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Individual Income Tax Return
Mistakes and How to Fix Them
INB4
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Top 25 Tax Mistakes
1. Failure to report income witnessed by 20 million people ........................................................................ 1
2. Not all forgiven principal residence debt is excludable ........................................................................... 5
3. How much trouble do you get in for not filing FinCen Form 114 (FBAR)? ............................................. 8
4. Gambling on changing the Constitution ................................................................................................ 20
5. You’re still in the minor leagues but think you’re a real-estate pro ....................................................... 22
6. Self-charged rent rules .......................................................................................................................... 26
7. “The hardest thing in the world to understand is the income tax” or perhaps calculating basis ........... 29
8. Failing to find hidden gains in Schedules K-1 ....................................................................................... 32
9. S shareholder loans - substance and form both matter ........................................................................ 36
10. Other income issues ........................................................................................................................... 40
11. House donated to fire department – and the deduction goes up in smoke ........................................ 43
12. Unreimbursed employee business expense deduction denied .......................................................... 45
13. Meal allowances for police or fire workers on 24 hour shifts .............................................................. 47
14. Accountant tries to deduct NOL carryover from self-employment income ......................................... 48
15. Is that Form 1099 (inadvertently) issued to an employee? ................................................................. 49
16. Form 2848 - Power of attorney issues ................................................................................................ 67
17. Failing in advance to protect taxpayers from increased 1099 penalties ............................................. 71
18. Practitioners Priority Service ............................................................................................................... 73
19. Protecting Seasoned Return Preparers Identity ................................................................................. 74
20. Social Security issues ......................................................................................................................... 80
21. Medicare issues .................................................................................................................................. 87
22. In a self-directed IRA, who is responsible for Madoff losses? ............................................................ 89
23. A self-directed IRA miscue eliminates bankruptcy exemption ........................................................... .90
24. 2014 Case -- IRS levy on pension account -- excepted v. exempt property ...................................... 92
25. Can we avoid distribution penalties? .................................................................................................. 94
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NOTES
Individual Income Tax Return Mistakes
and How to Fix Them
Learning objectives
1
I. Gross income reporting
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A. Failure to report income witnessed by 20 million people (#1)
1
1. 39 days, 16 people, ONE survivor!
1
2. The blooper
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3. The law is the solution
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B. Not all forgiven principal residence debt is excludable (#2)
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1. “Qualified” principal residence indebtedness
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2. The blunder
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3. The law – what exactly is qualified principal residence debt?
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4. Conclusion and solution
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C. How much trouble do you get in for not filing FinCEN Form 114 (FBAR)? (#3)
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1. More on income being income
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2. The blooper
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3. The law
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4. The conclusion, solution and New Form 8938
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5. Question and Answer examples provided by IRS
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II. Sole proprietorship and hobby items
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A. Gambling on changing the Constitution (#4)
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1. What are the odds?
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2. A novel approach
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3. First argument -- The house always wins
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4. Second argument -- Climate change -- Morally?
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5. The law
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6. No win, place, or sympathy
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III. Income from rents and pass-through entities
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A. You’re still in the minor leagues but think you’re a real-estate pro (#5)
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1. Passive activity loss deduction
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2. 2011 case – Are you really a real estate professional
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3. Management of short-term rental property is not considered in the 750 hour test for a RealEstate professional
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4. Conclusion – not a real estate professional
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5. The more than 50% of personal services and 750 Hour tests are conjunctive
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6. Certain hours not counted toward material participation
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7. The regulations may say one thing, but the courts need more
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8. A “ballpark estimate” - wishing upon a wishing star
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B. Self-charged rent rules (#6)
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1. Rental income that is not passive
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2. The blooper
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3. The law
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4. Conclusion and solution
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5. Similar case -- same result - Carlos
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C. “The hardest thing in the world to understand is the income tax” or perhaps calculating
basis (#7)
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1. 2012 case – Is basis increased by phantom income, or reduced by losses not deducted?
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2. Error in calculating basis
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3. The law - Specific order for adjustments to basis after 1996
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4. Conclusion and unsuccessful last ditch attempt
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5. Inconsistent treatment of Schedule K-1 items
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D. Failing to find hidden gains in Schedules K-1 (#8)
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1. Hidden partnership or LLC gains
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2. The error practitioners make – review of liabilities
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3. Solution – proper completion of basis worksheet
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4. Worksheet for basis in a partnership/LLC
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5. Worksheet for basis in an S Corporation
E. S shareholder loans - substance and form both matter (#9)
1. Overview of an ‘all too common’ issue
2. The typical path to bloopers and blunders
3. The law ‘primer’
4. 2009 Case illustrates lack of economic outlay in circular loan by shareholder
IV. Other income issues (#10)
A. Properly reporting income from hobbies
1. Practitioner errors in reporting
B. National Mortgage Settlement Payments
1. “Robo-signing” and other servicing violations
2. Tax status of settlement payments
V. Itemized deductions
A. House donated to fire department – and the deduction goes up in smoke (#11)
1. Can you trust your relatives?
2. The error is in the details of what exactly was donated
3. Defining quid pro quo
4. The deduction goes up in smoke
B. Unreimbursed employee business expense deduction denied (#12)
1. A classic illustration of ‘whose expenses are these?’
2. The blunder
3. The law
4. The conclusion and solution
C. Meal allowances for police or fire workers on 24 hour shifts (#13)
1. Everyone in practice for enough years has been asked this question
2. The urban legend
3. The law
4. Conclusion and solution
VI. Other selected taxes
A. Accountant tries to deduct NOL carryover from self-employment income (#14)
1. Net operating losses from other years
2. The mistake a practitioner makes
3. The law - §§1401 and 1402
4. Timing is everything
VII. Things professionals do not like to hear!
A. Is that Form 1099 (inadvertently) issued to an employee? (#15)
1. Background on issue
2. A big but common mistake
3. The law, conclusion, and solution
4. The conclusion and solution
5. The Voluntary Classification Settlement Program (VCSP)
6. Voluntary Classification Settlement Program procedures
7. All workers not required to be reclassified under VCSP
8. Current developments with Form I-9
B. Form 2848 - Power of attorney issues (#16)
1. 2012 revisions
2. Separate Form 2848 for joint returns
3. Revocation or withdrawal of power of attorney upon dismissal of clients
C. Failing in advance to protect taxpayers from increased 1099 penalties (#17)
1. Updated Publication 1586 – Reasonable Cause Regulations
2. Final regulations on reporting health care coverage
3. Front-end advisory required to meet the Reasonable Cause Regulations
VIII. Practitioner practice points
A. Practitioners Priority Service (#18)
1. Conduit between taxpayers and the IRS
2. 2014 changes to Practitioner Priority Services
B. Protecting Seasoned Return Preparers Identity (#19)
1. Identity Theft
2. Form 14039, Identity Theft Affidavit -- two reasons to file
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3. Identity Theft Affidavit for seasoned preparers
4. Combating identity theft and refund fraud
5. Law Enforcement Assistance Program expands nationally
IX. Retirement issues
A. Social Security issues (#20)
1. The Moment of Truth - The Deficit Reduction Commission Report
2. Enhanced Minimum Benefit for low-wage workers
3. Enhanced Benefits for the very old and the long-time disabled
4. Gradually increase early and full retirement ages, based on increases in life expectancy
5. Give retirees more flexibility in claiming benefits and create a hardship exemption for those
who cannot work beyond 62
6. Gradually increase the taxable maximum to cover 90 percent of wages by 2050
7. Miscellaneous other recommendations
8. House Ways and Means Committee -- Proposed Tax Reform Act of 2014
B. Determining when it is best to claim your Social Security
1. Reduced retirement benefits commencing at age 62
2. Delayed retirement
3. When to retire?
4. 2014 Earnings limits
C. Failure to consider delayed retirement
1. Normal or delayed
2. Evaluation of the choice
3. An approximation, based upon taxpayer born in 1950
4. The big “however”
D. Medicare issues (#21)
1. If delaying Social Security, don’t forget Medicare
2. 2012 CCA regarding deduction of Medicare premiums as self-employed health insurance
3. Appealing Medicare premiums
E. In a self-directed IRA, who is responsible for Madoff losses? (#22)
1. I can’t think of anything that's my fault
2. How dare they follow my directions
3. The Law
4. Conclusion and solution – who is responsible, - look in the mirror
F. A self-directed IRA miscue eliminates bankruptcy exemption (#23)
1. Can I borrow from my IRA?
2. Taxpayers always have two reasons for doing anything: a good reason and the real reason
3. The Law
4. Conclusion and solution – Bankruptcy Court, District Court, and Court of Appeals all agree
G. 2014 case -- IRS levy on pension account -- excepted v. exempt property (#24)
1. An abundance of caution
2. Was the pension excluded from, or included and exempted in bankruptcy estate
3. The law
4. The unfortunate result
X. Can we avoid distribution penalties? (#25)
A. A property settlement is not per se a QDRO
1. Background facts – common war, uncommon battle
2. The blooper
3. The law
4. Conclusion and solution
B. Inherited IRA cashed
1. Illustration of rollover foot faults, near saves, then disaster
2. The taxpayer blooper No. 1 – he is not Oedipus Rex
3. The IRS blooper
4. The taxpayer blooper No. 2
5. The law
6. Conclusion and solution
C. Bad IRS advice? Nah, never happens!
1. A verbal commitment is not worth the paper it is written on
2. The blooper
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3. The law
4. Conclusion and solution
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This product is intended to serve solely as an aid in continuing professional education. Due to the constantly changing nature of the
subject of the materials, this product is not appropriate to serve as the sole resource for any tax and accounting opinion or return
position, and must be supplemented for such purposes with other current authoritative materials. The information in this manual has
been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. In addition, Surgent McCoy CPE,
LLC, its authors, and instructors are not engaged in rendering legal, accounting, or other professional services and will not be held
liable for any actions or suits based on this manual or comments made during any presentation. If legal advice or other expert
assistance is required, seek the services of a competent professional.
