Tax Court

Alternative Investments in IRAs – Part II: Be Creative

WARNING:  Do not try the following strategy unless, at least:

  • Your daddy built a big company that exports products
  • You have the nerve to battle the IRS for many years
  • You have creative and careful tax advisors (like me!)
  • You have the money to hire white-shoe lawyers, who probably charge $1,000 per hour, to represent you in Tax Court
  • Preferably, you live within or relocate to be within the geographic boundaries of the Sixth Circuit Court of Appeals (MI, OH, KY or TN)

If you qualify, then read on, oh lucky, wealthy and intrepid taxpayer.

In my last blog, I urged caution when considering the acquisition of alternative investments in IRAs.  I still so urge.  However, the Sixth Circuit’s recent decision in Summa Holdings does inspire one to consider being creative.

Let’s start with the headline, as stated by nationally renowned IRA expert Ed Slott:  “$7,000 in Roth IRA contributions that became $6 million in tax-free gains.”

Do I have your attention?

Next, we consider quick explanations of two important tax-beneficial provisions of the Internal Revenue Code:  Roth IRAs and DISCs (Domestic International Sales Corporations).

A taxpayer may contribute after-tax dollars to a Roth IRA.  The earnings and gains within the Roth are, in most cases, not taxed.  If a taxpayer owns the Roth for at least 5 years and is at least 59 ½ years of age, distributions to the owner of the IRA are not taxed.  Sweet.  Why not put all my after-tax earnings in a Roth?  The limits on contributions to Roth IRAs are low, if your income is below a certain threshold that permits you even to make a Roth IRA contribution.  If you are not at least 50 years of age, then in 2017 you can contribute no more than $5,500.  The limit was $3,500 in 2001, when the Benenson brothers started the series of actions that resulted in the Summa Holdings case.

DISCs were created by Congress to subsidize U.S. exports.  Using DISCs can reduce tax rates on income from exports.  An exporter avoids corporate income tax by paying the DISC “commissions” of up to 4% of gross receipts or 50% of net income from qualified exports.  The DISC pays no tax on its commission income (up to $10,000,000 in a year) and may hold on to the money indefinitely, though the DISC shareholders must pay annual interest on their shares of the deferred tax liability.

Money and other assets in a DISC may exit the DISC as dividends to shareholders.  Individuals treat the dividends as qualified dividends and pay taxes on the dividends at long-term capital gains tax rates.  If an IRA owns the DISC, it must pay tax on its dividends at the high unrelated business income tax rates.

What kind of business operations must the DISC conduct to earn these benefits for its shareholders? None, nothing, nada.

So what did the Benenson brothers do?

  1. In 2001, each contributed $3,500 to his Roth IRA.
  2. Through a series of transactions, their Roth IRAs formed companies that resulted in a DISC.
  3. The DISC contracted with Summa Holdings, owned primarily by a trust for their benefit, to receive export commissions.
  4. The DISC made distributions to the Roths, which paid UBIT and retained the after-tax distributions.
  5. By the end of 2008, the two Roths initially funded with $3,500 each had each accumulated over $3,000,000. Earnings on the non-DISC investments of the Roth will never be taxed to the Roth and distributions will never be taxed to the Roth owners, if distributions don’t occur before age 59 ½.

The IRS came a-calling.  The Revenuers claimed that the “substance-over-form” doctrine applied to negate the transactions and the benefits.  The IRS recast the transaction as dividends from Summa Holdings to its shareholders (the trust and the boys’ parents).  The Tax Court agreed.

The Sixth Circuit disagreed with the IRS and the Tax Court.  The Court stated that the IRS stretched substance-over-form past its limits, which, in the Court’s opinion, are when the taxpayer’s formal characterization of a transaction fails to capture the economic reality and would distort the meaning of the Code.

The Sixth Circuit said that the taxpayers’ transactions fit well within the boundaries of the statutes enacted by Congress.  If Congress wants to change the statute, it can; the IRS cannot change the statute.  The Sixth Circuit pointed out that the whole DISC idea is a form-over-substance arrangement authorized by Congress to promote exports.

