Posts Tagged ‘law’

Who’s up for a little S Corporation 101?

Well, I’m doing it anyway. S corporations generally don’t pay tax. Instead, the corporation’s taxable income or loss is divvied up and allocated to its shareholders, who report the income on their Form 1040.[i]

S corporation shareholders are required to maintain their “basis” in their S corporation stock. This is done primarily for three reasons: to determine gain or loss on the sale of the stock, to determine the taxability of S corporation distributions[ii], and lastly, to determine the maximum amount of S corporation loss allowable on the shareholder’s individual income tax return. It is this final reason we concern ourselves with today.

Unlike a C corporation, a shareholder’s stock basis in an S corporation is not static. Because of the “flow through” nature of S corporations, a shareholder’s basis must constantly be adjusted to prevent the corporation’s income from being taxed twice.[iii]

In general, a shareholder’s basis in his S corporation stock is increased for:

  • Capital contributions
  • Items of income (including tax exempt income)

And decreased for:

  • Distributions
  • Items of loss and deduction (including non-deductible expenses like M&E)[iv]

For any tax year, a shareholder’s allocable share of the S corporation’s loss can only be deducted to the extent of the shareholder’s basis in his stock, after accounting for the increases listed above.[v] To the extent a loss is limited under this rule, it is “suspended” and carried forward, where it is treated as a new loss in the succeeding year and is again subject to the basis limitation rule.

Today, the Tax Court tackled a seemingly simple, yet interesting issue. What if a shareholder neglects to deduct a loss they are entitled to. Must they reduce their stock basis for the loss, even though they received no tax benefit from the loss?

Let’s apply some round numbers to make it easier to follow. In 1995, A set up S Co. with a $50,000 capital contribution. During 1995 and 1996, A was allocated $200,000 of loss from S Co. which reduced his basis to $0 as of the end of 1996. Because the loss exceeded A’s positive basis of $50,000, A only received the benefit of $50,000 of loss during those two years, with the remaining $150,000 of loss suspended as of December 31, 1996.

In 1997, A contributed $250,000 to S Co. S Co. allocated a $50,000 loss to A in  1997, which he deducted on his Form 1040. A, however, failed to deduct the prior year suspended loss of $150,000, despite the fact that his capital contribution gave him ample basis to do so. As a result, A did not decrease his basis for the suspended loss, leaving him with $200,000 of stock basis as of December 31, 1997.

Fast forward five years. From 1998-2003, A continued to reflect this “extra” $150,000 in his basis, which stood at $300,000 on January 1, 2003. In 2003, S Co. allocated a $275,000 loss to A, which he deducted in full on his return.

The IRS disallowed $125,000 of the loss, arguing that A’s stock basis was required to be reduced by $150,000 of additional losses in 1998 — even though A did not deduct the loss on his return, as he was entitled to. Because under this calculation, A would have only $150,000 of stock basis on January 1, 2003 ($300,000 according to A less $150,000 downward adjustment from 1998), S Co.’s 2003 loss of $275,000 was limited to A’s stock basis of $150,000.

In defense of his stock basis calculation, A argued that I.R.C. § 1367 requires basis reduction only for losses that the S corporation shareholder reports on his or her tax return and claims as a deduction when calculating tax liability.

The Tax Court disagreed and sided with the IRS, holding that a shareholder is required to reduce his basis in S corporation stock for his allocable share of the S corporation’s loss, even if the shareholder did not deduct the loss on his Form 1040. From the court:

The class of losses described in section 1366(a)(1)(A)[S corporation losses] is not limited to losses that were actually claimed as a deduction by the shareholder on the shareholder’s tax return. Therefore, the basis reduction rule in section 1367(a)(2)(B) is not limited, as the Barneses contend, to losses that were actually claimed as a deduction on a return.