Revised March 2014
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Copyright © 2014 Surgent McCoy CPE, LLC – INB4/14/02
Individual Income Tax Return Mistakes
and How to Fix Them
Learning objectives
Upon reviewing this manual, the reader will be able to:
•
Identify how practitioners have worked with clients who desire to “stretch” the law to the
last possible point without crossing the line into fraud or tax evasion, beginning with
ordinary income issues in which taxpayers must realize income is income. From
Schedule A, C, and E issues arise that practitioners must face, including finding “hidden”
gains.
•
Identify common practitioner issues such as employee vs. independent contractor,
penalties clients may avoid with proper planning, and retirement issues, including Social
Security, Medicaid, and retirement accounts.
Overview: The topics appear in a somewhat representative order of a tax return. Most topics
begin with some background or history of a situation. The mistake or error is identified followed by
the law at issue to allow for discussion and provide some idea of the “stretching” the taxpayer
performed. The mistake generally ends with a conclusion and sometimes a quite obvious hindsight
solution.
TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION:1
The United States has one of the highest tax compliance rates in the world at 83.7 percent. However,
each percentage point of noncompliance costs the Federal Government approximately $21 billion, which
equates to more than $345 billion in annual lost revenue. The IRS’s Examination function plays a vital
role in the IRS mission of promoting voluntary compliance with the tax law.
I. Gross income reporting
A. Failure to report income witnessed by 20 million people (#1)
1. 39 days, 16 people, ONE survivor!
a. Picture this: you are on a secluded island off the coast of Borneo, stranded with little more
than the clothes on your back. You and 15 others are divided into two teams that compete
against each other, with the losing team forced to vote a member off. Eventually the teams
merge and it's everyone for him- or herself. The lone survivor takes home $1 million dollars.
b. Issue: Are winnings from a reality game show earned in Borneo and witnessed by millions
of television viewers included in taxable income?
1
Per publication, Actions Are Needed in the Identification, Selection, and Examination of Individual Tax Returns With
Rental Real Estate Activity, December 20, 2010.
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2. The blooper
a. Income is income.
The first CPAs hired by Mr. Richard Hatch, the premier season winner of “Survivor”
properly included the winnings in his return. Unfortunately, Hatch did not file that return
and disengaged from the preparer. Sometime later he delinquently filed a return (not signed
by any preparer) which did not include his winnings.
b. On January 19, 2005, the United States Attorney's Office reported that Hatch failed to report
$1,000,000 prize winnings from the Survivor show on his federal income tax returns. In
addition, he failed to report in excess of $300,000 he received for other appearance fees. Hatch
was charged with filing a false tax return. An agreement was arranged whereby Hatch was
offered a lenient sentence in exchange for a guilty plea; however, Hatch did not accept the
arrangement. A ten-count indictment included additional charges that he failed to report rental
income from properties he owned, failed to declare an automobile he won on Survivor, used
money as personal income that was paid to a charity organization he had set up.
c. The use of money as personal income, which was earmarked for charity arises from another
television show in which Hatch appeared, “The Weakest Link.” Hatch was awarded $10,000
for his appearance, payable to the charity of his choice. In the criminal indictment, Hatch was
accused of establishing a bank account and ultimately having the “Weakest Link” proceeds
deposited therewith. Subsequently, the account was disbursed for personal use, and none of the
funds were utilized for a charitable purpose.
d. In January, 2006 a jury found Hatch guilty and he was sentenced to 51 months in prison.
e. In December, 2006 Hatch filed an appeal of his conviction claiming that the trial judge
prevented him from arguing that he had made a deal with CBS to pay his taxes. Without a jury
present, Hatch claims to have caught show employees providing other contestants food. Hatch
claims to have then made a deal with the show’s producers: he wouldn’t tell, and in return they
would pay his taxes if he ultimately won. In front of the jury, Hatch did not mention such a deal
and CBS has said the claim is false. In February 2008, Hatch's conviction was upheld by the
United States Court of Appeals for the First Circuit. The Court stated that Hatch was given
several opportunities to testify about the alleged deal, but he never took the opportunity, and
noted "The failure of Hatch to present any evidence of such conversations when invited by the
court strongly suggested that no actual promises were made, and no such 'deal' actually existed.
It was not the court's right, much less duty, to put words in Hatch's mouth."
f. Notable Quote included in a Department of Justice press release2 - "Our nation's federal tax
system is not a reality show to be outwitted, it is a reality, period.”
3. The law is the solution
a. Income is defined by the Code in what has been referred to as the “Santa Clause” in §61.
b. I.R.C. §61 - Definition of Gross Income
1) Section 61(a) defines gross income as follows:
a) “Except as otherwise provided in this subtitle, gross income means all income from
whatever source derived, including, (but not limited to) the following items:
(1) Compensation for services, including fees, commissions, fringe benefits, and similar
items;
(2) Gross income derived from business;
(3) Gains derived from dealings in property;
2
Attributed to prosecutor Eileen O'Connor.
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c.
(4) Interest;
(5) Rents;
(6) Royalties;
(7) Dividends;
(8) Alimony and separate maintenance payments;
(9) Annuities;
(10) Income from life insurance and endowment contracts;
(11) Pensions;
(12) Income from discharge of indebtedness;
(13) Distributive share of partnership [and S Corporation] gross income;
(14) Income in respect of a decedent; and
(15) Income from an interest in an estate or trust.”
The vast majority of professionals do not have problems interpreting this section.
Practice note – privilege of confidentiality:
The case touches on the privilege of confidentiality, an often misunderstood concept for CPAs.
The law does not accord the accountant a greater privilege than that enjoyed by attorneys.
§7525 provides that information transmitted for the purpose of preparing a tax return, even if
transmitted to an attorney, is not considered privileged information. For professionals who give a
client both tax advice and tax-return preparation, the IRS will contend that whatever tax advice
given, and whenever it was given, falls under the category of “tax-return preparation” that does
not qualify as legal advice for purposes of confidentiality privilege under §7525.
If the preparer has knowledge of unreported income or less than valid deductions, they
will be compelled to testify against the taxpayer. That is, the preparer may be the star
prosecution witness against their ex-client.
d. Failure to report income sequel - Wesley Snipes - who was charged in October 2007 with
fraudulently amending returns for 1996 and 1997 to claim zero income thereby receiving refunds
totaling nearly $12 million. He was also charged with failure to file returns from 1999 through
2004.
e. Snipes was acquitted on charges of tax fraud and conspiracy as jurors accepted his argument
that he was innocently duped by errant tax advisers. However, he was convicted on
misdemeanor charges. Before sentencing, the actor asked the court to show mercy and offered
three checks totaling $5 million, which the prosecutors and treasury accepted. Mr. Snipes was
sentenced to three years in prison on the misdemeanor counts of failing to file tax returns, which
he appealed. In November 2010 a federal judge ordered Snipes to surrender to authorities and
he began serving a three-year prison sentence, from which he was released on April 2, 2013.
Practice note: the “Starr” witness:
As noted above preparers may be the star prosecution witness against their ex-client. Review
the address on the 1997 Form 1040-X prepared for Snipes. In court, Ken I. Starr (not the same
Ken W. Starr known for his investigation of figures during the Clinton administration) testified as a
prosecution witness.
Subsequent to the Snipes trial, Ken I. Starr was arrested and charged for allegedly running a $59
million Ponzi scheme with the money of a number of celebrities as his clients including Snipes,
Sylvester Stallone, and Carly Simon. On September 10, 2010, Starr plead guilty.3
3
http://en.wikipedia.org/wiki/Kenneth_I._Starr.
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B. Not all forgiven principal residence debt is excludable (#2)
1. “Qualified” principal residence indebtedness
a. Mike Diamond incurred recourse debt of $800,000 when he purchased his principal residence for
$880,000. When the FMV of the property was $1,000,000, Mike refinanced the debt for
$850,000.
b. At the time of the refinancing, the principal balance of the original mortgage loan was $740,000.
Mike used the $110,000 difference he obtained from the refinancing ($850,000 minus $740,000)
to pay off his credit cards and to buy a new car.
c. About two years after the refinancing, with the mortgage still at a balance of $850,000, Mike lost
his job and was unable to get another position paying a comparable salary. Mike's residence had
declined in value to between $700,000 and $750,000.
d. Based on Mike's circumstances, the lender agreed to allow a short sale of the property for
$735,000 and to cancel the remaining $115,000 of the debt.
e. Mike receives a Form 1099-C in the amount of $115,000.
2. The blunder
How does Mike report the Form 1099-C income of $115,000? He remembers to when the mortgage debt
crisis was first surfacing, and that The Mortgage Forgiveness Debt Relief Act of 2007 added “Qualified
Principal Residence Indebtedness” to the excludable items under §108. 4
Armed with this information, Mike prepares Form 982, checks box 1e and reports $115,000 on line 2.