So, the taxpayers got a great result.  The general issue is probably not resolved.  Two similar cases are being pursued in two other Federal Circuits. A statute addressing economic substance has been enacted since the taxable years under consideration.  The Sixth Circuit’s apparent narrowing of the ubiquitous substance-over-form doctrine may have much broader reverberations.

In any case, under the right circumstances, being creative, bold and an IRA owner can be quite lucrative.

Ending Note.  On an evening that you have nothing better to do, you might read the Summa Holdings opinion written by Judge Sutton.  One can surmise that any court opinion starting with references to the bat-crazy Roman Emperor Caligula is going to be entertaining.

VKM

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Tax Court

Fleischer – Unsettling News for Independent Wealth Advisers

This is a very long blog because it is an important, complicated and current topic!

I am privileged to count among my clients some of the elite wealth advisers in the Dallas-Fort Worth area.  I team with them and a number of other prominent wealth advisers and financial planners to serve my high and ultra-high net worth clients.  Some of these professionals operate as independent registered investment advisers (“RIAs”).  They do not work as employees for a broker/dealer; they contract to be independent representatives of the broker/dealer.  Many of these independent RIAs may be affected drastically by a Tax Court Memorandum decision, Ryan M. Fleischer v. Comm., handed down in late December of 2016.

Understanding some important concepts underlying the Fleischer case

Three important background concepts undergird this looming challenge caused by Fleischer.

First, many independent RIAs, as well as many other service professionals, operate their businesses inside of S corporations.  Some sources have said that this structure is used by tens of thousands of RIAs.   S corporations don’t pay Federal income taxes on their earnings; their shareholders do, whether or not the income is distributed.  An employee (including, let’s say, an employee who owns 100% of an S corporation) pays FICA taxes.  The S corporation/employer also pays FICA taxes on those wages.  S corporation income, not in the form of employee compensation, recognized by an S corporation shareholder is not burdened by these payroll taxes.  Also, if the shareholder materially participates in the business, the shareholder does not pay the 3.8% net investment income tax on his/her share of the S corporation income.  The shareholder does not pay the 0.9% additional Medicare tax on his/her share of S corporation income.  So, if someone is a 100% shareholder of an S corporation, why take a salary at all?  (Hold that thought.)

Second, bad facts make bad law.  While underpaid, overworked, and often abused, a lot of IRS employees are smart people.  When the IRS does not like what it considers to be a “tax dodge,” its operatives will often lie in wait for a case with a good fact pattern (a bad fact pattern for the taxpayer).  When they find the sucker, they pounce.  They’ll win the case in court – usually pretty easily – and establish precedent that will be used to attack positions that are similar, but less dicey.

Third, pigs get fat and hogs get slaughtered.

Where Mr. Fleischer made a wrong turn and ran into the IRS

Mr. Fleischer is a financial adviser in Nebraska.  He is appropriately licensed to offer financial advice, to buy and sell securities, and to sell variable health and life insurance policies.  After working for some big companies, he struck out on his own.  On February 2, 2006, he personally entered into a representative agreement with Linsco/Private Ledger Financial Services (“LPL”), a securities broker/dealer.  On February 7, 2006, he incorporated Fleischer Wealth Plan (“FWP”).  Mr. Fleischer entered into an employment agreement with FWP on February 28, 2006.  On March 13, 2008, he personally entered into a broker contract with MassMutual Financial Group (“MassMutual”).

As I understand the pertinent rules affecting broker/dealers and their representatives, broker/dealers cannot pay an entity, unless that entity formally registers as its own licensed broker/dealer – a rather expensive and cumbersome process that requires additional ongoing expense and efforts.

So, the typical work and money flow is as follows.  The independent RIA works for an S corporation of which he/she may own all or part of the outstanding stock.  The independent RIA engages in a transaction with a client as an independent representative of the broker/dealer.  The broker/dealer collects the money from the client, including any fees associated therewith.  The broker/dealer gives the independent RIA his/her share of the fees.  The independent RIA remits those fees in their entirety to his/her employer, the S corporation, according to his/her contract with the S corporation.  With those fees, the S corporation then compensates the RIA employee, pays the expenses, and, hopefully, generates a profit for its shareholders.  Actually, the relationships among the parties can be more complicated and vary.  In the instant case, however, this is the work and money flow.

