Larry's Tax Law

Trugman v. Commissioner, 138 T.C. 22 (2012) exemplifies one of many reasons why you do not put real estate in a corporation, especially your personal residence.

The Trugmans were the sole shareholders of Sanstu corporation, an S corporation. Over the years, the S corporation acquired rental real estate all across the country.  The Trugmans likely did not utilize professional tax advisors.

In 2009, for some reason, the Trugmans awoke from a deep sleep and started thinking about tax planning.  To avoid tax on the income from their stock portfolio, they moved to Nevada which has no state income tax.

That same year, the Trugmans caused Santsu to purchase a single family dwelling they could occupy as their home.  Santsu contributed about 98% of the purchase price; and the Trugmans put in the other 2% or about $7500 toward the purchase.   The deed to the property listed Santsu as the sole owner.

Since they had not been homeowners in over three years, the Trugmans claimed a first-time homebuyer credit on their 2009 joint individual tax return under now expired IRC Section 36.

S corporations and their shareholders must keep track of stock and debt basis.  Failure to do so can lead to disastrous results.  Nathel v. Commissioner, 105 AFTR 2d 2010-2699 (2d Cir 2010), illustrates this point.

In Nathel, the government and the taxpayer stipulated to the facts.  Two brothers and a friend formed three separate S corporations to operate food distribution businesses in New York, Florida and California.  All three shareholders made initial capital contributions to the corporations.  The brothers also made loans to two of the corporations.

In 2001, one corporation was liquidated.  In a reorganization of sorts, the friend ended up owning 100% of the second corporation and the two brothers ended up equally owning the third corporation.

In late 2000, before the reorganization, the brothers made loans to the corporations totaling around $1.3 million.  In 2001, they made capital contributions totaling approximately $1.4 million.  Also, in 2001, they received loan repayments combined in excess of $1.6 million.

Immediately before the repayment of the loans, the brothers had zero basis in their stock and only nominal basis in the loans.  Ouch!  To avoid the ordinary income tax hit on the delta between the $1.6 million in loan repayments and their nominal loan basis, the brothers, with the likely help of their handy dandy tax advisor, asserted the $1.4 million in capital contributions was really tax-exempt income to the corporation, excludable under IRC Section 118(a), but which, under IRC Section 1367(b)(2)(B), increased their loan basis.  Therefore, the ordinary income tax hit on the loan repayments was nominal.

When tax advisors fail to follow the rules, it tarnishes our profession.  The bad behavior may subject them to discipline by the body governing their practice, the Office of Professional Responsibility and/or the criminal justice system.

Discipline may come in many flavors, depending upon the severity of the misconduct.  Sanctions generally consist of censureship, suspension, disbarment, financial penalties and imprisonment.

The stakes are high.  Tax advisors and their firms need to know and follow the rules, and implement systems to ensure compliance by the members of their firms.

Background

Effective June 30, 2005, Treasury issued final regulations amending Circular 230 (“2005 Regulations”).  The 2005 Regulations were specifically aimed at two goals:

• • Deterring taxpayers from engaging in abusive transactions by limited or eliminating their ability to avoid penalties via inappropriate reliance on advice of tax advisors; and

• • Preventing unscrupulous tax advisors and promoters from marketing abusive transactions and tax products to taxpayers based upon opinions that failed to adequately consider the law and the facts.

After the 2005 Regulations were issued, Treasury continued tinkering with the regulations to refine its approach, keenly keeping focus on these two goals.  Accordingly, we have seen numerous refinements to Circular 230 in the past nine (9) years, including:

• • Amendments to the 2005 Regulations published on May 19, 2005;

• • Broadened authority granted by lawmakers to Treasury to expand standards relating to written advice on October 22, 2004, with the passage of the American Jobs Creation Act of 2004 (“AJCA”).  In addition, the AJCA gave Treasury authority to impose monetary penalties against tax advisors who violate Circular 230;

• • Amendments to Circular 230 published on February 6, 2006, in proposed form, adopting, among other things, monetary penalties for Circular 230 noncompliance.  These regulations were finalized, effective September 26, 2007; and

• • Amendments to the written advice provisions of Circular 230 published on October 1, 2012 in proposed form.  These amendments were finalized on June 14, 2014.