3. The law – what exactly is qualified principal residence debt?
To qualify for exclusion under §108, qualified principal residence debt must have been used to buy,
build or substantially improve the principal residence and be secured by that residence. Refinanced debt
proceeds used for the purpose of substantially improving a principal residence also qualify for the
exclusion. However, proceeds of refinanced debt used for other purposes (for example, to pay off
credit card debt) do not qualify for the exclusion.
Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a
foreclosure, may qualify for relief. The maximum amount a taxpayer can treat as qualified principal
residence indebtedness is $2 million ($1 million if married filing separately).
If the discharge occurs in a title 11 case, Form 982, check box 1e may not be checked. In this case
the taxpayer must check box 1a noting the bankruptcy exclusion.
If the taxpayer is insolvent (and not in a title 11 case), they can elect to follow the insolvency rules by
checking Form 982 box 1b instead of box 1e and complete the form.
To show that all or part of a canceled debt is excluded from income because it is qualified principal
residence indebtedness, attach Form 982 to the federal income tax return and check the box on line 1e.
On line 2 of Form 982, include the amount of canceled qualified principal residence indebtedness, but not
4
The Mortgage Forgiveness Debt Relief Act was applicable to discharges after 2007 – 2009; however, the Emergency
Economic Stabilization Act of 2008 extended exclusion three years through 2012. The American Taxpayer Relief Act of
2012 further extended the provision through 2013.
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more than the amount of the exclusion limit. If a taxpayer continues to own the residence after a
cancellation of qualified principal residence indebtedness, they must reduce the basis in the residence.
If the taxpayer disposes of the residence, they may also be required to recognize a gain on its
disposition. If the taxpayer continues to own the residence after the discharge, enter on Form 982 line
10b the smaller of: (a) the amount of qualified principal residence indebtedness included on line 2, or (b)
the basis (generally, cost plus improvements) of the principal residence.
4. Conclusion and solution
Include on Form 982 line 2 the amount of discharged qualified principal residence indebtedness that is
excluded from gross income. Any amount in excess of the excluded amount (assuming no other §108
exclusion applies) will result in taxable income, which should be reported on line 21 of the taxpayers
personal income tax return, Form 1040.
Under the ordering rule, Mike can exclude only $5,000 of the canceled debt from his income under the
exclusion for canceled qualified principal residence indebtedness ($115,000 canceled debt minus the
$110,000 amount of the debt that was not qualified principal residence indebtedness). Barring another
exception or exclusion, Mike must include the remaining $110,000 of canceled debt in income on line 21
of his Form 1040.
Real life issue - Debt Tracking:
In the above example, Mike refinances the home for $850,000. At that time, the loan actually is a
“hybrid” loan consisting of three classifications, $740,000 acquisition debt, $100,000 home equity
debt, and $10,000 personal debt. Had the loans actually been three separate and distinct loans,
tracking would be rather easy. (The $740,000 is also qualified personal residence indebtedness
for COD purposes, while $110,000 is not qualified for exclusion).
In the reality of refinancing, Mike has one loan. The Service lacks guidance regarding tracking
the principal payments on “hybrid” loans.
For example, suppose in Mike’s case, the mortgage balance had been reduced to $782,000 at
the time the lender agrees to the short sale, resulting in cancelled debt of $47,000 ($782,000 $735,000). How much of the $782,000 is acquisition debt, home equity debt and personal debt,
respectively?
A straight “pro-rata” approach would result in $680,800 acquisition debt, $92,000 home equity,
and $9,200 personal.
In that case, under the ordering rule Mike would include the entire $47,000 in income. Mike
would not benefit under §108 unless the amount canceled exceeds the amount of the loan
(immediately before the cancellation) that is not qualified principal residence indebtedness.
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C. How much trouble do you get in for not filing FinCEN Form 114 (FBAR)? (#3)
Practice Note: Form TD F 90-22.1 is renamed
The Report of Foreign Bank and Financial Accounts (FBAR) was previously accomplished by
filing treasury Form TD F 90-22.1. This form has been renamed FinCEN Form 114. After June
30, 2013, the form must generally be filed electronically.
1. More on income being income
Many practitioners who have been prepared tax returns for more than a few years remember the days
before the computer matching of W-2’s, 1099’s etc. We were not always informed of all income
generating accounts. A practitioner passes along the following story.
Many years ago, a taxpayer received a notice from the IRS in which the computer cross-checked
several 1099’s, none of which appeared on the taxpayers return. The practitioner checked his file, and
found no records of these 1099’s (Yes, in those days we also copied much of the source data!). The
practitioner questioned the taxpayer, wondering why the 1099’s were not included in the information
provided for the preparation of the return. The taxpayer’s response: “If I don’t tell you about the
income, then it’s not taxable.”
2. The blooper
a. Failure to report an interest in a foreign financial account. With the globalization of the
economy, more and more people in the U.S. have foreign financial accounts. While there
are many legitimate reasons to own foreign financial accounts, there are also responsibilities that
go along with owning such accounts.
b. In general, individuals must first fulfill this requirement by answering questions regarding
foreign accounts or foreign trusts that are contained in Part III of Schedule B of the IRS
Form1040. Taxpayers who answer "yes" in response to the question regarding foreign accounts
must then file FinCEN Form 114 (FBAR). This form must be filed with the Department of the
Treasury, and not as part of the tax return that is filed with the IRS.
c. The granting by IRS of an extension to file Federal income tax returns does not extend the
due date for filing a FinCEN Form 114. There is no extension available for filing the this Form
th
beyond the June 30 due date.
d. Account holders who do not comply may be subject to both civil and criminal penalties.
3. The law
Each United States person, who has a financial interest in or signature authority, or other authority
over any financial accounts, including bank, securities, or other types of financial accounts in a foreign
country, if the aggregate value of these financial accounts exceeds $10,000 at any time during the
calendar year, must report that relationship each calendar year by filing FinCEN Form 114 with the
Department of the Treasury on or before June 30, of the succeeding year.
a. Civil and criminal penalties, including in certain (willful) circumstances a fine of not more than
$500,000 and imprisonment of not more than five years, are provided for failure to file a report,
supply information, and for filing a false or fraudulent report.
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b. Effective with respect to failures to report occurring on or after October 22, 2004, an additional
civil penalty may be imposed on any person who violates this reporting requirement (without
regard to willfulness). This new civil penalty is up to $10,000. 5
1) The penalty may be waived if any income from the account was properly reported on the
income tax return and there was reasonable cause for the failure to report.
2) In addition, the penalty for willful behavior is the greater of $100,000 or 50 percent of the
amount of the transaction or account.
c. Civil penalties can be assessed anytime up to six years after the date of the violation.
4. The conclusion, solution and New Form 8938
The harsh penalties coupled with the: “If I don’t tell you about the income then it’s not taxable.”
philosophy has resulted in many professional offices drawing specific attention to this item. Clients
across America are notorious for not completing an organizer (or is it just my clients?) or skipping
questions. Directing attention to the foreign account information in an organizer, an engagement letter
or whatever means necessary may hopefully keep this steep penalty at bay.
The Foreign Account Tax Compliance Act (FATCA) is an important development in U.S. efforts to combat
tax evasion by U.S. persons holding investments in offshore accounts. FATCA requires certain U.S.
persons holding foreign financial assets to report information about those assets on new Form 8938.
Filing commences for tax years beginning after March 18, 2010; however, the filing requirement was
deferred a year until 2012 for most taxpayers under Notice 2011-55.6
The Form 8938 instructions impart filing thresholds for taxpayers living in the U.S.7 and married filing a
joint income tax return if the total value of specified foreign financial assets is more than $100,000 on the
last day of the tax year or more than $150,000 at any time during the tax year. For unmarried taxpayers
or married filing separately, the reporting threshold is more than $50,000 of specified foreign financial
assets on the last day of the tax year or more than $75,000 at any time during the tax year.
Specified foreign financial asset means: (a) any financial account maintained by a foreign financial
institution; and (b) any of the following assets which are not held in an account maintained by a financial
institution: (i) any stock or security issued by a person other than a United States person; (ii) any financial
instrument or contract held for investment that has an issuer or counterparty which is other than a United
States person, and (iii) any interest in a foreign entity.
5
6
7
Section 5321(a)(5) of title 31, United States Code.
Notice 2011-55; July 18, 2011.
Thresholds are higher for taxpayers living outside the United States, see instructions to Form 8938
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Practice Note -- Assets not required to be reported on Form 8938:
The following financial accounts and the assets held in such accounts are not specified foreign
financial assets and do not have to be reported on Form 8938.
1.
A financial account that is maintained by a U.S. payer, such as a domestic financial
institution. In general, a U.S. payer also includes a domestic branch of a foreign bank or
foreign insurance company and a foreign branch or foreign subsidiary of a U.S. financial
institution. Examples of financial accounts maintained by U.S. financial institutions
include:
•
U.S. mutual funds accounts;
•
IRAs (traditional or Roth);
•
Section 401(k) retirement accounts; or
•
Qualified U.S. retirement plans.
•
Brokerage accounts maintained by U.S. financial institutions.
2.
A financial account that is maintained by a dealer or trader in securities or commodities if
all of the holdings in the account are subject to the mark-to-market accounting rules for
dealers in securities or an election under §475(e) or (f) is made for all of the holdings in
the account.
5. Question and Answer examples provided by IRS8
Q.
Is a U.S. resident with power of attorney on his elderly parents’ accounts in Canada required to
file an FBAR, even if the resident never exercised the power of attorney?