In two of three years at issue in the case, Mr. Fleischer reported on Schedule C in his personal tax return the income on 1099s issued to him by LPL and MassMutual and then deducted the entire amount of that income on Schedule C.  He indicated that he was collecting the money for FWP.  Then FWP reported all of the income.

For the years under consideration in the case, Mr. Fleischer paid himself a salary of about $35,000.  By the dint of his personal efforts, Mr. Fleischer did pretty well.  In one of the years, he had S corporation income of about $150,000 (after subtracting his $35,000 salary).  Is that a hog I hear in the pen?

What the IRS argued and what the Tax Court decided

The IRS could have argued simply, authoritatively, and probably successfully, that Mr. Fleischer should have paid himself a much higher and more reasonable salary than he did: the success of FWP was derived from the sweat of his employee brow.  The IRS could have gotten more payroll and other taxes referred to above.

But the IRS went further.  In a nutshell, the IRS said that because Mr. Fleischer personally executed the contracts with LPL and MassMutual and because the two companies did not have contracts with FWP, the income was his and he owed self-employment taxes on all of the fees (in lieu of his and the corporation’s FICA taxes on an appropriate amount of wages).  The additional Medicare tax would follow.  It appears that the IRS allowed the expenses in the S corporation in computing Mr. Fleischer’s income tax – whew!

The Tax Court agreed with the IRS.  It relied on the “Johnson test” (named after the 1982 Tax Court case that established the “test”) to determine that Mr. Fleischer, not FWP, controlled the earning of the income and, thus, was taxed on the income.  The Court pointed to several facts that it considered incriminatory.  It noted that the LPL contract was executed with Mr. Fleischer personally, that the contract was executed before FWP was incorporated, and that the contract did not mention FWP.  The MassMutual contract was executed after FWP was incorporated, but the contract was between MassMutual and Mr. Fleischer personally and the contract did not mention FWP.

So, based on this case, it appears that many, if not most, existing contracts between independent RIAs and broker/dealers may be open to attack by the IRS for employment taxes.  Some arrangements could result in strange results.  I am aware of situations where one independent RIA has the contract with the broker/dealer, on behalf of an S corporation of which he/she is a part owner.  There are many producers that work for the S corporation and whose fees are reported on the single 1099 going to the contracting RIA.  Will the one RIA be taxed on every RIA’s income?

 

What can independent RIAs do?

What is one to do?  Well, we’re still working on answers to that question.  There are several avenues of action that we are examining.  On a go-forward basis, could the answer be as simple as being sure that the previously-incorporated employer/S corporation is mentioned in the contract between the RIA and the broker/dealer?  Alternatively, must the S corporation become a broker/dealer so that it can contract with the broker/dealer to receive the fees directly? Must each RIA employee enter into a contract with the broker/dealer?

The RIA’s position should be enhanced and distinguishable from Fleischer if the RIA executes an agreement with his S corporation that says all of his income from each personal contract is assigned to the S corporation.

Definitely, the S corporation must pay reasonable and appropriate compensation to the RIA.

The Fleischer decision has some technical weaknesses.  While the memorandum decision is precedential, a memorandum decision is supposed to involve only cases where the law is well-established.  I think that is not the case here.  But the damage is done.

The Fleischer decision glosses over the fact that it is well established that nominees and agents don’t pay tax on income that they receive for someone else; that someone else pays the tax.

The case could be appealed and overturned.  The “Johnson test” is very rigid and not well-regarded in all jurisdictions.

If the case is not overturned, an RIA caught in the future in the crosshairs of the IRS might consider paying the disputed tax and seek a refund of those taxes in a jurisdiction other than the Tax Court.  The Tax Court would probably consider this Fleischer case precedential with respect to a wide array of fact patterns.  Other courts may not.

