Posts Tagged ‘tax law’

Yesterday, the Supreme Court of the United States denied certiorari to a tax case on an issue of first impression from the U.S. Court of Appeals for the Eighth Circuit — David E. Watson P.C. v. U.S., 668 F.3d 1008 (8th Cir., 2012).

You may remember Watson from our previous discussion here, or from this brilliantly written article in the Tax Adviser. Either way, Watson directly impacts tax advisors as it provides a long-awaited roadmap for quantifying a “reasonable compensation” amount for shareholder/employees in personal service S corporations.


In late 2010, an Iowa district court held that David Watson, a partner with a CPA firm who paid himself only $24,000 in annual salary while taking out over $200,000 in annual distributions, had avoided payroll taxes by failing to pay himself reasonable compensation. Because Watson actually reported some compensation, however, the court was facing an issue of first impression: determining just what constituted “reasonable compensation” for Watson’s services. The resulting analysis provided the first court-approved roadmap for tax advisers to use in setting appropriate salary amounts for their S corporation shareholder-employee clients.

In setting Watson’s salary, the IRS engaged the services of a general engineer, who first sought to determine the health of Watson’s CPA firm. By analyzing financial ratios published by the Risk Management Association — particularly profits/sales and compensation/sales — the engineer found that Watson’s firm was very healthy, and that compared to similarly healthy firms, Watson’s compensation was unreasonably low.

The court then looked internally at Watson’s firm, noting that Watson was paid less than those subordinate to him. In fact, Watson’s salary was less than what the firm was paying recent college graduates.

Finally, to quantify the appropriate salary, the engineer utilized MAP surveys conducted by the AICPA, which indicated that the average non-owner director of a CPA firm the size of Watson’s would be paid $70,000. The engineer then grossed up this salary by 33% to account for Watson’s stake as a shareholder, resulting in “reasonable” compensation of $93,000 for each of 2002 and 2003.

The District Court agreed, citing Watson’s experience, expertise, and time devoted to his role as one of the primary earners at a well-established firm.

In February 2012, the Eighth Circuit Court of Appeals affirmed the District Court’s decision. Watson appealed once more to the Supreme Court, but saw that dream die yesterday.

With Watson apparently in the books as concluded tax law, now is an appropriate time to remind ourselves what we can take away from this important decision:

What Can We Learn?

Above all else, Watson established that the IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing. At a minimum, in setting the compensation of our S corporation shareholder-employee clients, we must consider the following:

1. Nature of the S Corporation’s Business. It is no coincidence that the majority of reasonable compensation cases involve a professional services corporation, such as law, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated primarily by the personal efforts of the employees, and as a result, a significant portion of the profits should be paid out in compensation rather than distributions.

2. Employee Qualifications, Training and Experience, Duties and Responsibilities, and Time and Effort Devoted to Business. A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. The greater the experience, responsibilities and effort of the shareholder-employee, the larger the salary that will be required.

3. Compensation Compared to That of Non-shareholder Employees or Amounts Paid in Prior Years.  Here, common sense rules the day. In Watson, a CPA with significant experience and expertise was  paid a smaller salary than recent college graduates. Clearly, this is not advisable.

4. What Comparable Businesses Pay for Similar Services. Tax advisors should review basic benchmarking tools such as monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared to industry norms.

5. Compensation as a Percentage of Corporate Sales or Profits. Tax advisors should utilize industry specific publications such as the MAP to determine the overall profitability of the corporation and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, comparisons should be made to similarly sized companies within the same geographic region. If the resulting ratios indicate that the S corporation is more profitable than its peers but paying less salary to the shareholder-employee, tax advisors should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norm provided for in the publications is likely necessary.

6. Compensation Compared With Distributions. While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that all profits be paid out as compensation. Though the District court in Watson recharacterized significant distributions as salary, it permitted Watson to withdraw significant distributions in both 2002 and 2003. Perhaps the court was content to recharacterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue. In doing so, the payroll tax savings on Watson’s remaining distributions amounted only to the 2.9% Medicare tax.

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If you are one of the 97% of Americans whose home is worth significantly less than when they purchased it, you’ve likely been seeking out some type of debt modification with your lender. Or perhaps things have gotten so bad that you’re contemplating a foreclosure or short sale.