A. Yes, if the power of attorney gives the U.S. resident signature authority, or other authority
comparable to signature authority, over the financial accounts. Whether or not such authority
is ever exercised is irrelevant to the FBAR filing requirement.
Q.
A person owns foreign financial accounts X, Y, and Z with maximum account balances of $100,
$12,000, and $3,000, respectively. Does the person have to file an FBAR and if so, which
accounts must be listed on the FBAR?
A. The FBAR instructions require the filing of the FBAR form “ … if the aggregate value of these
financial accounts exceeds $10,000 at any time during the calendar year … ” In this scenario,
the person has an FBAR filing obligation because the aggregate value of foreign financial
accounts X, Y, and Z is $15,100. The person must report foreign financial accounts X, Y, and
Z on the FBAR even though accounts X and Z have maximum account values below
$10,000.
Q.
A person owns foreign financial accounts A, B, and C with account balances of $3,000, $1,000,
and $8,000, respectively. Does the person have to file an FBAR and if so, which accounts must
be listed on the FBAR?
A. Even though no single account is over $10,000, because the aggregate value of accounts A,
B, and C is over $10,000, the person has to file an FBAR and must report foreign financial
accounts A, B, and C on the FBAR.
8
See irs.gov - FAQs Regarding Report of Foreign Bank and Financial Accounts (FBAR) - Financial Accounts.
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Practice Point – Do we file BOTH the FBAR and Form 8938?
The filing of Form 8938 does not relieve a taxpayer of the separate requirement to file the FBAR if
they are otherwise required to do so, and vice-versa. Depending on the situation, taxpayers may
be required to file Form 8938 or the FBAR or both forms, and certain foreign accounts may be
required to be reported on both forms. The IRS has created a chart: “Comparison of Form
8938 and FBAR Requirements” which is a side by side analysis of the two. This comparison
chart can be found at http://www.irs.gov/businesses/article/0,,id=255986,00.html.
Form 8938 and FBAR were developed to meet two different governmental needs—tax
administration and law enforcement. Since Form 8938 is a new requirement, there is no data
available to determine the number of filers facing duplicative reporting requirements.
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II. Sole proprietorship and hobby items
Practice Note: Form 1099-K is not going away
Practitioners should take notice that the reconciliation requirement is being eliminated from the
face of the tax return; however, the IRS has not ceased 1099-K reporting. Form 1099-K remains
alive and well, with credit and debit card income information to be utilized by the IRS as a tool for
selection of audit targets.
In 2013, the IRS has been sending correspondence to taxpayers titled “Notification of Possible
Income Reporting” which begins by stating: “Your gross receipts may have been underreported.”9
The generation of the letter is a direct result of card transaction reporting and calculated averages
for taxpayers in certain businesses.
In practice, reconciliation of merchant card and third-party payments is not required on the face of
the tax return; however, it may be required in workpapers for certain clients receiving large
percentages of such.
A. Gambling on changing the Constitution (#4)
1. What are the odds?10
Mr. Lakhani filed separate Schedule C’s for his two trades, one as a CPA and the other as a professional
gambler. The first Schedule C is not at question; however, the gambling Schedule C included gambling
losses in excess of winnings. Mr. Lakhani’s game of choice was parimutuel wagering on horse races.
On each of the gambling Schedules C, Lakhani reported the gross amount he received on (winning) bets
as “Gross receipts or sales,” and he reported the amounts he had bet as “Cost of goods sold,” subtracting
the latter from the former, to determine his gross income or his loss from gambling. He also reported and
deducted miscellaneous other nonwagering business expenses of a professional gambler to determine a
net income or loss from gambling.
He then combined his net wagering income or loss with his accounting practice income for the year and
reported the sum of the two on Page 1, Line 12 of his Form 1040 as his total net “Business income or
(loss)” for the year. For each of 2005, 2006, 2008, and 2009 (gambling loss years), net wagering loss
exceeded his accounting practice income, so that Line 12 of each Form 1040 reported a business loss.
IRS proposed adjustments for each of the gambling loss years to disallow the deduction for net wagering
losses on the basis of §165(d), which provides: “Losses from wagering transactions shall be allowed only
to the extent of the gains from such transactions.”
2. A novel approach
Mr. Lakhani based his argument on two alternative grounds:
• For each of the parimutuel bets that he made, he is entitled to deduct that portion of the bet equal
to the takeout percentage that applies to the parimutuel pool formed to receive that bet.
• Section 165(d) is inapplicable to professional gamblers, in that it unreasonably discriminates
against business losses of professional gamblers and constitutes a violation of their constitutional
right to the equal protection of the laws.
9
10
The House of Representatives Small Business Committee, Rep. Sam Graves, chairman, has requested follow-up from
the IRS regarding the notices.
Shiraz N. Lakhani, et al. v. Commissioner, 142 T.C. No. 8, March 11, 2014.
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3. First argument -- The house always wins
For his first argument, Lakhani argues that, in extracting takeout from the betting pools, "the tracks are
acting in the capacity of a fiduciary, i.e., collection of taxes and fees which they are remitting to the
different state and local tax authorities.” He likens the process to that of an “employer collecting payroll
taxes from the employees and remitting them to the IRS and the state agencies.” He argues that his pro
rata share of the takeout constitutes the business expense of a professional gambler and, as such, is not
a loss from wagering transactions subject to disallowance.
Lakhani argued he is entitled to deductions or losses of a takeout rate of 19 percent as applied to his
wagers, but is willing to settle for a “minimum 15 percent take out percentage” citing Cohan v. Comm.11
4. Second argument -- Climate change -- Morally?
Secondly, Lakhani argues that §165(d) does not apply to the expenses, including the net wagering
losses, of a professional gambler. Professional gamblers should be allowed the same protection as any
other profession when the activity is legal and conducted as a profession. In a lawful and democratic
society, Congress enacted this law many decades ago, only because at that time, “gambling was taboo.”
Now gambling is legal in most States in the Union and this law is unjust, not interpreted correctly.
Lakhani states §165(d) should be considered unconstitutional and struck down as the moral climate
surrounding gambling has changed, gambling is part of American life, and professional gamblers are
recognized in society and on television.
5. The law
Section 162 allows taxpayers to deduct all ordinary and necessary expenses paid or incurred during the
taxable year in carrying on a trade or business. Expenses paid as ordinary and necessary expenses may
be deductible on Schedule C when the matter generating the expense arises from, or is proximately
related to, a business activity other than employment. 12
Section 165 as a general rule allows as a deduction any loss sustained during the taxable year not
compensated for by insurance or otherwise. However, §165(d) limits losses from wagering transactions
only to the extent of the gains from such transactions.
In Mayo v. Comm.,13 the Tax Court held that: “Losses from wagering transactions” include the trade or
business expenses of a professional gambler other than the costs of wagers, should no longer be limited
by §165(d). Accordingly, a professional gambler could not deduct wagering losses in excess of his
wagering gains, but could deduct ordinary, nonwagering business expenses.
6. No win, place, or sympathy
IRS wins the argument as the Court agrees:
(1) Because takeout is paid from the pool remaining from losing bets, it “is inseparable from the
wagering transaction and constitutes wagering losses” subject to the §165(d) limitation; and
(2) The taxes, license fees, and other expenses discharged from the takeout are expenses owed and
paid by the track, not by the individual bettor. And even if a deduction for takeout were available
11
12
13
Cohan v. Commissioner, (CA-2), No. 114, 39 F2d 540, March 3, 1930; holds that in the absence of adequate
substantiation of deductible expenditures, the taxpayer is entitled to a deduction, under §162, for a reasonable estimate of
such expenditures.
Test v. Commissioner, T.C. Memo. 2000-362.
Mayo v. Comm., 136 T.C.No. 4.; Jan. 25, 2011.
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to petitioner, his failure to furnish the factual information necessary to make a reasonable
determination of the takeout percentage applicable to his losing bets is sufficient to bar
petitioner’s right to a pass-through deduction for takeout.
The Court held the argument that §165(d) violates equal protection as applied to those engaged in the
trade or business of gambling borders to be on the frivolous side. Thus, Lakhani’s argument that he is
denied equal protection is rejected.
III. Income from rents and pass-through entities
A. You’re still in the minor leagues but think you’re a real-estate pro (#5)
1. Passive activity loss deduction
Under §469(c)(7) and Regulation §1.469-9, if the taxpayer spends the majority of his or her time in real
property businesses, meeting the 1/2 personal services and 750-hour tests, rental real estate losses are
no longer per se passive.
After meeting Real Estate Professional status, then for each rental real estate activity in which the
taxpayer or spouse materially participates, losses are fully deductible. If the material participation
test is not met for a rental real estate activity, even though the taxpayer is a real estate professional,
losses are passive and deductible only up to $25,000 (if MAGI is less than $100,000).
a. Losses from passive activities can only be used to offset passive income from that activity or
other passive activities.14 Real estate professionals may qualify for exemption from the
passive activity rules under certain conditions and report their rental real estate activities as
just another segment of their trade or business.
b. The eligibility requirements an individual taxpayer must meet to be considered a real estate
professional do not appear, at least upon first blush, to be all that imposing. The method of
proof is quite lenient, letting the taxpayers prove their time spent by “any reasonable means.”
Taxpayers who may still be in the minor leagues of real estate may feel like they can get their
pitch past a professional IRS batter.
c. The reward of (inadvertently?) treating real estate losses as “non-passive” rather than
limiting losses via the passive rules is too much for some taxpayers to pass up.