We will be working with other tax advisers and our clients on these and other possible solutions.

As I said, bad facts make bad law.  This is a perfect example.

VKM

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Tax Court

POOF! $64 Million Charitable Contribution Deduction Disappears

Alright, the facts in the case are a bit more complex than a “poof.”  But it got your attention for my at-least-annual reminder to obtain a contemporaneous written acknowledgment (“CWA”) from the donee for any contribution that is valued at $250 or more.

A CWA must state, among other things, (a) the amount of cash and description (but not the value) of any property other than cash contributed, and (b) whether the donee supplied the donor with any goods or services in consideration for the gift and, if so, must furnish a description and a good-faith estimate of the value of such goods or services.  The CWA must be in hand before you file the income tax return claiming the deduction and no later than the due date (including extensions) for filing such return.

A Tax Court decision issued in December, 2016 – 15 West 17th Street LLC, et al. (“LLC”) v. Commissioner -illustrates the CWA requirement vividly.

In September 2005, LLC purchased for $10 million a property in Manhattan (New York, not Kansas).  LLC planned to demolish a building built in 1903-04.  However, LLC was outflanked by a local preservation society, which got New York City to declare the building a “certified historic structure.”  No demolition could occur.

In December 20, 2007, LLC executed in favor of the Trust for Architectural Easements (“the Trust”) a perpetual historic preservation deed of easement.   On May 14, 2008, the Trust sent the LLC a letter acknowledging receipt of the easement.  The letter did not state whether the Trust had provided any goods or services to LLC, or whether the Trust had otherwise given LLC anything of value, in exchange for the easement.

LLC secured an appraisal concluding that, as of February 8, 2008 the property had a fair market value of $69,230,000 before placement of the easement and had a value after the easement of $4,740,000, a reduction of $64,490,000.  Wow! That property appreciated almost 600% in 2 ½ years!  I don’t think that President Donald J. Trump could claim that kind of real estate investing acumen.  (Okay, he probably would.)  LLC claimed a $64,490,000 charitable contribution on its 2007 tax return.

The IRS does not like deductions for charitable contributions of easements.  This case looks especially egregious.  I am sure that the Revenuers were girded for battle about the valuation.  But they won without firing a shot in that battle.

Most of the opinion of the Tax Court addressed a rather obscure and convoluted argument by LLC that it did not need a CWA, due to a special provision in the statute involving some rule-making authority delegated by Congress to the IRS, but never exercised by the IRS during a period exceeding twenty year.  The Tax Court did not buy LLC’s argument.

Then, the case addressed the provisions in the statute that define a CWA. The IRS simply pointed out that the acknowledgement was not a CWA, because it omitted required language about “no goods and services.”  Fight over.  LLC loses.

Reminder issued.

VKM

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Tax Court

What’s The Difference Between An Actuary And An Accountant?

An accountant looks at your shoes when he talks to you.  An actuary looks at his own shoes when he talks to you.

There is a difference between an actuary and a mathematician, too.  This difference is well illustrated in a Tax Court case published last week.

In Pizza Pro Equipment Leasing, Inc., the Tax Court was confronted with whether, under the law in effect at the time, excess contributions were made by an employer (having only one employee – the owner of the company) to a defined benefit plan and the consequences of making those excess contributions, if they existed.  The normal retirement age under the plan was 45 years of age.  The law and regulations require an adjustment to the maximum contribution to the plan where the normal retirement age under the plan is less than 62 years of age.  The adjustment is made to achieve “actuarial equivalence” in the amount of the maximum allowable and deductible contribution.

The taxpayer and the IRS each had its own expert.  The taxpayer used as its expert an obviously accomplished professor with a Ph.D in mathematics.  The IRS’s expert was one of its employees who had been an enrolled actuary since 1980. Before he “retired” and joined the IRS in 2009, this employee had worked for national actuarial consulting firms for his entire career.

