Posts Tagged ‘law’

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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Under the tax law, taxpayers are afforded favorable treatment when instead of selling appreciated property, they “exchange” it for other property; the idea being that the taxpayer has not cashed out its investment in the property, but rather simply changed the form of the investment.

Specifically, Section 1031(a) of the Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

Stated simply, a taxpayer recognizes no gain if instead of selling appreciated property, they exchange it for property that is “like kind.” And this, as you can imagine, is where issues arise. What is “like kind” property? The regulations offer scant guidance:

Section 1.1031(a)-1(b) of the regulations provides that the words “like kind” have reference to the nature or character of the property and not to its grade or quality. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.

This much is clear, however: This like-kind requirement precludes a taxpayer from exchanging real property for personal property, or vice versa.

As a result, over the years numerous court cases have sought to answer the question of whether Property A was “like kind” to Property B by looking to state law classifications. For example, in Commissioner v. Crichton[i], the 5th Circuit determined that a mineral right was real property under Louisiana state law and thus of like kind to other real property. Similarly, in Peabody Natural Resources Co. v. Commissioner[ii], the Tax Court determined that under New Mexico law, coal supply contracts constituted real property interests and were of like kind to the relinquished gold mine.

These decisions have led some practitioners to question whether state law classifications are in fact determinative in concluding whether two properties are of like kind. Last Friday, in PLR 201238027, the IRS clarified that state law classifications, while relevant, are not determinative of whether properties are of like kind. Rather, all facts and circumstances should be considered.

In the Ruling, the IRS presented four scenarios. In each of the four scenarios, similar properties were exchanged for one another. Under state law, however, the properties were classified differently. For example, in Case 1, a natural gas pipeline in State A (constructed along a right of way on real property) that was classified as personal property in State A was exchanged for a State B natural gas pipeline that was  constructed along a right of way on real property and that was classified as real property in State B. (The right of ways associated with the exchanged pipelines in State A and State B are also exchanged.)

The IRS declined to base its decision as to the like kind nature of the properties solely on their respective state law classifications. Instead, the Service looked to certain informative sections of the Code to glean how they classified property as personal or real, specifically, Sections 48, 263A, and 1245:

For example, § 1.263A-8(c)(1) of the regulations provides, in part, that real property includes land, unsevered natural products of land, buildings, and inherently permanent structures. Section 1.263A-8(c)(3) describes “inherently permanent structures” as including “property that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time, such as swimming pools, roads, bridges, tunnels . . . telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment. . . .”

Section 1.48-1(c) of the regulations provides in part, that for purposes of § 1.48-1, the term “tangible personal property” means any tangible property except land and improvements, including structural components of such buildings or structures. It further provides that “production machinery, printing presses, transportation and office equipment. . . contained in or attached to a building constitutes tangible personal property for purposes of the credit allowed by section 38.”  

Finally, § 1245(a)(3) provides that “§ 1245 property” is any property which is or has been subject to depreciation under § 167 and which is either personal property or other tangible property used as an integral part of certain activities, including manufacturing.  

Acknowledging that relying solely on state law classifications could yield absurd results – for example, in Case 1 where identical pipelines are exchanged but their respective states classify them as personal and real property, respectively, treating the properties as not being like kind would make little sense — the IRS concluded the basic nature and character of the property involved should override the state law treatment.

Applying these concepts to Case 1, since both pipelines were inherently permanent structures that were affixed to real property that will remain for an indefinite period of time, they both qualified as real property under the definition found at Regulation Section 1.263A-8(c)(1). Thus, the exchange of one pipe line for the other qualified as a like kind exchange under the meaning of Section 1031.

[i] 122 F.2d 181 (5th Cir. 1941).

[ii] 126 T.C. 261 (2006).

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My father-in-law came to visit this week, and over Friday night pizza, the conversation turned to politics; specifically, Mitt Romney’s much-ballyhooed 13.9% effective tax rate in 2010.

Being a tax guy, I wanted my father-in-law to understand exactly why Romney’s rate was so low given his $21,000,000 of AGI, which required a primer on the taxation of carried interest. [For your own primer, click here.]

As the discussion advanced, my father-in-law understandably struggled to understand why the profits received by private equity fund managers on their carried interest were taxed any differently than, say, the wages he earned over his 40-year career working for an insurance carrier.

Even after I advanced the standard arguments for a 15% rate on carried interest — the equity fund manager’s risk, the uncertainty of the profit stream, the “sweat equity” element, etc… — my father-in-law’s opinion remained blissfully simple:

“It still sounds like compensation to me.”