Here’s the thing: anytime a mortgage is modified (i.e., reduced), the borrower is required to recognize cancellation of indebtedness (COD) income under Section 61(a)(12). Similarly, if a property is sold at foreclosure or in a short sale and the underlying mortgage is recourse (meaning the borrower has personal responsibility for any excess loan deficiency remaining after the sale), then to the extent the remaining deficiency is forgiven, the borrower will again recognize COD income.

In the foreclosure or short sale context, this COD income is NOT treated as gain from the sale of the property, and thus is not eligible for exclusion under Section 121 (allowing a $500,000 exclusion for MFJ taxpayers who have owned/used the home as their principal residence for 2 of prior 5 years).

When the sh*t hit the fan in the real estate market in 2006 Congress recognized that something had to be done, as it seemed patently unfair to tax homeowners on COD income when they couldn’t even afford to service the underlying mortgage. And while exclusions to COD income have always existed under Section 108, prior to 2007 those exclusions were only of use to a homeowner if the homeowner were insolvent or bankrupt.

As a result, in 2007 Congress enacted Section 108(a)(1)(E), which provides that a taxpayer that is neither insolvent nor in bankruptcy can still exclude up to $2,000,000 of COD income related to the discharge (in whole or in part) of qualified principal residence indebtedness. This exclusion applies where a taxpayer restructures his or her acquisition debt on a principal residence, loses his or her principal residence in a foreclosure, or sells a principal residence in a short sale.

For these purposes:

  • Qualified principal residence indebtedness is debt that meets the Section 163(h)(3)(B) definition of acquisition indebtedness for the residential interest expense rules but only with respect to the taxpayer’s principal residence (i.e., does not include second homes or vacation homes), and with a $2 million limit ($1 million for married filing separate taxpayers) on the aggregate amount of debt that can be treated as qualified principal residence indebtedness.
  • Acquisition indebtedness includes refinanced debt to the extent the refinancing does not exceed the amount of the refinanced acquisition indebtedness.
  • For purposes of these rules, a principal residence has the same meaning as under the Section 121 home sale gain exclusion rules.

Why do you care? Because as of today, this exclusion is set to expire on December 31, 2012. That means you have to ask yourself: How much do you trust Congress to get an extension done before year end? If you do, then by all means, take your time with your debt modification/foreclosure/short sale efforts. But if you don’t, you might want to get a sense of urgency about getting something done with your bank prior to year end, so you can take advantage of Section 108(a)(1)(e) while it’s here.

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There are three things you’ll find in almost annoying abudance in every mountain town: soul patches on the men, dreadlocks on the women, and weed. Lots and lots of weed.

In Colorado, however, you can’t limit the love of marijuana to the denizens of its ski towns. To wit: in Denver — where medical marijuana has been legal since 2000 — there are more dispensaries within the city limits than there are Starbucks in the entire state.

Now, with state tax revenues lagging and criminal justice costs rising, Colorado is turning to an unlikely, albeit logical, solution to its woes: weed for all.

This November, residents of Colorado will vote on Amendment 64, which would legalize and regulate marijuana sales just as it’s done for booze and cigarettes. The goal, quite obviously, is to raise tax revenue. Just how much tax revenue is anyone’s guess:

State analysts project somewhere between $5 million and $22 million a year. An economist whose study was funded by a pro-pot group projects a $60 million boost by 2017.

The cause of the confusion, of course, is because buying recreational marijuana is currently illegal, nobody can be certain what the market for legal weed will be. Muddling matters further, there is no guarantee that those currently buying illegal marijuana would shift their loyalties to legalized outlets. After all, if I learned nothing else from the film “Pineapple Express” — and I didn’t — it’s that the pot smoker-drug dealer bond is a strong one forged through loyalty, trust and PlayStation, and is unlikely to be cast aside so capriciously.

Should the legislation pass — and right now, it looks possible but not likely — it will be fascinating to sit back and watch the state-wide elation greeting free-market marijuana be quickly destroyed by the heavy hand of the IRS. As we’ve discussed before, the Service has used a little known Code section, Section 280E to be specific, to deny all of the tax deductions related to medicinal marijuana dispensaries, effectively taxing the business on 100% of their revenues.