The dueling experts focused on the term “actuarial equivalence.”  The professor discounted the age 62 limitation by the time value of money for 17 years (to age 45).  The actuary followed the regulations (which the mathematician seemed to not quite understand) and reduced the age 62 limitation (a) by the time value of money and (b) by a calculation reflecting the difference in the  mortality tables for age 62 versus age 45.  The second adjustment is illustrated by one of the factors in pricing an annuity:  on average, fewer 45 years-old persons will die sooner than 62 years-old persons will die, at a specific point in time.  The second adjustment made a big difference in the calculation.

I have to give kudos to Tax Court Senior Judge David Laro (and the law clerks assisting him).  Judge Laro waded through some deep technical actuarial concepts to come to a decision and to express his decision as clearly as one possibly could, even though the opinion is still a pretty difficult read.

Judge Laro acknowledged that the professor was smart and his numbers were precisely calculated.  However, those calculations were not answering the right question.  The IRS expert hit the nail on the head.

Judge Laro told Pizza Pro to pay tax on overstated deductions and to pay several types of penalties that the IRS had levied.

So, I guess that the moral to the story is that you need to be sure that, when you need actuarial expertise, you hire the guy that looks at his own shoes when he talks to you.

VKM

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IRS, Tax Court

Don’t Tell My Clients About This Case

I always tell my clients to keep good records.  Often, I tell them again and again annoyingly.  It is my experience, and I daresay the experience of most other tax practitioners, that a taxpayer’s failure to keep good  books and records will almost always result in a bad experience, if the taxpayer has to tangle with the IRS.  Well, I said almost always.

Mr. Singer owned an S corporation of which the primary business was servicing, repairing, and modifying recreational vehicles.  The corporation also sold Kraftmaid cabinets used in the construction of homes.

Mr. Singer relocated his business from Florida to Colorado in 1999. After a slow start, Mr. Singer’s operations grew quickly.  He needed money to fund the business’s growth.  He established a home equity line of credit; he refinanced his home; he borrowed money from his mother and her boyfriend.  In total, from his own funds or from funds that he borrowed personally, he injected $646,443 into his corporation.

The corporation recorded the advances as loans from shareholder on its general ledger and Form 1120S, U.S. Income Tax Return for an S Corporation.  However, there were no promissory notes between Mr. Singer and the corporation, there was no interest charged, and there were no maturity dates.

It is no surprise what happened to the business in 2008.  Most money spent on recreational vehicles is discretionary and revenues dried up during the Great Recession.  Mr. Singer had to scramble. He moved his business back to Florida.  He borrowed more money from his mother and her boyfriend.  He paid personal bills out of the corporation’s bank account.  The corporation treated those bill payments as repayments of the shareholder loans.  He was taking no other compensation payments from the business.

In a recent case before the Tax Court, the IRS wanted to classify the payments from Mr. Singer to the corporation as contributions to capital and the corporate payments of Mr. Singer’s bills as wages to Mr. Singer.  As a result of those  classifications, the IRS wanted to collect employment taxes from the corporation.

The court cited thirteen factors to consider in classifying funds flowing between a closely held corporation and its owner.   Then, the court pretty much ignored the factors.  To my surprise, the court said that, up until the Great Recession ravaged his business, the advances by Mr. Singer were loans.  After that, the advances were contributions to the corporation’s capital.  The court further ruled that all the payments of the personal expenses by the corporation were repayments of the loans.

I would tell you that, without proper documentation of a loan, almost always the IRS will win the argument that arose in this case.  That’s almost always.

VKM

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Tax Court

Hey Vance, can I deduct my car expenses?

That’s not an unusual question.  The exchange continues often like this.

Vance:  Do you have contemporaneous records that document (1) the amount of the expense; (2) the time and place of the travel or use; and (3) the business purpose of the expense?

Client:  Well . . .

Vance:  How about an after-the-fact reconstruction of such information to a high degree of probative value that rises to the level of credibility of a contemporaneous record?

Client:  Huh?

Bottom line, you have to keep good records to deduct auto expenses.