As a result, A was denied $150,000 of loss on his 2003 tax return. Of course, A would have been entitled to amend his 1996 return to take the $150,000 loss he was entitled to during that year, if it weren’t closed by statute. Ouch.

[i] S corporation shareholders are generally required to be individuals, but see I.R.C. § 1361 for the rules regarding certain qualifying trusts.

[ii] See I.R.C. § 1368 and our previous post here

[iii] To illustrate, assume Mr. A contributed $100 to S Co. in exchange for all of its stock. S Co then earns $20 in year 1, which is not taxed at the S corporation level, but rather flows through to Mr. A and is taxed on his Form 1040. Presumably, the value of S Co. is now $120. If Mr. A sells the stock for $120, were he not required to adjust his basis in the S Co. stock, he would recognize $20 on the sale ($120 sales price – $100 basis). By increasing Mr. A’s stock basis by the $20 of income recognized by S Co., Mr. A recognizes no gain on the sale of the S Co. stock ($120 sales price – $120 basis). Thus, the $20 earned by S Co. is only taxed once.

[iv] I.R.C. § 1367

[v] The regulations at Treas. Reg. §1.1367-1(f) also require distributions to reduce stock basis before losses.

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Donald Carl Barker is the rare man with three names who failed to fulfill his destiny of becoming a serial killer, Nascar driver, or high profile assassin, and instead actually did something useful with his life. Barker works for NASA, and he’s made it his personal mission to enable humans to one day colonize Mars, where we’ll create a utopian society where jet packs are abundant, high-fives replace cash as currency, and we’re free to marry our attractive cousins without judgment.

Barker has the education necessary to make his dreams a reality: a double bachelor of science in physics and psychology, a master’s degree in physics, psychology and math, another master’s degree in space architecture, and at the time of his appearance in front of the Tax Court, a half completed Ph.D. in geology. Kinda’ puts your Liberal Arts degree to shame, no?

Alas, in all that learning, Barker never garnered an understanding of the finer points of the Internal Revenue Code. In 2003, Barker launched a Schedule C “business” called Mars Advanced Exploration & Development, Inc. (MAXD), which was established to obtain funding for various technologies relating to exploring the Red Planet.

Over the next half decade, MAXD sporadically pursued its goals: submitting a funding proposal to NASA in 2003 (denied), applying for a patent in 2005 (also denied), and publishing a design study in 2008. Over that same span, it generated exactly zero dollars in revenue.

None of that kept Barker from deducting expenses in each year, including $7,500 in 2006. The IRS denied the expenses, arguing that MAXD never actually…you know…did anything, and thus wasn’t engaged in an active trade or business.

The Tax Court was left to decide whether MAXD’s activity did in fact rise to the level of a trade or business, necessitating a review of three factors previously established by the courts:[i]

(1) whether the taxpayer undertook the activity intending to earn a profit;

(2) whether the taxpayer is regularly and actively involved in the activity; and

(3) whether the taxpayer’s activity has actually commenced.

To determine whether Barker undertook the activity intending to earn a profit, the Tax Court analyzed the nine regulatory “hobby loss” factors,[ii] which quite frankly, we’ve beaten to death on this blog, discussing it here, here, here, and here. The factors are:    

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 ruling that MAXD did not carry on a trade or business, the court held that Barker failed to keep accurate books and records, did not expend significant time on the activity during the year at issue, and was generating consistent losses that were offsetting Barker’s compensation income from his NASA job.

Next, the Tax Court addressed the second factor: whether Barker was regularly and actively involved in MAXD. Because Barker was working two jobs while also pursuing his Ph.D., the court found there was insufficient evidence to establish that Barker was involved with MAXD with any regularity.

With regards to the final factor, there remained no reason to determine whether MAXD had commenced its business,  since the court had already held that thre was no business. Thus, the Tax Court thus sided with the IRS, holding that Barker’s purported business expenses were not allowable.