2. 2011 case – Are you really a real estate professional15
a. During 2004 Mr. Bailey resided in California and worked as an emergency physician earning
$212,200. Mrs. Bailey operated three rental properties that the couple owned jointly. Two of
these properties were within a few miles of their residence, and the third in Boise, ID.
b. During 2004 they negotiated the purchase of a fourth single-family rental property, also in Boise,
ID. and researched a number of other potential single-family rental property acquisitions.
c. One of the properties they owned was called “The Inn on Alisal Road.” The property held two
structures; one consisted of a 1,200-square- foot, two-bedroom, 3/4-bath (no tub) front house,
and a smaller back unit that had been converted from a one-car garage into a separate
residential dwelling. As the name indicates, the Bailey’s furnished the two units and offered them
together or separately for short-term rent to overnight lodgers, usually for about three days at a
14
15
I.R.C. §469.
Todd D. Bailey, Jr., et ux. v. Comm., TC Summary Opinion 2011-22.
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time. They did not employ a management company. Instead, Mrs. Bailey operated the Inn
herself.
d. Below is a detailed description of rental real estate activities for 2004. The taxpayers had made a
previous election to group the properties as one activity.
Name of
Property
Type of
Rental
Hours
Gross
Income
Expenses
The Inn on
Alisal Road
ShortTerm
Sch C
Year-toYear
Sch E
Year-toYear
Sch E
N/A
324
$10,680
$31,363
Net
Income
(loss)
($20,683)
358
$11,000
$28,167
($17,167)
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$6,000
$5,655
$345
105
$0
$0
$0
N/A
192
$0
$0
$0
1,003
$27,680
$65,185
($37,505)
Second
Street
Property
Old Boise,
Idaho
Property
New Boise,
Idaho
Property
Research of
other
potential
acquisitions
3. Management of short-term rental property is not considered in the 750 hour test for a RealEstate professional
a. There are two main exceptions to the general rule that rental activities are per se passive
activities. One exception applies to rental real estate activities where the individual actively
participates in the activity during the year. The maximum deductible loss under this first
exception is $25,000; however, it begins to phase out when AGI exceeds $100,000 and phases
out completely when AGI is $150,000 or more. The Bailey’s AGI exceeds the $150,000 phaseout
ceiling; consequently, the active participation exception is not available.
b. The other exception is the one in controversy here. This second exception is available to
“taxpayers in real property business” (real estate professionals). Rental activities of a real estate
professional are not per se passive activities under §469(c)(2). To qualify as a real estate
professional, a taxpayer must satisfy both of the following requirements:
1) More than one-half of the personal services performed in trades or businesses by the
taxpayer during such taxable year are performed in real property trades or businesses in
which the taxpayer materially participates, and
2) Such taxpayer performs more than 750 hours of services during the taxable year in real
property trades or businesses in which the taxpayer materially participates.
c. To compute the 750 hours, the Code treats each real estate activity as a separate activity unless
the taxpayer makes an election to combine some or all of the activities.
d. However, the IRS contends that the Inn is not a “real property trade or business” for
purposes of the 750-hour test. The significance of this contention is that if the Bailey’s can
include the hours spent on the Inn, then they easily satisfy the 750-hour requirement. If, on the
other hand, she cannot include the hours relating to the Inn, then she spent only 679 hours on her
real estate activities.
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4. Conclusion – not a real estate professional
a. In the ruling the Court agreed with the IRS, in that Bailey’s activities that are related to the “Inn”
are disregarded for purposes of determining whether she was a real estate professional,
because the “Inn” is not “rental real estate” as defined in §1.469-9(b)(3).
1) Regulation §1.469-9(b)(3).defines “rental real estate” as “any real property used by
customers or held for use by customers in a rental activity within the meaning of §1.4691T(e)(3).”
2) Regulation §1.469-1T(e)(3) states that, except as otherwise provided, an activity is a “rental
activity” for a taxable year, if “during such taxable year, tangible property held in connection
with the activity is used by customers or held for use by customers”. It further states an
“activity involving the use of tangible property is not a rental activity for a taxable year if for
such taxable year the average period of customer use for such property is seven days or
less.”
Being “On Call” is NOT performance of service in rental real estate:
In another case,16 a taxpayer documented he worked 645.5 hours toward qualifying as a real
estate professional, and in fulfilling the 750 hour requirement the taxpayer argued that he was
participating by being "on call" with respect to the rental properties, and “could have been called
to perform work at the rental properties” whenever he was not working at his regular job.
The court rejected the taxpayer's innovative argument, noting that a taxpayer must "perform" the
activities for the hours to factor into the analysis.
5. The more than 50% of personal services and 750 Hour tests are conjunctive
a. In the case of married taxpayers filing jointly, one spouse must meet both the tests to qualify
as a real estate professional.
b. After one spouse meets Real Estate Professional status, then the times of both spouses are
counted for the material participation tests.17 That is; spouses filing a joint return for a taxable
year shall be treated as one taxpayer, and for each rental real estate activity in which they meet
the material participation test, losses are fully deductible.
6. Certain hours not counted toward material participation
a. In determining material participation, generally any work done by an individual (without regard to
the capacity in which the individual does the work) in connection with an activity in which the
individual owns an interest at the time the work is done shall be treated as participation of the
individual in the activity. 18 However, certain work does not qualify:19
(i) Work not customarily done by owners. Work done in connection with an activity shall not
be treated as participation in the activity if—
• Such work is not of a type that is customarily done by an owner of such an activity; and
• One of the principal purposes for the performance of such work is to avoid the
disallowance, under §469, of any loss or credit from such activity.
16
17
18
19
James F. and Lynn M. Moss v. Comm., 135 No 18, September 20, 2010.
Treas. Regs. §1.469-1T(j)(1).
Treas. Regs. §1.469-5(f)(1).
Treas. Regs. §1.469-5T(f)(2).
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(ii) Participation as an investor. Work done by an individual in the individual's capacity as an
investor in an activity shall not be treated as participation in the activity unless the individual
is directly involved in the day-to-day management or operations of the activity. Work done by
an individual in the individual's capacity as an investor in an activity includes—
• Studying and reviewing financial statements or reports on operations of the activity;
• Preparing or compiling summaries or analyses of the finances or operations of the activity
for the individual’s own use; and
• Monitoring the finances or operations of the activity in a non-managerial capacity.
Practice Note: More on time as an Investor
Regulation §1.469-9(b)(4) applies the personal services performed by an individual in the
capacity as an investor to §469(c)(7) (real estate professional - 50% of time and 750 hour
requirement).
7. The regulations may say one thing, but the courts need more
a. Generally, the taxpayer bears the burden of proving entitlement to any deductions claimed. This
burden may shift to the Commissioner if the taxpayer introduces credible evidence with respect to
any relevant factual issue and meets other conditions, including maintaining required records.
b. Per the regulations, the extent of an individual's participation in an activity may be
established by any reasonable means. Contemporaneous daily time reports, logs, or similar
documents are not required if the extent of such participation may be established by other
reasonable means. Reasonable means for purposes of this paragraph may include but are not
limited to, the identification of services performed over a period of time and the approximate
number of hours spent performing such services during such period, based on appointment
books, calendars, or narrative summaries.20
c. The Courts have consistently held that they do not allow a post-event “ballpark guesstimate.”21
2013 technical mistake? A fraudulent intent, however carefully
concealed at the outset, will generally, in the end, betray itself 22
In Hassanipour v. Comm., TC Memo 2013-88, the taxpayer provided a 2008 calendar as
contemporaneous evidence to support real estate professional status. Unfortunately, upon close
review, it was determined the calendar had a 2009 copyright date!
8. A “ballpark estimate” - wishing upon a wishing star
•
•
Claiming to be a real-estate pro without actually meeting the eligibility requirements; and
Attempting to make it look like you met the real-estate pro requirements after the fact.
The Tax Court has denied a couple's passive activity losses, finding that the wife did not qualify as a
real estate professional based on her "ballpark guesstimate" of her participation.23
The taxpayers did not live in Sanibel, but operated their rental activities from their home in
Massachusetts. They received onsite assistance from a Sanibel resident and real estate agent who
sold them their first two rental properties; he periodically checked the properties when they were
vacant to make sure the premises were secure, and the water and heat systems were functioning. He
20
21
22
23
Temp. Regs. §1.469-5T(f)(4).
Goshorn v. Commissioner, T.C. Memo. 1993-578. Fowler v. Commissioner, T.C. Memo. 2002-223.
Titus Livius Patavinus (59 BC – AD 17)—known as Livy, a Roman historian.
Hanna v. Commissioner; T.C. Summ. Op. 2006-57.
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also supplied keys to repairmen and, on rare occasions, to renters. He spent a total of approximately
six hours a month looking after the properties.
a. In addition to managing their rental activities, both taxpayers worked full time in the Boston
metropolitan area. The husband worked approximately 2,000 hours of work; the wife worked as a
computer consultant for three different companies totaling 2,119 hours of work.
b. The wife did not keep a contemporaneous log of the time spent on the rental activities. However,
they did produce two summaries of the time spent on the rental activities. The first indicated that
she spent 3,247 hours on rental, the second created shortly before trial indicated that she spent
2,610 hours on rental activities. No explanation was given or offered as to the discrepancy
between the two summaries.
Practice Note: Not that they ignore the regulation, rather….