In a recent Tax Court Memorandum decision, the result of failure to keep good auto expense records is well illustrated.  Mr. Powell owned an S corporation that was involved in several aspects of the petroleum marketing business.  He had several problems with his personal tax return, some of which he blamed on his tax preparation software.  (By the way, blaming TurboTax did not get him out of his understatement penalties.)

One of the issues before the court was his business auto expenses.  The need for the regular use of an auto in the business is pretty convincing.  No problem there.  But, it seems that Mr. Powell was a sporadic auto record-keeper.  Sometimes, he kept detailed contemporaneous records.  Sometimes, he was able to assemble after-the-fact convincing records.  Sometimes, he seems at some late date to have thrown together some pretty questionable information to document the auto use he had claimed on his tax return. For example, the Tax Court noted that one particular destination seemed to have varied in round-trip distance from 325 miles to 600 miles (with no further explanation by Mr. Powell for the difference).

So, the Tax Court let him deduct the auto expenses (based on the per-mile allowance method) for which he had good records and denied the auto expense deductions for which he did not have good records.

If the IRS audits your auto expenses and you don’t keep good records – preferably contemporaneous – you’ll lose every time.  If you want to increase your chances of debating the issue with the IRS, deduct 100% of the costs of an automobile.  Except for a vehicle that wouldn’t be used for personal transportation of any kind – maybe a front end loader, for example, deducting 100% of an automobile’s expenses as business seems to be an IRS audit red flag.

VKM

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Tax Court

OUCH!

I agree with the IRS’ and Tax Court’s interpretation of the law, but Mr. Udeobong sure paid through the nose – twice, to be exact.  I’ll save you the gory details.  In fact, they might make you a little less sympathetic.  In any case, Mr. Udeobong still took a lickin’.  Here is the summary and sanitized version of the recent Tax Court Memo decision.

Mr. Udeobong had a medical supply and equipment business that reported its taxable income on the cash basis of accounting.  Sometime before 2005, Mr. Udeobong reported as income receipts from Cigna in the amount of about $260,000.

Mr. Udeobong had a dispute with Cigna.  Sometime between 2005 and 2010, Mr. Udeobong repaid the $260,000 to Cigna and did not deduct the repayments.

In 2010, Cigna repaid the $260,000 to Mr. Udeobong.  Since he had already taken into income the payments and had not deducted them when he returned the money, Mr. Udeobong thought he had taken care of his tax liability.

In 2012, the IRS issued a deficiency notice to Mr. Udeobong based on the omission of about $152,000 of the $260,000 that he received in 2010 and did not report as income.  Of course, Mr. Udeobong had already paid taxes on this income once before.  That does not matter.  In general, a cash basis taxpayer reports receipts as income.

The statute of limitations had already run for the year he first reported the income and for the year in which he may have taken, but did not take, a deduction for paying the money back.  He could not amend his returns for these years.  The Tax Court ruled that he had to pay tax on the $152,000 again in the year of receipt – 2010.

So, Mr. Udeobong paid taxes on $152,000 twice.  The IRS said he was also was liable for the substantial understatement penalty of 20% of the tax underpayment in 2010.

Mr. Udeobong did have a small victory in this bruising battle.  After filing its paperwork with the Tax Court, the IRS caught the difference between the $260,000 received and the $152,000 on which it computed the tax deficiency.  It amended its answer to the taxpayer’s Tax Court petition and asked for more money from Mr. Udeobong.  The Tax Court replied that it is within the rights of the IRS to ask for more in such a situation and it is within the rights of the Tax Court to reject the request.  So, the Tax Court rejected the IRS’ amendment to its answer.  I guess the court thought that the law and the IRS had beaten up on Mr. Udeobong enough.

However, the Tax Court upheld the 20% penalty.  It said that paying your taxes on the amount in a prior year did not represent “reasonable cause” or “good faith” for not paying the taxes again. Yep, you read that right.

Just a small advertisement here.  Mr. Udeobong apparently prepared his own tax returns.  He represented himself without legal counsel before the Tax Court.  This is one of those times that some professional help would have been well worth the cost.

VKM

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