Personal Taxes

Hey Vance, Can I Deduct the Costs of my MBA?

On occasion, I am asked if a taxpayer can deduct the costs of graduate education.  I consulted with a client about deducting the costs of his MBA as recently as a month ago.  I confidently tell my inquirer that, in the vast majority of cases, if the costs were deductible, the costs would be treated as an employment expense and deducted as a Schedule A miscellaneous deduction subject to a floor of 2% of adjusted gross income.  Beyond that advice, the deductibility gets a bit murky, particularly with respect to an MBA.

Issued in 1958, Regulation Section 1.162-5 addresses the deductibility of educational expenses.  Basically, the regulations say that if the education is (a) a prerequisite for a specific profession or (b) required to meet the educational requirements for qualification in his or her employment, the costs are not deductible.  Costs such as continuing education requirements are deductible.

So, the costs of becoming a lawyer or doctor or a physician’s assistant are clearly not deductible: you get a license to practice a profession after you complete your studies and pass an examination (or two or three).  An MBA is different.  Generally, an MBA does not bestow upon you a license.  It may or may not qualify you for a new job; it could just make you better at your existing job.  Pursuing an MBA may cause one to take a break in employment, if one elects to enter a full-time MBA program. This break in employment, along with other variations on the MBA theme, muddies the deductibility of MBA costs.

Derek A. Jones, an attorney in Orono, Maine, and Steven C. Colburn, an associate professor of accounting at the University of Maine in Orono, published an article about this topic in the July 2017 issue of Practical Tax Strategies/Taxation for Accountants.  They examine carefully the development of the case law about the subject and lay out a clear explanation and guidelines for determining the deductibility of MBA costs.  They look at different kinds of MBA pursuits.   They even summarize their findings in a decision tree-type chart.  Kudos, gentlemen!

I paraphrase key aspects of the summary of the findings set forth by Jones and Colburn.  I am responsible for any faults in the paraphrase.  Their summary addresses how a taxpayer can best position to deduct the MBA costs, based on the regulations and court cases.

  • Before seeking an MBA, work for at least two years in a field of business to which an MBA can be applied.
  • If possible, pursue the MBA part-time. If you must study full-time, don’t take off more than two years.
  • After getting your MBA, work for the same employer in the same field. While not as convincing a case, if you don’t work for the same employer, work in the same field.
  • As much as possible in the MBA program, take courses that pertain to the type of employment you had before and after the MBA.
  • Don’t take a job after getting your MBA that requires an MBA.
  • Don’t obtain a degree that may qualify you for a professional certification (such as a CPA), whether or not you pursue that profession certification.

I’ll be asked again about the deductibility of MBA costs, I am sure.  Until authoritative pronouncements change the landscape, I will simply refer the questioner to this fine scholarship by Mr. Jones and Dr. Colburn.

VKM

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Personal Taxes

Home Is Where The Dog Is

Three times during this spring busy season I researched extensively the facts and the law surrounding the states of residence of taxpayers in order to determine where state taxes should or should not be paid. Maybe I should have just posed a simple question:  “Where’s your dog?”

In February 2017, the State of New York Division of Tax Appeals (the “Court”) decided the case of Gregory Blatt.  Mr. Blatt was an attorney who in 2009 had worked for several years for InterActive Corporation (“IAC”) as general counsel.  He lived in New York City.  After a corporate reorganization, Mr. Blatt decided to move on.  He spoke to IAC Chairman and CEO Barry Diller about his plans.

Mr. Diller wanted to keep Mr. Blatt as part of IAC.  He asked him if he wanted to run IAC company Match.com., based in Dallas.    Shortly after breaking up with his long-time live-in girlfriend, single Mr. Blatt is given the chance to run dating sites that include Match.com and Tinder.  Hmm. . .

Mr. Blatt was tempted to swipe right on the deal.  But there was one drawback – Dallas.  Mr. Blatt was a sophisticate from the East Coast.  What possibly would there be to do in the heart of the hinterlands?  So, Mr. Blatt negotiated to work at least half the time in New York.  He kept his apartment and his boat in New York.  He took the Dallas job in early 2009.  Match would pay his Dallas living expenses.

He rented a very nice apartment in the Ashton, in the heart of Dallas’ Uptown.  He fell in love with Dallas, the thriving social scene in Uptown, the great restaurants within walking distance, the sports and entertainment venues easily accessible.  (Full disclosure – I live about three blocks from the Ashton – Mr. Blatt is right!)

While not discussed directly in the case, I am sure of another factor.  He had to have fallen for Texas women.  And, he’s the guy that runs Tinder!

He embraced Texas.  He made the final commitment in late 2009 – he moved his dog to Big D.