The same section would apply equally to legal recreational sales, because marijuana will remain on the federal controlled substance list, and thus the IRS would be able to wield Section 280E to deny any and all deductions related to “trafficking” in the drug. With a string of recent successes in the Tax Court featuring medicinal dispensaries, the IRS would have a strengthened resolve to pursue recreational sellers of the drug, and likely tax them out of existence.

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Election fatigue is rapidly setting in. Mitt Romney hates half of America. President Obama is a socialist. Kinda’ makes me think of this:


So rather than get immersed in the mudslinging, let’s just stick to good ol’ fashioned tax law talk, shall we?

Fact: Converting from an S corporation to an LLC is generally a painful event. Why? Because in order to convert, regardless of the form the conversion may take, the conversion will generally require a taxable liquidation of the S corporation. And upon liquidation, an S Corporation recognizes gain under Section 336 as if it sold all of its assets, including any intangible assets (i.e., goodwill) for their FMV. This deemed sale usually creates gain at the S corporation level that is prohibitive.

Example: S Co. is owned 100% by A, who has a $300,000 basis in the S Co. stock. S Co. owns hard assets worth $1,000,000 with a $300,000 tax basis. S Co. also has intangible value of $500,000, making the total enterprise value $1,500,000.

If S Co. wishes to convert to an LLC by liquidating and then having its shareholders contribute the assets to the new LLC, S Co. will recognize $1,200,000 of gain under Section 336 ($1,500,000 FMV – $300,000 tax basis) upon distribution of the assets. 

When S Co. then passes out the assets in liquidation, S Co.’s shareholders will treat the $1,500,000 FMV of the distributed assets as the amount realized in exchange for the shareholders’ stock under Section 331. Because the $1,200,000 corporate level gain flows through and increases A’s stock basis under Section 1367, however, A’s basis will be $1,500,000 after adjustment ($300,000 + $1,200,000). Thus, A will recognize no further gain or loss upon liquidation ($1,500,000 amount realized less $1,500,000 stock basis).

Nevertheless, the $1,200,000 of corporate level gain is often reason enough not to pursue the conversion.

But what if you have an S corporation that is in the business of property development or home building? These types of activities have two things going for them that may facilitate a conversion:

1).There is often no goodwill value, as the entities are typically special purpose entities designed for one piece of development, not an ongoing business; and

2) In the current real estate market, many property development or home builder S corporations have mortgages that exceed the FMV of the developed property.

Why is this important? Because given those two facts, now may be the opportune time to convert to an LLC, if so desired:

Assume instead, S Co. owns a property with a FMV and tax basis of $1,000,000. S Co. also owns other assets with a basis and FMV of $500,000. The property is encumbered by a mortgage of $1,500,000. A has a stock basis in the corporation of $0.

If S Co. decides to liquidate and convert to an LLC, Section 336 requires that in computing S Co.’s corporate level gain upon liquidation, the FMV of the property cannot be less than any liability encumbering the asset. As a result, S Co.’s gain will be $500,000 ($1,500,000 debt + $500,000 FMV other assets – total basis of $1,500,000).

This gain then flows through to A, and will increase his stock basis from $0 to $500,000.

Furthermore, when S Co. distributes the assets, the case law (See Ford) dictates that the amount realized on the liquidation is the $1,000,000 FMV of the building  plus the $500,000 FMV of the other assets less the debt distributed along with it of $1,500,000. Thus, S Co. is treated as having received no value for the stock, and will recognize a $500,000 capital loss under Section 331 or Section 165. This loss may offset the $500,000 of gain passed through from the S corporation, resulting in no net gain or loss to A.

What’s the point? With the real estate market still suffering and many properties encumbered by debt in excess of the FMV of the property, now may be the time to correct the “mistake” of placing real estate in an S corporation. Provided intangible value is not a concern, distributing real estate encumbered by debt that exceeds the FMV of the asset may mitigate the normal pain of converting an S corporation into a more tax-friendly LLC.

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In a case with far-reaching implications — including the potential for refund claims to be filed by any employer making severance payments to terminated employees during the recent economic downturn — the Court of Appeals for the Sixth Circuit concluded on Friday that severance pay pursuant to an involuntary layoff was not subject to FICA employment taxes.