Now, my father-in-law is a staunch Republican in every way, shape and form. But yet, he failed to see how a 15% tax rate is justified on the income received by fund managers to do what they do: manage funds. Of course, my father-in-law is not the final arbitrator on such matters: after all, this is the same man who once advised me to buy a house located squarely within the Delaware River’s floodplain.

So perhaps you should decide for yourself. To facilitate your decision-making process, the Wall Street Journal has published this point/counterpoint on the carried interest tax issue, with Michael Graetz, a professor of tax law at Columbia Law School, arguing for carried interest to be taxed as ordinary income, while David Tuerck, executive director of the Beacon Hill Institute and a professor and chairman of the economics department at Suffolk University in Boston, argues that the preferential capital gains rates should be preserved.

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On corporate tax returns, it’s second nature to disallow any deductions for “officer’s life insurance premiums” expensed on the corporation’s books. But why do we do it?

Under I.R.C. § 101, life insurance proceeds paid upon the death of an insured to the beneficiary are generally excludable from the beneficiary’s income. Thus, when a corporation takes out a life insurance policy on one if its key employees — and the corporation is both the owner and beneficiary of the policy — the proceeds paid to the corporation upon the death of the employee are generally tax-exempt.

Because I.R.C. § 101 serves to exclude life insurance proceeds from income, I.R.C. § 264 prevents a second tax benefit by disallowing a deduction for any premiums paid on a policy on which the payor is the beneficiary. That way, the taxpayer doesn’t get a deduction for premiums AND tax-exempt proceeds when the policy is paid out.

But did you know that for policies issued after August 17, 2006, the proceeds from corporate owned life insurance policies may be taxable to the corporation upon receipt? Unless certain notice and consent requirements are met, I.R.C. § 101(j) provides that life insurance premiums paid to a corporation upon the death of an employee will be excludable from income only to the extent of any premiums or other amounts paid for the policy. Proceeds in excess of such costs will be taxable to the corporation.

In order for the entire amount of life insurance proceeds to be tax-exempt to the beneficiary corporation, the employee must:

1. Be notified in writing that the applicable policyholder (employer) intends to insure the employee’s life and of the maximum face amount of the policy at the time of issue,

2. Must provide written consent to being insured and that the coverage may continue after the insured terminates employment, and

3. Must be informed in writing that the applicable policyholder (employer) will be a beneficiary of any proceeds payable upon the death of the employee.

In addition, every applicable policyholder corporation owning one or more employer-owned life insurance contracts issued after August 17, 2006 must file a Form 8925 for each year such contracts are owned, showing:

1. The number of employees at the end of the year and the number of those employees insured under employer-owned life insurance contracts;

2. The total amount of insurance in force under such contracts at the end of the year;

3. The name, address, TIN, and type of business of the applicable policyholder; and

4. That the applicable policyholder has a valid consent for each insured employee or the number of insured employees for which no consent has been obtained.

A few weeks ago, in PLR  201217017, the IRS ruled that a corporation met the notice and consent requirements even where the corporation failed to acquire separate documentation prior to purchasing life insurance contracts on each shareholder/employee that explicitly satisfied the items detailed in I.R.C. § 101(j).

Instead, the corporation required each shareholder/employee to fill out insurance applications that indicated that the corporation was to be the owner and beneficiary of the policy, as well as the amount of coverage being obtained, while also requiring the shareholder/employees to sign an agreement dictating that if the shareholder terminates his ownership  interest, the shareholder has the right to purchase the policy from the corporation.

The IRS concluded that between the application and the agreement signed by the participating shareholder/employees, the notice and consent requirements had been met and I.R.C. § 101(j) was satisfied. Thus, proceeds received by the corporation upon the death of any of the insured’s will be tax-free under I.R.C. § 101.

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As the filing deadline draws mercifully closer, the nation’s tax geeks are finally free to go on a Robert Downey-sized bender turn their attention to what promises to be the most  tax-driven presidential election in recent memory.

Right on cue, the Senate will be spending this evening voting on the first iteration of the Democratic-sponsored Buffett Rule, which would require taxpayers earning over $1,000,000 to pay a minimum 30% effective tax rate. The vote is being dismissed as largely symbolic, because as I discussed previously, the Buffett Rule is much more of a mechanism for the current administration to cast roles in the upcoming election — A vote for Obama is a vote for fairness, puppies, and rainbows! A vote for Romney is a vote for rich white guys, unjust tax breaks, and Aspen ski homes! — than it is reflective of potentially impactful legislation.  