Towards the end of 2010, Mr. Blatt got the opportunity be the CEO of IAC.  He tried to run IAC from Dallas, because he now fully appreciated the charms of Texas.  But he ultimately decided to move back to New York in 2011.  He claimed to be a Texas resident for most of 2009 and for 2010.  He avoided over $400,000 in New York state income taxes by so claiming.  New York’s Department of Revenue took issue with his self-classification as a Texan.

The Court conceded that Mr. Blatt did not live more than 183 days in New York in 2009 or 2010.  So, he was not a statutory resident of New York.  His residency hinged on his domicile – the place in which an individual taxpayer intends to be his permanent home.  When this saga began, he was domiciled in New York.  To change domicile (from New York to anyplace else), “a taxpayer must prove his subjective intent based upon the objective manifestation of that intent displayed through his conduct.”

The Court pointed out that Mr. Blatt submitted over 100 statements of fact regarding his intentions.  Only one seemed to really matter:

“In reviewing the factors of a change in domicile, historically, the move of items near and dear tend to demonstrate a person’s intention.  As borne out by the evidence in this case, petitioner’s dog was his near and dear item which reflected his ultimate change in domicile to Dallas.“

VKM

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Personal Taxes

Unconventional Investments in IRAs – Part I: Be Careful

I remember when Individual Retirement Accounts (“IRAs”) were first established in 1974.  (Yep, I’m no spring chicken.)  At first, these tax-deferred IRAs were restricted to those workers who were not already covered by a qualified employment-based retirement plan.  In 1981, that restriction was removed.  IRAs became big business. Then Roth IRAs came along in 1997.  The Investment Company Institute reported that at yearend 2015, people had IRAs worth $7.3 trillion.

Many people assume that any income inside an IRA is nontaxable.  Quite a few IRA holders don’t think much about what kind of investment they place in their IRAs.

I could write a book about all the problems you can have, if you are not careful with your IRAs.  I won’t do that; I wrote a book in my last blog.  Let me touch on just a few of the key problems into which one can run.

Excepting general prohibitions on investing retirement funds in life insurance or collectibles, you can invest your IRA funds in a broad spectrum of assets.  Most of the investments in IRAs are publicly-traded stocks, marketable bonds, mutual funds and ETFs.  For the most part, income and gains from those kinds of investments are not taxed currently to either the IRA or the IRA holder.  However, beyond a threshold of $1,000 per year per IRA, IRAs may have to pay tax on income and gains from some kinds of “unconventional” investments, such as hedge funds, private equity funds, publicly traded partnerships, real estate, and closely-held businesses operated as partnerships or limited liability companies treated as partnerships for tax purposes.  This tax is levied on “unrelated business taxable income” (“UBTI”).  The tax is levied also on “unrelated debt-financed income” (“UDFI”) of the IRA.  The IRA must file a Form 990-T and pay tax at rates that quickly reach top individual rates.

Recently, The Wall Street Journal reported that Ms. Fanny Handel, a retiree from Queens, was shocked and dismayed to get a notice from the IRS in 2015 that her IRA owed $92,000 in taxes, penalties and interests.  Her IRA had invested in Kinder Morgan, an energy publicly traded partnership.  Upon a taxable merger, Kinder Morgan generated a lot of income and gain for its limited partners.  Ms. Fanny or her IRA paid the tax, but got a bit of break from the IRS on the penalties and interest.

So, one’s IRA can owe tax, if one has UBTI or UDFI in one’s IRA.  Your problems don’t stop there.   You can’t engage in prohibited transactions (a) with disqualified persons or (b) involving self-dealing.  Just a few examples of prohibited transactions in an IRA include: (1) having your IRA purchase for you a vacation home; (2) selling your own assets to the IRA; (3) taking a salary from an IRA-funded business; and (4) personally working on and/or paying for repairs on a rental property that your IRA owns.  If you do engage in a prohibited transaction, what happens?  The entire IRA loses its tax-favored status as an IRA, and the account is treated as distributing all of its assets to the IRA owner at the fair market value on the first day of the year in which the transaction occurred.  If it’s a traditional IRA, you may have a huge tax bill.  If you are less than 59 ½ years old when this happens, you’ll also owe a 10% early distribution penalty.

Let’s throw in one more complexity – valuing unconventional assets.  This is can be a particularly vexing problem when you reach 70 ½ years of age, the age at which you must begin taking required minimum distributions (“RMDs”) from traditional IRAs. Generally, you calculate the RMD by applying a percentage to the value of your IRA accounts at the beginning of the year of the RMD.  What if you underestimate the value of the unconventional assets (for example, stock in a private company) in your IRA accounts and, thus, don’t distribute enough to satisfy your RMD?  You pay an excise tax equal to 50% of the amount that the RMD exceeds what you paid.

