately, the court concluded that mere ownership of the Emil foster house was not enough; the Strommes were required to provide foster care at the house at which they reside.

We interpret the Code’s use of the word “home” to mean the house where a person regularly performs the routines of his private life–for example, shared meals and holidays with his family, or family time with children or grandchildren.

Ultimately, the Strommes were sold out by their Lacasse neighbors — with whom they seemed to have engaged in previous altercations — who testified that the Lacasse home was indeed where the Strommes resided:

The LaCasse Drive neighbors also knew the Strommes owned two houses, and those neighbors understood that the Strommes worked at the Emil Avenue house. They frequently saw Ms. Stromme leave in the morning to go to work at the Emil Avenue house and then return in the evening. They often saw Mr. Stromme working in the yard or on his cars; they saw both Strommes bringing in groceries and noted Ms. Stromme’s car was reliably in the driveway around dinnertime. They also credibly recounted scenes of the Strommes having ordinary suburban American fun, like returning from a Minnesota Wild hockey game [Ed note: there’s nothing fun about a hockey game] or throwing a lively pool party–

Based in part on this damning testimony, the court was forced to conclude that while the Strommes owned two houses, only the Lacasse property was their home. And since the Strommes did not provide foster care in their home, the full amount of the payments were taxable, as the Strommes’ failed to meet the requirements of Section 131.

The decision was not without its controversy. While both Judges Holmes and Gustafson concurred with the opinion, they disagreed on the precedent being established.

Judge Holmes believed that a foster care provider could have more than one home; the exclusion is not limited to payments received for providing care at the taxpayer’s primary residence. For example, a taxpayer could own and reside in a primary residence as well as a vacation home, with foster care provided in either one qualifying for exclusion. The issue in Strommes — according to Judge Holmes — was that the Emil house was not even a vacation home, it was simply a place of business. But in other situations, where a taxpayer provided foster care services in one of several homes owned and used by the taxpayer as a residence, the taxpayer should be entitled to the Section 131 exclusion.

Judge Gustafson disagreed, arguing that exclusions must be narrowly construed, and thus a taxpayer’s home had to follow the singular language written into the statute.

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Aside from Amway dealerships, the most frequently challenged activities under the  “hobby loss” provisions of Section 183 are horse breeding and drag racing. So when a family does both — deducting big losses from each activity — they’re almost begging to wind up in front of the Tax Court.

In Ryberg v. Commissioner, husband and wife — who were both gainfully employed with 9-5 jobs — also jointly operated a horse breeding activity. In what little time he had left, husband would race. Both activities had generated substantial losses since their inception. Illustrating the thin line between business and hobby, the Tax Court held that the horse breeding activity was entered into for profit, while husband’s drag racing activity was not.

As a reminder, the hobby loss rules exist for the sole purpose of determining whether a taxpayer’s activity is a “activity entered into for profit” or a “hobby.” If the activity is the former, losses of the activity may be deducted in full and can offset other sources of income, subject to certain limitations. If the activity is a hobby, however,  a taxpayer can only deduct losses to the extent of the income; they cannot create a tax loss.

The regulations established — and the courts routinely examine — nine factors to be used in determining whether a particular activity is entered into for profit or a hobby:

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

In reaching its split decision in Ryberg, the court analyzed each activity in accordance with the regulations, highlighting the following factors:

Horse Breeding Activity = Activity Entered Into for Profit

  • Carried on the activity in a  businesslike manner, conducting market research before start-up, educating themselves on the business and economic aspects of the activity, drafting formal breeding contracts, and extensively advertising and publicizing their services.
  • Kept accurate books and records on a monthly basis, and maintained a separate charge account
  • Developed extensive expertise in horse breeding and studied the business and economic side of the business; utilized the knowledge to cut costs.
  • Changed operating methods and adopted new technique with the intent of improving profitability.
  • Consulted with other business owners regarding the profitability of adding horse boarding.
  • Did not ride the horses for pleasure
  • Abandoned the horse breeding operations in 2007 when they finally determined they could not turn a profit.

Based on these factors, the court concluded that the horse breeding activity was entered into for profit, notwithstanding the history of losses from 1998-2006, as this represented the “startup phase” of the activity.

Drag Racing = Hobby

  • Failed to provide a copy of a spreadsheet or any document used to track expenses.
  • Did not provide any books or records to document race winnings or sponsorship money.
  • Sought advice to improve racing skills, not profitability.
  • Did not study or build a particular expertise in the business aspects of drag racing.
  • Even in his best racing season, he could not turn a profit because of the large amount of expenses attributable to the activity.
  • High elements of personal pleasure.