Barker’s loss, however, is the American people’s gain. With this defeat behind him, Barker can refocus his efforts on helping NASA with its most daring and exciting project yet: blowing up the moon:

[i] Commissioner v. Groetzinger, 480 U.S. 23 (1987); McManus v. Commissioner, T.C. Memo. 1987-457, aff’d without published opinion, 865 F.2d 255 (4th Cir. 1988).

[ii] Treas. Reg. §1.183-2(b).

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House Republicans released a budget proposal today that would consolidate the six current individual income tax brackets into only two — a 10% and a 25% bracket — while also reducing the top corporate rate to 25% and eliminating taxes on U.S. companies’ overseas profits.

The proposal is part of  a larger election-year message signifying that Republicans — unlike their Democrat counterparts — have a plan to balance the federal budget in a way that does not necessitate tax increases.

As part of Congressman Paul Ryan’s plan, spending would be cut on Medicare, food stamps, college tuition grants, and other “safety net” programs. The plan would produce a 10-year deficit of only $3.13 trillion, less than half the deficit created by President Obama’s recently released budget.   

Equally as predictable, Democrats’ panned the proposal as screwing the poor to finance tax cuts for the rich.

Either way, from a tax perspective the proposal is as meaningful as rearranging the deck chairs on the Titanic, as neither side realistically expects the suggested reform to become law. Rather, the Republican plan is aimed towards establishing the party’s position on spending and taxes prior to the November election.

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It is with an inordinate amount of joy that I relay the news that Tax Masters — the “tax resolution” company whose commercials offering to reduce or eliminate IRS deficiencies became a staple of late night television, giving rise to parodies by Saturday Night Live, among others — has filed for bankruptcy.

In this case, it’s not just our typical schadenfreude at work; we’ve had a bit of  a personal vendetta against the company since a good buddy of ours sheepishly confessed to us that he paid Tax Masters several thousand dollars to help with a large unpaid tax bill, only to get the runaround whenever he tried to gauge the company’s progress. The standard response coming out of Tax Masters was along the lines of “We’ll need another installment payment from you before we can continue to pursue your case,” causing him to eventually abandon hope of receiving the help he had paid for and leaving him $4,500 deeper in debt.

My problem with Tax Masters is that like the makers of the shake weight and Axe Body spray, they prey on the desperate, offering quick solutions to deep-rooted problems.

As any CPA knows, negotiating a successful Offer in Compromise can be a long, arduous, and most importantly, unpredictable process. The likelihood of success is largely dependent on the specific facts: the client’s financial picture and compliance history, the size of the deficiency, and the reasonableness of the offer. To wit: in 2010, the IRS received 57,000 OIC applications, but only 14,000 were accepted.

According to Tax Masters’ three-page bankruptcy filing, the company has less than $50,000 in assets and up to 5,000 creditors with claims nearing $10,000,000, many of whom our former clients like my friend who want to be made whole, but thanks to bankruptcy protection, will likely never see a dime. From Janet Novack at Forbes:

According to a report on Houston’s KHOU this morning, the bankruptcy filing “comes as the Texas Attorney General’s Office is set to begin a trial against the tax resolution firm for misleading consumers under Texas’ Deceptive Trade Practices Act.”

Texas sued TaxMasters in May 2010…alleging that TaxMasters misled consumers by offering an installment payment plan for its fees to prospective customers, without disclosing it wouldn’t start working on a case until it got all its money—even if that meant key Internal Revenue Service deadlines were missed. Last month, KHOU’s I-Team reported that consumer complaints about TaxMasters were continuing to pour into the state.

Coming on the heels of the untimely demise of JK Harris and Roni “The Tax Lady” Deutch — two other “debt resolution” pitchmen — the Tax Masters’ bankruptcy offers a stern if painful reminder to taxpayers to steer clear of late night TV snake oil salesmen. If you find yourself owing the IRS back taxes, hire a lawyer, a CPA or an enrolled agent.

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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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