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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IRS

National Taxpayer Advocate’s 2016 Annual Report to Congress – Some Key Takeaways

Every year, by law, the National Taxpayer Advocate, “an independent voice for the taxpayer within the IRS,” issues a report to Congress.  For 15 years, the National Taxpayer Advocate has been Nina E. Olson.  She knows her stuff.

Issued last week, the 2016 report is about 965 pages, give or take a page or two.  The executive summary alone is 95 pages long.  The IRS ignores the National Taxpayer Advocate at its peril.  The new Congress and the new President would be wise to heed her advice, too.

The 2016 report includes a lot of good ideas, observations, complaints, and suggestions.  I may come back to some additional items in future blogs.  In this blog I focus on three “foundational themes” that she identifies as core to improving the IRS and its operations.

  1. “Simplify the Internal Revenue Code Now.” Of course, the IRS does not write the tax laws; Congress does.  Nevertheless, the IRS’ job revolves around this massive, complicated and confusing document.  Olson points out that the Internal Revenue Code consists of four million words.  She estimates that taxpayers spend six billion hours in order to meet filing requirements. (Based on the way the number is calculated, that may include some or all of tax preparers’ time.  She admits that it’s a rough estimate.)
  1. “The IRS needs to talk to the taxpayer. IRS must present a human side to the agency to foster and keep voluntary compliance.”  While self-service assistance has its beneficial attributes, she points out that behavioral science studies confirm the human voice is quite soothing to someone who is stressed and anxious.  Indeed, she cites a number of behavioral science lessons that may be applicable to taxpayer compliance.
  1. There is a “need for establishing minimum standards of and testing for competency of Federal tax return preparers.” She is not worried about CPAs, attorneys, and enrolled agents.  However, there are a lot of tax return shops that don’t have any real proficiency standards and sometimes have no scruples.  Consider the guy standing on the side of the road at the strip shopping center dressed as the Statue of Liberty; when somebody parks and walks into his storefront, he takes off his costume and prepares a tax return.  It might be good to check his credentials.

VKM

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IRS

Happy New Year 2017! A Little Gift

 

I was cleaning out my “blog topic” file this morning and readying for the new year.  I found a note that I should send this link to my friends and readers.

The IRS website is full of helpful information, if you can navigate to it.  Take a look at “A-Z Index for Business” at  www.irs.gov/businesses/small-businesses-self-employed/a-z-index-for-business. There are probably more than 500 topics that are just a click away.

If you have time, you might send the IRS a suggestion for topics that would fall under “X”, “Y”, or “Z”, which are without topics at this time.

Happy New Year!

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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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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Tax Policy

FEARLESS FORECASTS

Warning:  Take anything that I forecast with a grain of salt.  Along with most of the civilized world, I predicted wrongly the outcome of the 2016 presidential election.

Once I overcame the shock of the presidential election results, I began to watch, listen, discuss and read about possible tax changes that could occur.  For the first time, I read seriously President-elect Trump’s tax plan.  I dusted off my copy of the tax proposals in “A Better Way – Our Vision for a Confident America,” published by House Republicans this summer.  Here are a few fearless forecasts and related observations about possible Federal tax law changes.

  1. Sometime during the next two years – 2017 and 2018, expect the most drastic tax changes since 1986. They may be even more drastic than the 1986 tax reforms.  Republicans (at least, in name) control the White House, the Senate and the House of Representatives and will do so at least until 2019.  While the Senate majority is not filibuster-proof, Senate Republicans can use the budget reconciliation process to pass tax changes with their 52-48 majority.
  1. Obamacare is toast. However, there will be some kind of government-sponsored, government-enabled, government-encouraged, and/or government-subsidized health insurance solutions for people that can’t access healthcare through employers or Medicare or Medicaid.  You can’t just get rid of entitlements; they are sticky like fly paper.
  1. Individual and corporate tax rates will be reduced. The tax base will be increased somewhat.
  1. Related in part to item 3 above, 2016 may be one of the most significant years to follow closely and meaningfully the old tax planning strategy of accelerating deductions (into years with higher rates, it appears) and deferring income (into years with lower tax rates, it appears).
  1. The alternative minimum tax will go away. Yippee!!
  1. The Federal estate tax will most likely be repealed. However, there may be some fiscal counter-measures.  There could be no step-up (or limited step-up) in basis of property at death.  There may be continued gift taxes.
  1. The specter of massive increases in the Federal budget deficit will temper some of the Trump and Congressional tax cutting proposals. Indeed, fiscally conservative Republicans and Democrats may forge an uncomfortable alliance to rein in the total amount of tax cuts without revenue increases or spending cuts from someplace.
  1. Both proposals provide for immediate expensing of capital expenditures. The details differ, but not enough to derail the idea.
  1. There are many other tax law changes in both proposals. Some align, others do no.  Many will be enacted.
  1. While generally pointed in the same direction, the Trump campaign proposals and the House Republican proposals are different in a number of ways. The Trump proposals are very light on details.  While “A Better Way” is more comprehensive and cohesive, the authors concede that it is a policy “blueprint.”  Many details still must be developed.

Again:  I’ve been dead wrong before – recently.

VKM