In addition to the above, the Tax Court concluded that the history of continuous losses from 1990-present was too much to overcome, as a twenty year time span far exceeded any reasonable startup time. Thus, the drag racing activity was held to be a hobby, with expense only allowable to the extent of its income.

We’ve said it again but it bears repeating; if you want your activity to be respected as a business, you have to treat it like one. Keep detailed books and records, and USE those records to make changes to your busienss in an attempt to drive profits. Garner expertise: take classes, consult with other profesionals in the industry, and constantly go back to the drawing board if things aren’t working out. Lastly, keep the personal pleasure to a minimum, and if all else fails, quit.

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If you believe this handy chart, as part of any future corporate tax reform both President Obama and Rick Santorum would institute preferential tax rates for U.S. manufacturers, with Santorum doing away with the corporate tax entirely for businesses that, you know… build stuff.

I add that overly simplistic description because, truthfully, it is not always easy to explain exactly what constitutes “manufacturing.” In a lot of ways, manufacturing is like pornography or the infield fly rule, you can’t define it, but you know it when you see it.

But with preferential treatment potentially to be afforded to manufacturers, meeting the “manufacturing” definition could become extremely important, a fact not lost on David Cay Johnston over at Reuters.

Johnston takes an innovative approach in a column titled “Obama’s Hamburger Problem,” which is not to be confused with Chipper Jones’ hamburger problem.

In the column, Johnston compares the assembly of a car — which is considered manufacturing — with the assembly of a fast-food hamburger, which is not: 

The notion of hamburger-making as manufacturing may seem silly, a bit like the 1981 U.S. Agriculture Department proposal to classify ketchup as a vegetable for school lunches. But classifying activities as manufacturing or not becomes crucial if manufacturers pay taxes at a reduced rate.

Hamburgers may seem like pure assembly, but a case can be made that they are more like manufacturing than assembling a car from finished parts made overseas. Your local hamburger joint starts with raw meat, fresh or frozen. If it comes in lumps then someone must make the meat into uniform discs or squares. Then the protein must be fried, grilled or broiled. Only then can the meat, lettuce and whatnot be assembled.

Johnston ultimately concludes that the real beneficiaries of preferential manufacturing rates would be the attorneys and CPAs charged with making the case that their clients meet the definition:

Imagine all the high-paying jobs Obama’s plan would create. Companies of all kinds will want to hire more tax accountants and lawyers making the case their client’s business activity is manufacturing. These are not the sort of additional jobs America needs.

 I , obviously, beg to differ.

The point, of course, is that even code reform based on good intentions comes with the price of complexity and confusion. Most people agree that providing tax incentives to manufacturers would encourage U.S. job growth, but as is usually the case when it comes to tax law, the problem lies in the execution. Any reform would likely further complicate the code and invite abuse as non-manufacturers clamor to meet whatever definition makes its way into the statute.

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[Ed note: We’re lucky to have WS+B Partner Hal Terr to keep us apprised of the happenings in the estate, trust, and gift world. Today, Hal tackles the case of Tonda Lynn Dickerson, which reminds us that winning the lottery is sometimes more trouble than it’s worth.

/not really

Now, on to Hal:]

Everyone has at one time or another dreamed of winning the lottery, leaving the grind of a 9-5 job and living the life of luxury.  As CPAs, this is a fantasy we indulge in hourly from January until April.  

Instant wealth has its pitfalls, however. We were recently reminded of this when Louise White, an 81-year old Rhode Island resident, won last month’s Powerball lottery of $336.4 million.  Before claiming the lottery winning she consulted with an attorney, and the lottery winnings were claimed by the “Rainbow Sherbert Trust”.   Hopefully she obtained  better legal advice then Tonda Lynn Dickerson, who won the Florida lottery in 1999, but upon sharing her newfound riches with her family, was held by the Tax Court to have made a taxable gift.

Tonda worked at a Waffle House in Alabama where a patron, Mr. Seward, would give lottery tickets as tips.  In 1999, Mr. Seward gave Tonda a Florida lottery ticket for the previous night’s lottery which happened to be the winning ticket for over $10 million.  

Tonda claimed there was an implied agreement with her family that winning the lottery meant sharing the windfall with them.  To facilitate this, Tonda consulted with her father and attorney and created an S Corporation which would claim the lottery winnings. Tonda and her husband would own 49% of the S Corporation and her parents and siblings would own the other 51%.  

Soon after, the IRS came knocking on Tonda’s door, requesting she file a gift tax return. Tonda did so, but claimed that  no gift was made. The IRS disagreed, arguing that she made a gift of $2,412,388 and owed gift tax of $771,570.