Until 2005, Circular 230 was untouched for almost two decades.  An enormous storm awoke Treasury from a deep sleep, causing a loud roar to permeate among lawmakers, the IRS, Treasury and the tax community.  The result was the adoption of rules aimed at achieving the two goals set forth above.

The ultimate cause of the storm was the broad sweeping allegations of fraud and deception in the accounting and law professions which we saw in the early part of this millennium, including scandals involving ENRON, Global Crossing, imClone, WorldCom, Qwest, Tyco, HealthSouth and Aldelphia.  Further feeding the storm were the black clouds created by the collapse of Arthur Andersen and the financial penalties assessed against and the practice limitations imposed upon KPMG.  Last, but certainly not least, the investigations and lawsuits against tax advisors (and their firms) for developing and marketing abusive tax shelters, including the investigations and lawsuits leading to the demise of the large law firm of Jenkens & Gilchrist (“Jenkens”), added to these dark times.

On June 19, 2014, San Francisco tax attorney, James P. Kleier, entered into a plea agreement with the government for his failure to file tax returns and pay income taxes.  Per the agreement, Mr. Kleier will be imprisoned at the Atwater Federal Corrections Institution for 12 months commencing September 18, 2014.  Following release from prison, he will be subject to a 1-year supervised parole.  In addition, Mr. Kleier is required to pay the IRS a total $650,993.

Mr. Kleier was a partner in the San Francisco law office of Preston Gates & Ellis LLP (now known as K&L Gates LLP) from 1999 to 2005.  Thereafter, he practiced law in the San Francisco office of Reed Smith LLP.  Both of these organizations are large prestigious international law firms.  According to the complaint filed by the government in the U.S. District for the Northern District of California, tax attorney Kleier failed to report income of more than $1.3 million while practicing law at these firms.  Specifically, he earned $624,923 in 2008; $476,088 in 2009; and $200,734 in 2010.  Nevertheless, he failed to file tax returns for these years and pay the taxes due and owing.

The Internal Revenue Service (“IRS” or “Service”) has repeatedly stated that, while its crackdown on the failure of taxpayers to report foreign financial accounts has been strong, it is reasonable in the application of the law. At least one taxpayer, Mr. Carl R. Zwerner, would likely debate that pronouncement.

On June 9, 2014, Bloomberg BNA Daily Tax Report (No. 110) revealed that a long and hotly-contested battle between Mr. Zwerner and the United States government has come to an end. This highly-publicized case is frightening. It illustrates that the IRS may not always be reasonable in the application of the foreign financial account reporting (“FBAR”) laws.

Mr. Zwerner, an 87-year old retired specialty-glass importer, is a United States citizen who resides in Coral Gables, Florida. He had a financial account in Switzerland. The account balance never exceeded $1.7 million. It appears the account was opened by Mr. Zwerner during 2004 in the name of a foundation. In 2007, he closed the original account and transferred the account balance to another Swiss account. The new account was opened in the name of yet another foundation. Mr. Zwerner controlled these accounts; he was undisputedly the beneficial owner of the accounts.

On June 11, 2013, the battle commenced when Assistant Attorney General Kathryn Keneally instituted a lawsuit against Mr. Zwerner in the United States District Court for the Southern District of Florida, seeking to collect almost $3.5 million in penalties from him for violating the FBAR rules. The assessment which the government was pursuing against Mr. Zwerner amounted to more than double the highest account balance of his Swiss financial account.

A California couple was recently walking their dog when they noticed a rusty tin container protruding from the soil next to a tree in their garden. Upon investigating the matter, they discovered several tin cans buried in the soil. The cans contained 1,400 gold coins. The coins, which are said to be in mint condition, date back to the 19th century. Experts have placed a preliminary value on the coins of more than $10 million. For obvious reasons, the couple is keeping their identity and the location of their home out of the media.

It appears the couple is legally entitled to retain the treasure trove. A law professor from the University of North Carolina, John Orth, recently told TIME Magazine, because the coins were found on the couple’s own property, they will likely be able to retain them.

Like the winner of a lottery, the California couple will be required to declare their new fortune as gross income for income tax purposes. This is not the first time a person has been faced with good fortune and a corresponding tax bill.

In Cesarini v. U.S., 23 AFTR 2d 69-997 (Northern District of Ohio, 1969), a couple purchased a piano in 1957 for $15. In 1964, while cleaning the piano, they discovered almost $4,500 in U.S. currency.