Now, wait a minute, you might say.  Does not the IRA custodian have to keep up with all the particulars of your IRA investments, including valuing your unconventional assets?  Usually, no.  Does not the IRA custodian prepare the IRA Form 990-T for and pay the tax from your IRA? It depends; often not.  When your IRA invests in unconventional assets, you should assume that you are assuming a lot of responsibilities.

The Government Accountability Office released a report in December 2016 and suggested that the IRS give a lot more guidance to and, basically, post big warning signs for IRA holders who are invested in, or are thinking of investing in, unconventional assets.  Good idea.

So, placing unconventional assets in an IRA can cause problems.  On the other hand, placing unconventional assets can create significant wealth.  I’ll discuss a very creative example of this wealth-building in my next blog, Alternative Investments in IRAs – Part II:  Be Creative.

VKM

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Personal Taxes

Hey Vance, How Long Should I Keep My Tax Records?

Regularly, I am asked how long one should keep tax records.  This is an important and straight-forward question.  My usual answer is less direct: “it depends.” As you can see below, that’s a pretty good answer.  Except for my comments in italics, the following advice is from the IRS website and IRS Newswire IR-2016-162. To read from the IRS website click here. Henceforth, I will forward a copy of this blog to inquisitors.

How long should I keep records?

The length of time you should keep a document depends on the action, expense, or event which the document records. Generally, you must keep your records that support an item of income, deduction or credit shown on your tax return until the period of limitations for that tax return runs out.

The period of limitations is the period of time in which you can amend your tax return to claim a credit or refund, or the IRS can assess additional tax. The information below reflects the periods of limitations that apply to income tax returns, unless otherwise indicated. Other types of taxes may have other periods of limitations.  Unless otherwise stated, the years refer to the period after the return was filed. Returns filed before the due date are treated as filed on the due date.

Note: Keep copies of your filed tax returns. They help in preparing future tax returns and making computations if you file an amended return.  Keep these copies forever.

Period of Limitations that apply to income tax returns

  1. Keep records for 3 years if situations (4), (5), and (6) below do not apply to you.
  2. Keep records for 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later, if you file a claim for credit or refund after you file your return.
  3. Keep records for 7 years if you file a claim for a loss from worthless securities or bad debt deduction.
  4. Keep records for 6 years if you do not report income that you should report, and it is more than 25% of the gross income shown on your return.
  5. Keep records indefinitely if you do not file a return.
  6. Keep records indefinitely if you file a fraudulent return.

This is a rather interesting and awkward way to address the fraud issue.  A bit more explanation is in order.  The period of limitations for assessing taxes does not run for false or fraudulent returns with the intent to evade tax.  There is, however, a six year period of limitations for filing criminal tax evasion charges.  The government has the burden of proof to prove fraud and the hurdle is high for the government.  Nevertheless, if you are “skating on one night’s ice,” you should consider retaining your records forever, if they will help exonerate you.  Note:  If you have to worry about this, I doubt that you are my client or ever will be.  I’ll refer you to a good tax controversy attorney. 

  1. Keep employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later.

Bottom line for me:  Keep all your records for at least six years after you file a tax return or the original due date, whichever is longer.  While 25% of gross income seems like a big change, I’ve seen increases or alleged increases of that magnitude arise with surprising frequency.

Note that state periods of limitations may differ from the Federal periods.

Health care information statements should be kept with other tax records. Taxpayers do not need to send these forms to IRS as proof of health coverage. The records taxpayers should keep include records of any employer-provided coverage, premiums paid, advance payments of the premium tax credit received and type of coverage. Taxpayers should keep these – as they do other tax records – generally for three years after they file their tax returns.

Whether stored on paper or kept electronically, the IRS urges taxpayers to keep tax records safe and secure, especially any documents bearing Social Security numbers. The IRS also suggests scanning paper tax and financial records into a format that can be encrypted and stored securely on a flash drive, CD or DVD with photos or videos of valuables.

Note that you can store your records electronically and not keep reams of paper documentation.

The following questions should be applied to each record as you decide whether to keep a document or throw it away.

Are the records connected to property?

Generally, keep records relating to property until the period of limitations expires for the year in which you dispose of the property. You must keep these records to figure any depreciation, amortization, or depletion deduction and to figure the gain or loss when you sell or otherwise dispose of the property.

If you received property in a nontaxable exchange, your basis in that property is the same as the basis of the property you gave up, increased by any money you paid. You must keep the records on the old property, as well as on the new property, until the period of limitations expires for the year in which you dispose of the new property.

What should I do with my records for nontax purposes?

When your records are no longer needed for tax purposes, do not discard them until you check to see if you have to keep them longer for other purposes. For example, your insurance company or creditors may require you to keep them longer than the IRS does.

Last word:  The ability to securely and inexpensively electronically store tax records takes away most of the reasons to worry about destroying your tax records.  Keep them forever!