Many cases involve an individual nominally fully employed in an entirely separate activity trying to
establish participation in terms of hours (either to qualify as a real estate professional or as
materially participating under one of the tests involving hours spent in the activity). To say the
least, the Service and the courts are skeptical of persons who on a practical level would have
to be spending significant time on the side venture without strong, convincing, rock-solid
evidence. And, because one prong of the test is a comparative balance between the two
interests, one must have evidence of the hours spent in the non-real estate activities as well.
B. Self-charged rent rules (#6)
1. Rental income that is not passive24
John Veriha is the sole owner of John Veriha Trucking, Inc. (JVT), a C corporation trucking company that
leases its trucking tractors and trailers from two different entities, an S corporation (TRI) and a single
member LLC (JRV).
Both TRI and JRV were also owned by Veriha; therefore, the rental of trucking equipment to the C
corporation are related-party leases.
Each of hundreds of tractors and trailers were leased to JVT as a specific unit. The monthly rate for
leasing each tractor was determined by the tractor’s age, and the monthly rate for leasing each trailer was
determined by the type of trailer.
2. The blooper
a. TRI generated net income, which it reported to Mr. Veriha on a Schedule K-1, Shareholder’s
Share of Income, Deductions, Credits, etc., and which the Veriha’s treated as net passive income
on their return. In that same year, JRV generated a net loss, which the Veriha’s reported on their
Schedule C, Profit or Loss from Business, and treated as passive loss on their return. The
Veriha’s netted the income and loss on their personal income tax return.
b. The IRS disallowed the net losses on of JRV under §469(a) as passive activity losses.
24
Veriha v. Comm., 139 T.C. No. 3 (2012).
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3. The law
a. Code §469(a) disallows a passive activity loss of an individual taxpayer. It defines “passive
activity” as an activity involving the conduct of a trade or business in which the taxpayer does not
materially participate.
1) A “passive activity” generally includes any rental activity, regardless of material
participation.25
b. Regulations set rules for grouping tax items together to determine what constitutes a single
“activity.”26
1) The regulations allow one or more trade or business activities or rental activities to be
treated as a single activity if the activities constitute an appropriate economic unit for the
measurement of gain or loss for purposes of the limitation on passive losses and credits.
c. Section 469(d)(1) defines “passive activity loss” as “the amount (if any) by which the aggregate
losses from all passive activities for the taxable year exceed the aggregate income from all
passive activities for such year.
d. Passive activity loss is computed by first netting items of income and loss within each
passive activity and then subtracting aggregate income from all passive activities from aggregate
losses.
e. While the general rule characterizes all rental activity as passive, the regulations provide what
is commonly referred to as the self-rental rule. The self-rental rule looks at each “item of
property” rather than each activity:
1) An amount of the taxpayer's gross rental activity income for the taxable year from an item of
property equal to the net rental activity income for the year from that item of property is
treated as not from a passive activity if the property is rented for use in a trade or
business activity in which the taxpayer materially participates.27
2) This has the effect of re-characterizing net rental activity income from an “item of
property” rather than net income from the entire rental “activity.”
f. Example - Self rental rule
Facts
Daniel owns a property and all outstanding stock of My Brother, Inc. Daniel materially
participates in the operations of the corporation which generates $250,000 of income and has
$130,000 of operating expenses. Daniel enters a lease agreement with My Brother, Inc.
requiring it to pay $75,000 annual rent for use of his property.
Analysis
If My Brother, Inc. were to pay $75,000 income to Daniel in the form of salary, he would
have $75,000 of income not from a passive activity. Because the $75,000 is paid to Daniel
in the form of rent, it is per se passive income according to the general rule of §469(c)(2).
The self-rental rule of regulation §1.469-2(f)(6) re-characterizes the $75,000 net rental
income as not from a passive activity.
4. Conclusion and solution
The Court determined that each individual tractor and each trailer was a separate “item of property” within
the meaning of §1.469- 2(f)(6). However, because IRS has not contested Verihas’ netting of gains and
25
26
27
I.R.C. §469(c)(2).
Treas. Regs. §1.469-4(c).
Treas. Regs. §1.469-2(f)(6).
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losses of each tractor or trailer within TRI, it was agreed that only TRI’s net income is recharacterized as
nonpassive income.
Practice Note -- In theory every lease in this case is an “item of property”
Practitioners should be aware, the Court stated each and every lease was for a separate “item of
property” and in theory hundreds of leases should be examined to determine which result in
income (non-passive) and which result in a loss (passive). The Court agreed to accept the
reclassification of the net income of TRI as nonpassive. Veriha most likely received a better
outcome than he would have received had each of hundreds of leases been dissected.
Regulation §1.469-2(f)(6) recharacterizes the net rental activity income from “an item of property” rather
than the net income from the taxpayer’s entire rental activity. This means that the passive losses
generated by unprofitable (JRV) rental properties remain passive activity losses. Therefore, those
losses do not offset the recharacterized (from passive activity to non-passive-activity) income (TRI) from
the taxpayer’s profitable rental properties.
5. Similar case -- same result - Carlos28
Tony and Judith Carlos (taxpayers) resided in Apple Valley, California. They personally owned two
commercial real estate properties. They also owned all of the stock of two S corporations—one
operating a steel company and the other a restaurant. They leased one of their properties to the steel
company and leased the other property to the restaurant.
a. The steel company agreed to pay rent of $120,000 per year. The steel company actually did
pay rent, which, after taxes, depreciation, and bank charges, resulted in net rental income of
$102,646 in 1999 and $102,045 in 2000.
b. The restaurant agreed to pay rent of $60,000 per year. The restaurant did not pay rent, which,
after mortgage interest, taxes, depreciation, and amortization resulted in a net rental loss of
($41,706) in 1999 and ($40,169) in 2000.
c. Taxpayers grouped the rental properties together to constitute a single “activity.” Therefore, on
Schedule E, Supplemental Income and Loss, they netted the income from property one and the
loss from property two.
d. The self-rental rule applied to re-characterize income from the steel company rental. Income
was wholly nonpassive while losses retained passive character and were subject as such to
the passive loss limits imposed by §469.
e. A simple solution would be to have the restaurant pay its rent. The case did not reveal the
reasons involved for the failure of the restaurant to pay rent, so we can only assume one reason
could have been economic. Perhaps a requirement that all steel company employees eat at
least one meal per day at the restaurant may increase its cash flow allowing it to pay its rent. Of
course if the food is just not palatable, the steel company employees may have a say about that
rule.
28
Tony and Judith Carlos v. Comm.; 123 T.C. 275; September 20, 2004.
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C. “The hardest thing in the world to understand is the income tax”29 or perhaps
calculating basis (#7)
1. 2012 case – Is basis increased by phantom income, or reduced by losses not deducted?30
a. In 1995 Barnes acquired a 50% interest in Whitney by making a $44,271 contribution of capital.
Whitney operated at a loss in 1995, Barnes' pro rata share of that loss was $66,553, of which
$44,271 (the amount of their basis in the Whitney stock) was allowable, and $22,282 suspended.
b. In 1996, Barnes made no contributions of capital, and received a pass-through loss of $136,228.
However, Barnes’ reported on their (w/spouse MFJ) 1996 return a pro rata gain from
Whitney of $22,282?
c. The parties agree that at the beginning of 1997 Barnes' basis in the Whitney stock was zero. In
1997 Barnes made a $278,000 contribution of capital to Whitney. Barnes pro rata share of
Whitney's 1997 loss was $52,594, which they claimed a deduction for. They ignored the
suspended losses. Barnes’ contends that they “are not required to reduce their basis for
losses that were never claimed or deducted.”
d. After a few years, the difference in basis calculations remains at $158,510 (represented by
$22,282 1995 phantom income and $136,228 1996 non-deducted losses).
e. Subsequently Whitney reported a large loss, with Barnes share amounting to $276,289.
Recap:
Begin Year
Basis
K-1 PassThrough
Correct
Reporting
Reported by
Taxpayer
Loss
Suspended
($44,271)
$0
$211,104
Loss
Suspended
($44,271)
($22,282)
+ $22, 282
($180,792)
($52,594)
($180,792)
$44,271
($66,553)
($22,282)
($136,228)
$0
($158,510)
New
($52,594)
$0
Capital
$278,000
???
($276,289)
By 2003, the difference in basis calculations remains at $158,510 (represented by $22,282 phantom
income and non-deducted losses of $136,228).
2. Error in calculating basis
Barnes believed his basis before deducting the $276,289 loss amounts to $225,406. IRS believes the
basis is $158,510 lower. Barnes contends:
(1) Basis increases for amounts reported by a shareholder as his or her pro rata share of passthrough S corporation income, even where the reported income amount is not actually the
shareholder's pro rata share of the S corporation's income for that year; and
(2) Basis is not reduced for pass-through S corporation losses that the shareholder did not report
on his or her return and did not claim as a deduction, despite being required to do so by
§1366(a)(1).
29
30
Albert Einstein.
Marc S. Barnes, et ux. v. Commissioner, TC Memo 2012-80.
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3. The law - Specific order for adjustments to basis after 1996
The service in final regulations31 provides for two possible methods of accounting regarding the
specific order for adjusting a shareholder’s basis.
a. First Method -- Specific order for adjustment to basis32
Unless the shareholder elects the second situation, the adjustments are to be made to the basis
of a share of stock in the following order:
1) 1st -- Increases for income (including non-taxable income) items and also the excess of the
deductions for depletion in excess of the cost basis of the property subject to depletion,
then,
2) 2nd --- Decreases for Distributions,
then,
3) 3rd -- Decreases for nondeductible expenses, noncapital expenses and deductions for oil
and gas depletion up to cost basis,
then,
4) Last -- Decreases for deductible items of loss and expenses.
b. Second Method -- Special written shareholder election to reduce basis by deductible losses and
expenses first before reducing basis by nondeductible expenses.