In the gift tax regulations, a transfer of property to a corporation for less than adequate consideration represents gifts to the other individual shareholders of the corporation to the extent of their proportionate interests. Tonda argued that there was no taxable gift because at the time the lottery ticket was received there had previously existed and remained in effect a binding and enforceable contract under Alabama state law to share the winnings. Alternatively, she argued that the family members and Tonda were all members of an existing partnership.  

The Tax Court determined under Alabama state law that the terms were too indefinite, uncertain and incomplete, and even if the agreement was enforceable, would not be allowed under Alabama anti-gambling statute. The Tax Court contrasted the facts in this case to the Estate of Winkler, where an implied family partnership did exist.

In Winkler, the family pooled their money to purchase lottery tickets, the purchase of the tickets was a consistent activity and each member of the family was treated as a partner, including attending the meetings with the accountant and attorney having a say in formulating the agreement. To the contrary, in this case, Tonda’s father made the ultimate decision on how the lottery proceeds would be divided, and there was no requirement that each family member buy the lottery tickets, no pooling of money and no predetermined sharing percentages.  As such, the Tax Court found that Tonda had made a gift of 51% of the S Corporation to her family.

Next, the Tax Court had to determine the value of the gift. Tonda had made many implied promises in sharing of lottery winnings.  With the promise of sharing the lottery winning with her family, her co-workers at the Waffle House also believed they had a right to a share of the lottery winning. The co-workers sued Tonda in Alabama court for their share of the winning, but ultimately lost on the same grounds that the oral agreement between the co-workers was unenforceable on public policy because it was “founded on gambling consideration.”

This lawsuit actually worked in Tonda’s favor against the IRS. Under the gift tax regulations, the value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having a reasonable knowledge of the facts.  With the potential claim of the co-workers, the value of the gift should be discounted for the cost of the potential litigation. The Tax Court agreed with the expert testimony and discounted the value of the gift to $1,248,765.

What can we learn from this case? If you ever win the lottery, go to an exotic island and live the life of luxury. There are ways to support your family through annual exclusion gifting, direct payments for medical care and education and usage of the lifetime gift exemption. If you are going to make a transfer of the lottery proceeds, make sure you have your facts straight before going to the lottery office to claim your winnings.

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In a case with damaging implications for wealthy gay and unmarried couples, the Tax Court held yesterday that the $1,100,000 limitation on mortgage debt for purposes of determining deductible interest expense must be applied on a per-residence, rather than a per-taxpayer basis.

As we discussed in a previous post, I.R.C. § 163(h)(3) allows a deduction for qualified residence interest  on up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness. Should your mortgage balance (or balances, since the mortgage interest deduction is permitted on up to two homes) exceed the statutory limitations, your mortgage interest deduction is limited to the amount applicable to only $1,100,000 worth of debt.

Now assume for a moment that you and your unmarried girlfriend/lifemate/Japanese body pillow go halfsies on your dream house, owning the home as joint tenants. And assume the total mortgage debt — including a home equity loan of $200,000 –is $2,200,000, with each of you paying interest on only your $1,100,000 share of the debt.

Are each of you entitled to a full mortgage deduction — since you each paid interest on only $1,100,000 of debt, the maximum allowable under Section 163 — or is your mortgage deduction limited because the total debt on the house exceeds the $1,100,000 statutory limitation?

The answer, according to the Tax Court, is the latter. In Sophy v. Commissioner, this issue was surprisingly addressed for the first time in the courts (it had previously been addressed with a similar conclusion in CCA 200911007), with the Tax Court holding that the $1,100,000 limitation must be applied on a per-residence basis.

Thus, in the above example, even though the joint tenants each paid mortgage interest on only the maximum allowable $1,100,000 of debt, each owner’s mortgage interest deduction is limited because the maximum amount of qualified residence debt on the house — regardless of the number of owners — is limited to $1,100,000. Assuming the joint tenants each paid $70,000 in interest, each owner’s limitation would be determined as follows:

$70,000 *  $1,100,000 (statutory limitation) = $35,000

                 $2,200,000 (total mortgage balance)

Instead of each owner being entitled to a full $70,000 interest deduction, the mortgage interest deduction is limited for both because the total debt on the house exceeds the statutory limits. The court reached this conclusion after examining the structure of the statute and determining that the plain language required the applicable debt limitation to be applied on a per-residence basis:

Qualified residence interest is defined as “any interest which is paid or accrued during the taxable year on acquisition indebtedness with respect to any qualified residence of the taxpayer, or home equity indebtedness with respect to any qualified residence of the taxpayer.” Sec. 163(h)(3)(A) (emphasis added).

The definitions of the terms “acquisition indebtedness” and “home equity indebtedness” establish that the indebtedness must be related to a qualified residence, and the repeated use of the phrases “with respect to a qualified residence” and “with respect to such residence” in the provisions discussed above focuses on the residence rather than the taxpayer.

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