VKM

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Personal Taxes, Tax Court

Didn’t know about your ownership in a partnership? Doesn’t excuse you from paying tax on income from the partnership.

Divorces can be nasty. Just ask Mrs. M. (a prominent Dallas family (aka, divorce) lawyer with whom I live). In this Tax Court Memorandum decision, you get an idea of how ugly things can get, particularly when you drag the IRS into the fray.

Vince (not Vance) and Ann Carrino were married in 1990 and legally separated in June 2002. Their divorce dragged on for four more years. The Tax Court described Vince as “an exceptionally skilled financial manager.” He was a hedge fund guru. He was also crafty.

Vince initiated a new hedge fund in January of 2002 – CR LP. He did not tell Ann about it. The new hedge fund started business later in 2002. CR LP did really well in 2003. Ann was not listed as a partner in legal documents, did not get a K-1, and did not know about CR LP until quite a bit later.

When Ann got wind of CR LP, she took action. The California divorce court ruled that she owned a piece of the partnership under community property law and she received over $6 million to liquidate her interest in CR LP in November 2006. In December 2006 the divorce was granted.

On what appeared to be the last day to file a 2003 amended return for CR LP (April 15, 2007), Vince filed an amended partnership return and sent Ann a 2003 K-1 in 2007 showing her share of income of over $750,000 and reduced his general partner entity share of income by the same amount. She did not file an amended return for 2003 to report her income on the K-1. The IRS noticed that omission. The parties went to Tax Court.

Ann tried to argue that she was not really a partner under California community property law. She lost that argument. The Tax Court said she owed the money.

Of course, Vince filed an amended return for 2003 seeking a refund. Apparently his refund claim was disallowed by the IRS. It seems that Vince filed a Tax Court petition pro se seeking relief from an IRS determination to disallow his refund claim. He did not go through the right channels to appeal the initial disallowance, so he lost the right to get a refund.

Just to add a little salt to the wounds of Vince and Ann, the Tax Court decision contained some dicta. It pointed out that the California divorce court, while criticizing Vince’s hasty and unilateral action, slapped him with all of Ann’s penalties, interest, fees and costs above the actual federal and state taxes she owes. Then the Tax Court mentioned in a footnote to the case that Ann and her lawyers did not argue innocent spouse relief, hinting that she may have received some tax relief from those provisions. The Court pointed out that it can’t address arguments not made.

Did I say that divorces can be nasty?

VKM

IRS, Personal Taxes

Individual IRS Audit Rates Went Down in 2013, But . . .

The Kiplinger Tax Letter recently reported that 2013’s individual audit rates fell to 0.96% and are expected to fall further in 2014, due to budget restraints. (These are audits conducted in fiscal year 2013, not 2013 returns.) That probably can be considered good news, but . . .

• The IRS audited 10.85% of returns showing income of $1 million or more.
• 100% of business use of a vehicle on an individual return paints a red target on a return.
• Schedule C attracts attention, especially if it shows big meals, travel and entertainment deductions.
• A combination of a W-2 and a Schedule C with a loss can raise a hobby loss flag.
• Higher-than-average deductions may attract attention of the IRS, but should not be a problem if proper documentation exists.
• Tax return does not match 1099s and/or information returns? Expect a letter (correspondence audit) from the IRS.

Bottom line. Random audits may go down. Come up on the radar screen of the IRS and you’ll still get a chance to communicate with Uncle Sam.

Also, from Kiplinger: If you want to speak with a live person at the IRS, you have a 61% chance of doing so if you are willing to wait up to 20 minutes. Take it from me, the “hold music” is torture.

-VKM

Personal Taxes

Don’t Tell Mrs. Maultsby

My wife is a very attractive, successful, intelligent, and well-respected attorney. Sometimes I’m sure she wonders why she married an uninteresting and undistinguished tax nerd. She puts up with my corny jokes, my slightly anal-retentive personality, my mechanical ineptitude and my other quirks. If she knew what it was really costing her, I might be just a distant memory.

While there have always been marriage tax penalties in the Internal Revenue Code, they were tempered a bit by the Bush tax cuts starting in 2001. These penalties returned in full force in 2013.

What penalties? To name a few, less than doubling of “filing single” amounts for:
• Tax brackets (For example, the top bracket for singles starts at $400,000 of taxable income; for married persons filing jointly the top bracket starts at $450,000.)
• AMT phaseout
• Capital loss deductions
• IRA deduction AGI limits
• Affordable Care Act taxes exemption ceilings
• Many tax credit limitations

I went to the marriage penalty calculator at taxpolicycenter.org and discovered that it’s costing Mrs. M (and me) about $30,000 in 2013 alone to share our wedded bliss. Now, if the lovely lady starts to be a bit more distant, or suggests that we divorce and shack up, I’ll know that one of you told her. I’m not saying anything!

VKM