First, a bit of history: The treatment of certain supplemental unemployment compensation benefits (“SUB”) for FICA purposes has long been clouded. SUB payments were created in the 1950s as a way to supplement the state unemployment compensation benefits received by employees upon involuntary termination, and were defined in Section 3402(o) as amounts:

1) Which are paid to an employee, 2) Pursuant to an employer’s plan; 3) Because of an employee’s involuntary separation from employment, whether temporary or permanent, 4) Resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and 5) Are Included in the employee’s gross income. [Ed note: this will encompass most involuntary severance payments.]

These SUB payments have always been subject to federal income tax withholding by virtue of that same Section 3402(o), which provides that for purposes of determining whether a SUB payment is subject to withholding, it “shall be treated as if it were a payment of wages by an employee to an employee for a payroll period.”

In the most important court decision on this issue prior to last Friday, the Court of Appeals for the Fifth Circuit had concluded in CSX Corporation v. United States, 518 F.3d 1328 (5th Cir., March 2008), that this language did not mean that SUB payments were treated as wages only for purposes of determining whether they were subject to federal income tax withholding. Rather, the court held that SUB payments were also wages for purposes of FICA taxes, stating:

…because we have rejected the first part of CSX’s argument-that the reference to the term “wages” in section 3402(o) necessarily implies that all payments falling within the definition of SUB in that subsection are non-wages, we reject CSX’s statutory argument.   Based on that analysis, we disagree with the trial court’s conclusion that all payments that qualify as SUB under the statutory definition in section 3402(o)(2)(A) are non-wages for purposes of FICA. We therefore reverse those portions of the trial court’s judgment that were based on the trial court’s adoption of that theory of the case.

On Friday, the 6th Circuit took a different approach, and reached a different conclusion, in Quality Stores, Inc. v United States, holding that severance payments were not subject to FICA.

Quality Stores was an agricultural-specialty retailer who filed for Chapter 11 during 2001. Prior to November, 2001, Quality Stores involuntarily terminated 75 employees, with all remaining employees terminated after November 2001 when Quality Stores closed its doors and went out of existence.

As part of the severance packages offered by Quality Stores, employees were paid based on years of service, and the payments were not tied to the receipt of any state unemployment compensation.Because SUB payments clearly represent income that is subject to federal income tax withholding pursuant to Section 3402(o), Quality Stores reported the payments on the recipients’ Forms W-2, and remitted over $1,000,000 in FICA tax to the IRS. Soon after, Quality Stores filed a claim of refund for the FICA taxes, arguing that the severance payments were not subject to FICA as they were not “wages” for those purposes.

In an initial hearing, a bankruptcy court ruled in favor of Quality Stores in 2005, and late last week, the 6th Circuit affirmed the bankruptcy court’s decision, holding that the SUP payments were not wages subject to FICA tax.

The 6th Circuit reached its conclusion by first looking to the legislative history of Section 3402(o). When the provision was enacted in 1969, Congress recognized that SUB payments “are not subject to federal income tax withholding because they do not constitute wages or remuneration for services.” Because SUB payments represent taxable income to the recipient, however, Congress wanted to take the income tax burden of the recipient by requiring withholding at the source, adding:

Although these benefits are not wages, since they are generally taxable payments they should be subject to withholding to avoid the final tax payment problem for employees.

Having established that SUB payments were not wages for federal income tax purposes, the Sixth Circuit then looked to prior case law, which held that Congress intended for the definition of wages for federal income tax and FICA purposes to be one and the same.[i]

Congress imposed federal income tax withholding on SUB payments because they qualify as gross income, not because they are “wages.” Reading the definitions of “wages” found in the FICA and federal income tax statutes consistently, SUB payments do not constitute “wages” under either statutory scheme.

What’s the lesson? With the Fifth and Sixth Circuit Court of Appeals disagreeing on such an impactful issue, the determination of whether SUB severance payments are wages subject to FICA is likely heading to the Supreme Court. In the meantime, it may behoove any employers who recently paid FICA tax on SUB payments to file a  protective claim for refund.

[i] See Rowan Cos. v. United States, 452 U.S. 247 (1981)

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One of the most revealing aspects of using WordPress as a blog host is having the ability to track the different search engine terms that have ultimately led people to Double Taxation.