Once this election is made it cannot be revoked in future years without IRS permission. 33 If this
election is made, the adjustments to basis of a share of stock will be in the following order:
1) 1st -- Increase for income (including non-taxable income items and also the excess of the
deductions for depletion in excess of the cost basis of the property subject to depletion),
then
2) 2nd -- Decrease for Distributions,
then
3) 3rd -- Decrease for deductible items of loss and expense,
then
4) Last -- Decreases for nondeductible expenses, noncapital expenses and deductions for oil
and gas depletion up to cost basis.
4. Conclusion and unsuccessful last ditch attempt
Regarding the upward Basis Adjustment in 1996, the IRS takes the position that Barnes' basis in the
Whitney stock did not increase by $22,282. It contends that, under §1367, there is no upward basis
adjustment for amounts that are erroneously reported by the shareholder as pass-through income but that
do not correspond to the shareholder's actual pro rata share of pass-through income. Barnes’ seem to
argue, without citation of authority, that the upward basis adjustment was appropriate because they
reported $22,282 in pass-through income. The fact that they reported $22,282 of pass-through income
on their return is irrelevant because they had no pass-through income from Whitney for 1996, their basis
did not increase by $22,282 in that year.
Regarding the failure To Make Downward Basis Adjustment for 1997, basis is reduced even if the
shareholder does not actually claim the pass-through losses on his or her return. Therefore, the IRS
31
32
33
Treas. Regs. §1.1367-1.
Treas. Regs. §1.1367-1(f).
Treas. Regs. §1.1367-1(g).
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argues Barnes' basis was reduced by $136,228 for 1997. The plain language of §§1366 and 1367
supports the interpretation.
Barnes then desired to implement the “Tax Benefit Rule” which they believed should permit the benefit
in 2003 of the suspended loss they did not report as a deduction in 1997.
Tax Benefit Rule:
The tax benefit rule is a judicially created principle intended to remedy some of the inequities that
would otherwise result from the annual accounting system used for federal income-tax purposes.
The Supreme Court explains that "[t]he basic purpose of the tax benefit rule is to achieve rough
transactional parity in tax, and to protect the Government and the taxpayer from the adverse
effects of reporting a transaction on the basis of assumptions that an event in a subsequent year
proves to have been erroneous.”
The rule has two components: an inclusionary component and an exclusionary component. The
inclusionary component is a rule providing that, where a taxpayer properly deducts an outlay in
one year and then, in a later year, recovers the same amount, the subsequent recovery is
generally included in the taxpayer's gross income. The exclusionary component of the rule
provides generally that gross income does not include amounts subsequently recovered to the
extent that the prior deduction did not give rise to a tax benefit.
The exclusionary component of the rule does not become an issue unless, and until, the
inclusionary component of the rule is satisfied.
The inclusionary component of the tax benefit rule would not require Barnes to include in gross income
for 2003 any amount deducted in a prior taxable year and subsequently recovered. Therefore, neither
component of the tax benefit rule applies and does not provide for an exclusion from income for 2003.
In a last ditch effort, Barnes contends that, even if the IRS is correct with respect to basis in the Whitney
stock, their failure to claim $136,228 in pass-through losses on their 1997 return caused them to
incorrectly calculate their net operating loss (NOL) for that year. They argue that the amount of their
1997 NOL should be recalculated, taking into account the $136,228 they failed to deduct. They argue
further that, because they “never used” this NOL, it remains available to offset their taxable income for
2003. They allude to a theory that a time bar affects the 1997 tax year, however, they did not provide a
factual basis for carrying a 1997 NOL all the way forward to their 2003 tax return. For its part, the IRS
argues that Barnes' NOL argument should be rejected because of the dearth of supporting evidence and
should not even be considered because they waited until after trial to raise this contention. The Court
agreed with both of the IRS's contentions and so rejected the NOL argument.
5. Inconsistent treatment of Schedule K-1 items
Generally, taxpayers must report items shown on Schedule K-1 (and any attached statements) the same
way that the items are reported on its return. If the treatment on the original or amended return is
inconsistent with the entity’s treatment, or if the entity was required to but has not filed a return, the
taxpayer must file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request
(AAR), with its original or amended return to identify and explain any inconsistency (or to note that a
return has not been filed).
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Practice Note:
If a taxpayer is required to file Form 8082 but does not do so, it may be subject to the accuracyrelated penalty. This penalty is in addition to any tax that results from making the amount or
treatment of the item consistent with that shown on the return. Any deficiency that results from
making the amounts consistent may be assessed immediately.
Practice Note: - Errors
If a taxpayer believes an error is on Schedule K-1, it should notify the entity and ask for a
corrected Schedule K-1. The taxpayer may not change any items on its copy of Schedule
K-1. Verify that the entity sends the corrected Schedule K-1 to the IRS.
D. Failing to find hidden gains in Schedules K-1 (#8)
1. Hidden partnership or LLC gains
A partner/member’s share of partnership/LLC liabilities is included in their adjusted basis. When
liabilities are increased and each partner’s share of such liabilities is thereby increased, the amount of
each partner’s increase shall be treated as a contribution of money by that partner to the partnership.
Where the liabilities are decreased and each partner’s share of such liabilities is decreased, the
amount of the decrease shall be treated as a distribution of money to the partner by the partnership.
1) Example:
Facts
Haymitch is a member of Panem LLC, in which he maintains a basis at the beginning of
the current year of $6,000. Information from his current Form K-1 is as follows:
Box 1:
Ordinary income
$10,000
Box 19A:
Cash distributions
10,000
Question K
Share of Recourse Debt:
60,000
Haymitch anticipates reporting $10,000 income for the current year.
2. The error practitioners make – review of liabilities
To properly complete the current-year basis calculations, one must first review the prior-year Schedule
K-1, which reveals Haymitch’s share of Recourse Debt of $100,000.
Practice Note: - Changes in liabilities
Changes in liabilities normally result from fluctuations in liability balances, and/or from the
acceptance of new or retirement of old partners or members.
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3. Solution – proper completion of basis worksheet
Haymitch must complete a basis calculation.
1) Example: continued
Analysis - Line numbers refer to the Worksheet for basis in a partnership
1)
2)
3)
4)
Beginning basis
Initial share of debt basis
Ending share of debt basis
Net change in debt basis
$6,000
5)
6)
7)
8)
Taxable income
Nontaxable income
Upward adjustments
Tentative basis for distribution purposes
10,000
9)
10)
11)
12)
Actual distributions
Net decreases in share of debt basis
Total distributions
Downward adjustments
10,000
40,000
50,000
$100,000
60,000
(40,000)
13) Tentative basis for loss purposes
14) Amount realized
15) Gain recognized
(Potential for Hidden Gain)
10,000
16,000
16,000
0
50,000
$34,000
(Hidden Gain)
Haymitch expected to report only K-1 income of $10,000. He does report the ordinary income
but also may be surprised to also report $34,000 gain from distributions in excess of basis.
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4. Worksheet for basis in a partnership/LLC
Worksheet for Basis in a Partnership
Beginning basis
1. ________
Initial share of debt basis
2. ________
Ending share of debt basis
3. ________
Net change in debt basis (Line 3 - Line 2)
4. ________
Taxable income
5. ________
Nontaxable income
6. ________
Upward adjustments (Line 5 + Line 6 + Line 4 (if positive))
7. ________
Tentative basis (Line 1 + Line 7) for distribution purposes
8. ________
Actual distributions (money and adjusted basis of property)
9. ________
Net decreases in share of debt basis (Line 4 (if negative))
10. ________
Total distributions (Sum of Lines 9 through 10)
11. ________
Downward adjustments (Smaller of Line 8 and Line 11)
12. ________
Tentative basis (Line 8 - Line 12) for loss purposes
13. ________
Amount realized (Greater of Line 11 and Line 8)
14. ________
Gain recognized (Line 14 – Line 8)
15. ________
Current deductible losses
16. ________
Current nondeductible expenditure not chargeable to CA
Total current losses (Sum of Lines 16 through 17)
17. ________
18. ________
Allowable current losses (Smaller of Line 18 and Line 13)
19. ________
Tentative basis (Line 13 – Line 19)
20.
Excess current losses (Line 18 – Line 19)
21. ________
Deductible percentage (Line 16/Line 18)
22. _________
Nondeductible percentage (Line 17/Line 18)
23. ________
Suspended deductible loss (Line 22 x Line 21)
24. ________
Suspended nondeductible expenditures (line 23 x Line 21)
25. ________
Current allowable deductible loss (Line 16 – Line 24)
26. ________
Carryover deductible losses
27.
Carryover nondeductible expenditure not chargeable to CA
28.
Total carryovers (Sum of Lines 26 through 27)
29.
Allowable carryovers (Smaller of Line 20 and Line 29)
30.
Ending basis (Line 20 - Line 30)
31.
Loss carryover to next year (Line 29 - Line 30)
32.
Deductible percentage (Line 27/Line 29)
33.
Nondeductible percentage (Line 28/Line 29)
34.
Suspended deductible loss (Line 33 x Line 32)
35.
