Larry's Tax Law

Barnes v. Commissioner, 712 F.3d 581 (D.C. Cir. 2013) aff’g T.C.M. 2012-80 (2012) is illustrative of the point that understanding the basis adjustment rules is vital.

If this case was made into a movie, the name of the movie would tell the entire story – S corporation shareholders are not allowed to just make up the basis adjustment rules!  Also, as I have repeatedly stated, poor records lead to disastrous results.  The DC Circuit affirmed the US Tax Court in April of 2013 to finally put an end to the case.

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.

Please join me for the NYU 73RD Institute on Federal Taxation.  This year’s Institute will be held in San Diego at the Hotel Del Coronado November 16 – 21, and in New York City at the Grand Hyatt New York October 19 – 24.  Please see the attached brochure.  The coverage of tax topics is both timely and broad.  This year’s presentations will cover topics in the areas of:  executive compensation and employee benefits; partnerships and LLCs; corporate tax; closely held businesses; and trusts and estates.  What is so terrific about the Institute, in addition to a wonderful faculty and the interesting current presentation topics, you can choose the presentations you want to attend.  In other words, you can pick and choose the topics that relate to your tax practice.

This is my second time speaking at the Institute.  My topic this year is: "Developments In The World Of S Corporations."  I plan to deliver a White Paper that will provide attendees with an historic overview of Subchapter S and a look through a crystal ball at the future of Subchapter S, including a review of the recent cases, rulings and legislative proposals impacting Subchapter S.

I hope to see you in either San Diego or New York.

Best,

Larry

The IRS will strike down transactions among related parties that lack economic outlay. At least two recent US Tax Court cases are illustrative of the issue.

Kerzner

Kerzner v. Commissioner, T.C. Memo 2009-76 (April 6, 2009). The Service beat the taxpayers in this case by a nose. Mr. and Mrs. Kerzner were equal partners in a partnership that owned a building. The partnership leased the building to an S corporation which was owned equally by two shareholders, Mr. and Mrs. Kerzner. Over the years, the partnership loaned the Kerzners money. In turn, they loaned the money to their S corporation, which used the money to pay rent to the partnership.

At the end of each year, promissory notes were drafted to document the loans; some of the notes stated an interest rate, some did not. Even though the notes required payment of principal, virtually no payments were ever made because the notes each year were replaced with new notes before any payment was due.

The S corporation had large losses. The Kerzners claimed basis in the loans to the corporation and took the losses on their individual tax returns. Upon audit, the Service claimed the loans lacked economic substance and did not give the Kerzners basis to absorb the losses.

Introduction 

Robert Southey’s fairy tale, Goldilocks and the Three Bears, which was first published in 1837, provides tax practitioners with the proper analysis to determine whether compensation is reasonable. Compensation cannot be too high and compensation cannot be too low. It must be just right to be considered reasonable for tax purposes. Unfortunately, the determination is subjective in nature. Consequently, it may be subject to debate.

Code Section 162 is the starting point in every reasonable compensation case. Code Section 162 provides:

There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including--(1) a reasonable allowance for salaries or other compensation for personal services actually rendered***.

The Treasury Regulations, Section 1.162-7, expand the focus into 2 parts:

• • The first part of the analysis is the “Intent Test.”  Under this test, the compensation payments must be intended to be made solely as payment for services rendered.  In other words, the payments cannot be intended as consideration for anything other than for personal services.
  • The second part of the analysis is the “Amount Test.” Under this test, the compensation payments must be reasonable in amount. The payments cannot be greater in amount than what is reasonable under the circumstances for the services actually rendered.

Most S corporation reasonable compensation cases involve allegations of unreasonably low compensation.  There are, however, at least four (4) circumstances where taxpayers may be motivated to pay unreasonably high compensation in the S corporation context, including:

• • BUILT-IN GAINS TAX AVOIDANCE. The first circumstance is where a taxpayer wishes to avoid the application of the built-in gains tax under Code Section 1374 by zeroing out the corporation’s taxable income determined as if it were a C corporation. Remember, the net recognized built-in gain under Code Section 1374(d)(2)(A) can never exceed the taxable income of the S corporation, determined as if it were a C corporation. So, if the taxable income of the C corporation is zero for the taxable year, there can be no built-in gains tax liability for the year. As a result of TAMRA 1988, however, if the taxable income for the taxable year is zero, the built-in gain gets carried over to future years and gets recognized to the extent of taxable income in the future years. But, if income is zeroed out for each of the remaining years during the built-in gains tax recognition period (by expenses such as compensation), the built-in gain tax is avoided forever.  Under current law, Code Section 1374 (d)(7), the built-in gains tax recognition period is ten (10) years. As you recall, Congress shortened the recognition period to as little as five (5) years for tax years 2009, 2010, 2011, 2012 and 2013, in the name of economic stimulus. The law reverted back to ten (10) years on January 1, 2014.  An interesting side note: Ways and Means Committee Chairman Dave Camp proposed, as part of his tax simplification legislation that he distributed to members of the House in early February of this year, to permanently reduce the recognition period to five (5) years.
  • MAXIMIZE RETIREMENT PLAN CONTRIBUTIONS. The second circumstance is where the taxpayer wishes to maximize shareholder/employee earned income so that it may maximize contributions to a retirement plan.  Retirement plan contributions are based on wages.  Increasing wages allows the shareholder/employee to maximize the amount contributed to his or her retirement account.
  • AVOID VIOLATING THE SINGLE CLASS OF STOCK REQUIREMENT.  The third circumstance is where the taxpayer wishes to avoid violating the single class requirement of Code Section 1361(b)(1)(D).  If the taxpayer desires to treat shareholders differently, it may attempt to use compensation to meet this objective.  When that is done, the Service may throw out the reasonable compensation flag on audit to attack the validity of the S election.   The Service generally only prevails in these cases when the fact pattern is egregious.  Nevertheless, you need to be aware of the issue and be cautious so that compensation is reasonable and is paid for actual services rendered.
  • AVOIDING THE APPLICATION OF CODE SECTION 1411.  The fourth circumstance was given life by the Affordable Care Act.  S corporation taxpayers may now be motivated to pay compensation to shareholders who do not actively participate in the business of the S corporation in an attempt to avoid the application of the 3.8% Net Investment Tax under Code Section 1411.   This new 3.8% tax applies to what is called “net investment income.”  Included in the definition of “net investment income” is pass-through income from an S corporation in which the shareholder does not actively participate.  So, if there is no colorable argument that the shareholder materially participates in the business of the S corporation, there may be the motivation to pay wages to the shareholder.  If the shareholder does not perform work for the corporation, the Service will be able to successfully attack the payment on the theory of unreasonable compensation.

Taproot Administrative Services v. Commissioner, 133 TC 202 (2009), 679 F3d 1109 (9th Cir. 2012), is an S corporation shareholder eligibility case.  It was decided by the US Tax Court in 2009 and eventually made its way to the 9th Circuit Court of Appeals, where a decision was rendered in 2012.

Background

Prior to the enactment of the American Jobs Creation Act of 2004, only the following were eligible S corporation shareholders:

• • US citizens and resident individuals;
  • Estates;
  • Tax-exempt 501(c) charities and 401(a) retirement plans; and
  • Certain trusts, including QSSTs, ESBTs and grantor trusts

As a result of the lobbying efforts of family-owned rural banks, as of October 22, 2004 (the effective date of the American Jobs Creation Act), a new eligible shareholder was added to the list, IRAs, including Roth IRAs, provided two criteria are met:

• • The S corporation must be a bank, as defined in Section 581 of the Code; and
  • The shares must have been owned by the IRA on October 22, 2004, the enactment date of the American Jobs Creation Act.

As you might imagine, having an eligible IRA shareholder will be rare. The exception to the S corporation eligibility rules provided by the American Jobs Creation Act is quite narrow.

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.

As of June 12, 2014, with the exception of what are commonly known as “Marketed Opinions,” tax advisors and their firms no longer need separate standards governing Written Advice.  Section 10.35 of Circular 230 (“C230”) has been eliminated.  Consequently, the crazy, overused C230 disclaimers can go in the trash bin.  No more emails to mom, dad, children or other family members, and/or friends with a federal tax disclaimer.  I bet that will be somewhat of a relief to these email recipients.  No longer will they find themselves looking for tax advice as a result of the prominent disclaimer in a message that has absolutely nothing to do with taxes.

Representatives of the IRS and the Office of Professional Responsibility (“OPR”) have vocalized glee about the elimination of C230 disclaimers.  Karen Hawkins, Director of the OPR, told participants at a tax conference in New York last week:  “I’m here to tell you that jurat, that disclaimer off your emails.  It’s no longer necessary.”  IRS Chief Counsel, William Wilkins, echoed the same sentiments last week when he said:  “The Circular 230 legend is not merely dead, it’s really most sincerely dead.”

Treasury estimates this amendment to C230 and the removal of the corresponding compliance burden on tax advisors “should save tax practitioners [and/or their clients] a minimum of $5,333,200.”