Through analyzing this data, I’ve realized two things:

1. There are some sick, sick people out there. To wit: the single-most common string of words that have led web users to this blog during its 18-month history is “power ranger porn.”  Sadly, I’m not making that up. Needless to say, when these deviants wound up getting this blog post instead of whatever depravity they were hoping for, they were more than a little let down.

2. People really want to know whether they can claim a tax deduction for mortgage interest they pay on a mortgage that’s not in their name. My previous discussion on the issue has been an oft-searched post, a result I attribute to our depressed economy. With banks having tightened their purse strings, many non-traditional arrangements for home ownership have sprung up. In many cases, the individual who owns the home and borrows the mortgage is not the same individual who lives in the home and pays the mortgage.

These arrangements are not unique to primary residences. Consider the case of Omar Abarca, a real estate investor who owned rental property through six partnerships. Because Abraca had limited borrowing capacity, each time he wished to purchase a rental property he would enter into a partnership; Abraca would contribute cash, while the other partner would use their borrowing ability to take out a mortgage and purchase the desired property. Abraca would then pay all the operating expenses of the property, including the mortgage interest.

It was unclear whether the borrowing partner ever actually contributed the title of the property to the partnership. What was clear, however, was that Abraca was never listed on the title for each property, nor was he listed as a lender. On his tax returns, Abraca failed to acknowledge the separate legal existence of the partnerships, opting instead to report the activity for each rental property directly on Schedule E, where he deducted the mortgage interest paid on behalf of each property.

The IRS challenged the deductions, asserting that because Abraca was neither the title holder nor the borrower on each property, he was not entitled to deduct the mortgage interest.

To support their position, the IRS cited I.R.C. § 163, which begins by providing the general rule that “There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.”  However, I.R.C. § 163 further provides that the indebtedness must be an obligation of the taxpayer, and not an obligation of another. An exception to the general rule that interest paid on an obligation of the taxpayer is deductible only by that taxpayer is found in Treas. Reg. §1.163-1(b), which provides in part that:

“Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness.”

In summary, just as with primary residences, in order for an individual to deduct interest expense on a rental property he must be either:

1. named as a borrower on the mortgage, or

2. be either the legal owner or equitable owner of the property.

Because Abraca failed to establish that he met either test, the Tax Court sided with the IRS, holding that Abraca was not entitled to deduct any of the mortgage interest he paid on behalf of the rental properties.

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Apparently, just because you say you dropped five grand on a toilet and $2,500 on a shower head doesn’t mean the IRS has to believe it.

Take it from Jovita Diaz. Diaz owned two properties, both of which were sold between 2007 and 2008.

Diaz purchased Property #1 in 1997 for $154,000. Upon selling Property #1 in 2007 for $459,000, Diaz claimed an adjusted tax basis of $553,000 and a resulting capital loss of $94,000. The IRS disallowed the loss, arguing that Diaz’ basis in Property #1 remained her original cost of  $154,000, and thus the sale resulted in a $305,000 gain.

Property #2, a rental property, was purchased by Diaz in 2005 for $490,000. In June 2008, upon selling Property #2 for $299,000, Diaz claimed a basis of $595,000, resulting in a capital loss of $296,000. The IRS again challenged the loss, this time allowing depreciation against the acquisition cost in computing a tax basis in the rental property of $452,000, reducing the claimed capital loss to $153,000.

In both scenarios, Diaz argued that she had made significant improvements to each property: nearly $400,000 in the case of Property #1 and $100,000 for Property #2. In each case, the Tax Court held that Diaz failed up carry her burden of establishing her basis in the sold properties:  

Petitioner did not introduce an invoice from the contractor, a canceled check, a construction permit for the improvements, or before and after pictures. Petitioner contended that she did not have documentation because she kept moving from one place to another. Her testimony was unpersuasive in support of her claim of [the] improvements.

The lesson is obvious. When reporting a sale from real estate, save all documents supporting not only your acquisition cost (such as a closing statement), but also those establishing the cost of any and all improvements made to the property. After all, it’s up to you to prove you spent what you say you did; it’s not up to the IRS to prove you didn’t.

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