On the Republican side of the campaign trail, Mitt Romney has at long last started to show his hand regarding where he will make up the increase to the federal deficit caused by his proposed 20% across the board reduction of the current tax rates.  From the Wall Street Journal:

Mr. Romney, the presumptive Republican nominee for president, said he would eliminate or limit for high-earners the mortgage interest deduction for second homes, and likely would do the same for the state income tax deduction and state property tax deduction.

Ok, that should raise some revenue. But historically, Republicans have been fiercely protective of their home mortgage interest deduction. It’ll be interesting to see how those claims evolve should Romney’s party members push back the way I imagine they will.

Of course, increased tax revenue is only one way to skin the deficit cat. What about spending cuts?

He also said he would look to the Department of Education and the Department of Housing and Urban Development for budget cuts. Mr. Romney said he would either consolidate the education department with another agency or make it “a heck of a lot smaller.” “I’m not going to get rid of it entirely,” he said.

He also vowed to stand up to teachers unions and warned that unions would funnel dues to Mr. Obama’s reelection campaign. “The unions will put in hundreds of millions of dollars,” Mr. Romney said. “There’s nothing like it on our side,” he said, and he encouraged attendees to get their friends to donate, as well.

Now there’s a policy I can get behind. At the risk of sounding unpopular, if there’s one thing I’m sure of  it’s that educators are paid far too much. Personally, I’m sick of watching these kindergarten teachers cruise around in their Ferraris during spring break while I’m stuck in the office, counting their millions and preparing their tax returns.

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President Obama is hitting the road to renew his push for a “Buffett Rule” that would require taxpayers earning over $1,000,000 to pay an effective tax rate of at least 30%. The timing is no accident, as the Senate is poised to vote on the Buffett Rule on Monday.

In recent months — or at least since it was revealed that the Buffett Rule would put nary a dent in the federal deficit — the Obama administration has repositioned the rule as being in the interest of fairness, rather than a significant revenue generator.

But let’s call the Buffett Rule what it is: political posturing. It’s got no chance to pass the Republican led House, but it can still play a significant role in the November elections. Because — truth be told — the Buffett rule is a whole lot less about Warren Buffett than it is about President Obama’s chief competition come this fall, Mitt Romney.

It’s Romney, after all, who upon making public his tax returns in January, revealed that he paid an effective tax rate of a mere 13.9% on $21,600,000 in adjusted gross income. Now granted, Obama first announced his plans for a Buffett Rule in August of 2011, months before Romney’s admission, but the Obama administration is not populated with dummies, no matter what Rush Limbaugh might think. They had identified Romney as their most likely threat, and they knew that — as a man who made millions as a private equity fund manager — Romney was benefitting greatly from the preferential rates currently afforded investment income long before he released his returns.

When billionaire Warren Buffet famously announced that he pays a lower tax rate than his secretary, he did the president a tremendous favor. By handing Obama a poster child for his war against the perceived inequities of the current tax regime, Buffett allowed Obama to build a campaign against Mitt Romney without ever having to say Romney’s name.

If it hadn’t been made clear already, the president’s recent road show will tell the nation that the tax system is broken. Many people, both Democrat and Republican, will agree that a man earning $21,000,000 should not pay tax at a lower rate than a school teacher. They will view Mitt Romney as the enemy; the embodiment of this broken system, and many will find it difficult to relate to,  and vote for him, come November.

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The U.S. Supreme Court is typically charged with determining the victor of the country’s most important debates, such as Roe v. Wade, religion v. science or, which shape marshmallow should be added to boxes of Lucky Charms. So when the high court goes slumming, setting aside three days to hear debate with potentially major implications on the tax law, it’s incumbent upon every CPA to stand up and take notice.

Of course, it’s a rather busy time of year, and given the pile of Form 1040s overwhelming your desk, the events transpiring in D.C. are probably the least of your concerns. So as a bit of a public service, we’ve put together the following “heads up” for our industry peers, hopefully giving you the information you’ll need when your clients inevitably ask you for your take on the Supreme Court’s review of “Obamacare.” You can thank us after the 17th.

Q: What’s Obamacare? It sounds like a charitable organization to which I don’t contribute.  

A: On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act, a 2700-page bill that took aim squarely at the country’s health care practices. The reform would extend health insurance to an additional 32 million Americans while revamping one of the nation’s largest industries: prohibiting insurance companies from denying coverage due to preexisting conditions, expanding the Medicaid threshold to 133% of the poverty line, and eliminating the ability of insurers to cap an insured’s “lifetime limit” of benefits.

Q: I didn’t hear anything about tax in there, so why do I care?

A: The Act also contained several major tax provisions, one of which set off a firestorm of debate regarding its constitutionality. Beginning in 2014, I.R.C. § 5000A will require taxpayers to purchase or retain health insurance that qualifies as minimum essential coverage, and to report this information on their federal tax returns, subject to certain codified exceptions. If the taxpayer fails to maintain adequate insurance, a monthly “penalty” is imposed equal to the greater of a flat dollar amount (phased in starting at $95 in 2014) or a percentage of the taxpayer‘s income (phased in starting at 1% in 2014).

Q: Where does the “constitutionality” come in?  

A: Twenty-eight states have filed suit seeking to overturn this individual insurance mandate, challenging whether Congress is overstepping its taxing powers by imposing a penalty on individuals for failing to obtain insurance. In 2010, a Virginia federal court ruled the individual mandate unconstitutional, striking it from the Patient Protection Act but allowing the rest of the act to stand. The case was later overturned on appeal.

In early 2011, however, a Florida district court also held the individual insurance mandate unconstitutional, but refused to sever the provision from the rest of the Act, rending the entire Act unconstitutional. This time, on appeal, the verdict stood, but the appeals court disagreed on the severability of the individual mandate, allowing the rest of the Act to remain. The Department of Justice asked the Supreme Court to hear the case, which brings us to today.

Q: So what’s the Supreme Court going to decide?

A: Over the next three days, the U.S. Supreme Court will begin its review of Obamacare, an unprecedented act in the sense that it is the first time the high court has considered striking down a president’ signature legislation in the midst of his re-election campaign.  Here’s how the next few days are expected to shake out:

Today: Before the discussion of constitutionality can even get off the ground, the Supreme Court must determine whether the “penalty” under I.R.C. § 5000A for filing to obtain insurance is a “tax” or a “penalty.” If it’s truly a tax, then the current debate might be over before it gets started, courtesy of this old-timey law as explained by Bloomberg:

A 145-year-old law, the Anti-Injunction Act, says courts can’t rule on the legality of federal taxes until they are imposed. For the no-insurance penalty in the 2010 health care law, which takes effect in stages, that comes in 2015. The justices may decide it’s too soon to rule on the health law’s constitutionality.

In other words, if the penalty under I.R.C. § 5001A is held to constitute a tax, the Supreme Court might be barred from deciding the constitutionality of the insurance tax until it is actually imposed beginning in 2015.

Tomorrow: Assuming today’s hearings don’t render the remaining debate moot, tomorrow is likely to contain the most spirited arguments, as the Supreme Court will hear debate on whether the Constitution allows the government to require Americans to either get insurance, or pay a penalty.

Q: What will each side be arguing?

A: Similar to the state courts, the argument is likely to consist of the following positions:

On one side, detractors of the Patient Protection Act will insist that Congress has no authority to order someone to give up their own desire not to buy a commercial product and force them into a market they do not want to enter. The federal government, on the other hand, will defend the new law as being allowable under the Commerce Clause, the Necessary and Proper Clause, and the taxation power of the General Welfare Clause.

Q: What’s left to hear on Wednesday?

A: Wednesday could actually have far-reaching effects on the tax world. The court will hear debate about what should happen to the rest of Obamacare should the individual insurance mandate be found unconstitutional. If the Supreme Court were to strike down the entire Patient and Protection Act because the individual insurance mandate was found unconstitutional, the remaining tax provisions would die with it. As a reminder, some of the other significant tax provisions found in the Patient Protection and Affordable Care Act include the following:

  •  Starting in 2014, pursuant to I.R.C. § 4980H,  applicable large employers must provide minimum essential coverage to each full-time employee and their dependents. Failure to comply with the employer mandate will result in a penalty equal to one-twelfth of $3,000 for each month multiplied by the applicable number of full-time employees. In general, an “applicable large employer” is any employer with a work force in excess of fifty full-time employees.
  • Higher Medicare taxes will be imposed upon wealthy taxpayers beginning in 2013. Section 3101(b)(2)will be amended to include an additional tax of 0.9 percent on all income in excess of $200,000 or $250,000 for joint filers.
  • 2013 will also add to the Code I.R.C. § 1411, which creates a 3.8 percent Medicare tax on investment income in excess of $250,000 for joint filers, $125,000 for married filing separately, and $200,000 ―in any other case.

We’ll do our best to keep you apprised of any big developments.

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