Suspended nondeductible expenditures (line 34 x Line 32)
36.
Current allowable deductible loss (Line 27 – Line 35)
37.
5. Worksheet for basis in an S Corporation
Repayment of shareholder loans by an S corporation when the shareholder's debt basis has been
reduced requires the shareholder to report as income some or all of the debt repayment. Practitioners
must also be conscientious about hidden gains in repayment of reduced basis shareholder loans.
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Worksheet for Basis in an S Corporation
Beginning stock basis
1. __________
Initial debt basis
2. __________
Beginning debt reduction
3. __________
Loss carryover from prior years
4. __________
Taxable income
5. __________
Nontaxable income
6. __________
Total upward adjustments (Line 5 + Line 6)
7. __________
Amount allocated to debt restoration (Lesser of Line 3 or Line 7)
8. __________
Debt basis (Line 2 + Line 8)
9. __________
Amount allocated to stock (Line 7 - Line 8)
10. __________
Tentative stock basis (Line 1 + Line 10)
11. __________
Losses
12. __________
Losses allocable to tax-exempt income
13. __________
Losses not allocable to tax-exempt income (Line 12 - Line 13)
14. __________
Taxable income (Line 5)
15. __________
Negative adjustments to AAA (Lesser of Line 14 or Line 15)
16. __________
Total adjustments to AAA (Line 15 - Line 16)
17. __________
Beginning AAA
18. __________
AAA (Line 17 + Line 18)
19. __________
Distributions
20. __________
Amount of distribution from AAA (Lesser of Line 19 or Line 20)
21. __________
Tentative stock basis (Line 11)
22. __________
Amount of AAA distribution return of capital (Lesser of Line 21 or Line 22)
23. __________
Interim stock basis (Line 22 - Line 23)
24. __________
Gain on distribution from AAA (Line 21 - Line 23)
25. __________
Balance of distribution (Line 20 - Line 21)
26. __________
Earnings and profits
27. __________
Amount of distribution from earnings and profits (Lesser of Line 26 or Line 27)
28. __________
Balance of earnings and profits (Line 27 - Line 28)
29. __________
Balance of distribution after earnings and profits (Line 26 - Line 28)
30. __________
Interim stock basis (Line 24)
31. __________
Nontaxable portion (Lesser of Line 30 or Line 31)
32. __________
Gain portion of distribution (Line 30 - Line 32)
33. __________
Stock basis (Line 31 - Line 32)
34. __________
Losses (Line 12)
35. __________
Losses allocated to stock (Lesser of Line 34 or Line 35)
36. __________
Final stock basis (Line 34 - Line 36)
37. __________
Debt basis (Line 9)
38. __________
Losses not allocable to stock (Line 35 - Line 36)
39. __________
Maximum losses allocable to debt (Line 2)
40. __________
Losses allocable to debt (Lesser of Line 38, Line 39, or Line 40))
41. __________
Final debt basis (Line 38 - Line 41)
42. __________
Carryover loss (Line 39 - Line 42)
43. __________
Total losses used (Line 35 – Line 43)
44. __________
If no election is made, the nondeductible losses
45. __________
Total nondeductible losses used (Lesser of Line 44 and Line 45)
46. __________
Unused nondeductible losses (Line 45 – Line 46)
47. __________
Deductible losses
48. __________
Current deductible losses (Lesser of Line 47 and Line 48)
49. __________
Carryover of deductible losses (Line 48 – Line 49)
50. __________
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E. S shareholder loans - substance and form both matter (#9)
1. Overview of an ‘all too common’ issue
a. Entrepreneurs are eternally optimistic, frequently over-estimate anticipated revenue, and
usually under-estimate operating expenses when they start a new business venture. Many of
our small business clients have a difficult time understanding the clear tax law distinctions
between their business checking account and their personal financial transactions. This is
most clearly brought to their attention when the initial capital contributions used to form the
business are exhausted and it comes time to finance continuing operating expenses of their
S corporation with money borrowed from third party lenders.
b. To many clients it does not seem significant whose name is on the top line of the bank loan
document as primary borrower and who is personally guaranteeing that the loan will be repaid
as subordinate obligor in case of default. To the IRS and the courts, however, it makes a big
difference.
c. All that many clients understand is that if money is not borrowed soon to fund the operating
expenses (and in many cases, losses) of the business, then suppliers will not be paid,
employee payroll checks will start bouncing like rubber balls, and the business must consider
ordering that ‘going out of business’ sign.
d. In general, shareholders of S corporations can only deduct losses to the extent of their basis
in stock and loans made directly from the shareholders to the S corporation.
2. The typical path to bloopers and blunders
a. The first blooper is under estimating the amount of initial capitalization required to make the
business operate profitably. Frequently, the practitioner does not know a new business was
started until the following February or March when a client discloses they started a new S
corporation last year. The client says nonchalantly that the business had an operating loss and
borrowed money from the bank to pay expenses, but this year looks a little better so far.
Famous last words.
b. The first blunder occurred when the financial institution or other lender made a loan directly to
the S corporation and asked the owner or owners of the corporation to personally guarantee
that the loan amount will be repaid. Many loan officers at financial institutions (not all, but
many) do not understand the tax significance of this potential blunder. In all fairness to the
lenders, it is not in their job description to understand the tax laws. It is in their job
description to lend money to qualified businesses, consider the ability of the borrower to make
timely loan payments, and to obtain adequate security for that loan for the benefit of the lender
and its owners in case the payments default.
c. A subsequent ‘blunder’ occurs when the loan payments are made directly from the S
corporation checkbook to the lender. This blunder, if one can call it a blunder, is a condition
subsequent based on the first blunder. Of course the corporation made the payments directly to
the lender. The S corporation is the entity that is the primary obligor on the loan documents with
responsibility to make the payments. At this point, the horse is out of the barn.
d. Now you are involved because there is a problem that needs to be fixed.
e. Life is wonderful and there are no blunders – as long as the S corporation is profitable and
reports positive taxable income to all the shareholders annually. However, in many cases the S
corporation reports an operating tax loss for the year and passes losses and deductions
through to the shareholders on Schedules K-1.
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3. The law ‘primer’
The S corporation’s items of loss and deduction are taken into account on the shareholder's individual
tax return first to the extent of adjusted stock basis and then to the extent of basis in shareholder
loans directly to S corporation.
a. Stock basis is pro-rata, per share. The adjustments to basis required for the shareholder's
pro-rata share of the corporation's items of income, loss, or deduction are made to each
share of stock on a per share, per-day basis.
1) If the amount of the loss or deduction attributable to a share exceeds its basis, the
excess is applied to reduce (but not below zero) the remaining basis of all other shares of
stock owned by the shareholder in proportion to the remaining basis of each of those shares.
2) While this ‘iterative’ process of allocating excess losses to those shares with basis
remaining, it has no effect on the tax deductible amount for the current year, it does
affect the gain on sale when a shareholder later sells some shares (i.e., shares with zero
basis) but retains other shares (i.e., those with basis remaining).
3) In summary, S stock basis is not a “fungible item” or a “pool of basis.” Each share
potentially has its own unique basis if acquired at different times for different prices.
b. Loan Basis - The adjusted basis in the shareholder's indebtedness owed directly by the
S corporation to the shareholder. Shareholder's guarantee of third party debt does not
increase the shareholder's debt basis for the calculation of the S loss includable in the individual
return.
1) Example:
Facts
S corporation had a non-separately computed loss for the year of ($100,000). John
Zimmer, the sole owner, had a stock basis of $20,000, loaned the corporation $40,000
and guaranteed $50,000 of corporation debt at the local bank.
Analysis
John could deduct on his individual return $60,000 of the loss equal to his stock basis
and his direct indebtedness. The guaranteed corporate debt is not taken into
consideration. The remaining unused loss of $40,000 is carried forward to the
subsequent year.
c. More than one shareholder debt 34 - If the shareholder holds more than one debt at the end
of the corporation's taxable year, the reduction of basis applies to each debt in the same
proportion that the basis of each debt bears to the aggregate bases of all S corporation debt.
d. Net basis increase - If for any taxable year there has been a reduction of the shareholder's basis
of an S corporation debt, any net increase for any subsequent taxable year must be used to
restore the basis of the debt before it may be used to increase the basis of the
shareholder's stock.35
34
35
Treas. Regs. §1.1367-2(b)(3).
Treas. Regs. §1.1367-2(c).
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1) Net basis increase is the amount by which the sum of the shareholder's items of income
and excess deductions for depletion exceeds the sum of the items of loss, deduction,
nondeductible noncapital expenses, distributions, and certain oil and gas depletion
deductions.
2) Example:
Facts
Eliza’s stock basis at beginning of the current year is $0 and the remaining basis in a
$30,000 loan directly from Eliza to the S corporation is $10,000, reduced by prior year
losses allocated. During the current tax year, Eliza is allocated $10,000 trade or business
income, ($8,000) capital loss and the S corporation distributed $4,000 cash to her this
year.
Analysis
There is no ‘net increase’ to restore loan or stock basis this year since the $12,000 sum
of losses, deductions, and distributions ($8,000 capital loss + $4,000 distribution)
exceeds the income items allocated (i.e., $10,000).
e. The basis restoration rules apply to S corporation debt held by the shareholder on the first
day of the taxable year in which the net increase arises, and the basis restoration is limited to
the outstanding balance of the S corporation debt as of that day.
1) If the shareholder holds more than one S corporation debt during the corporation's taxable
year, any net increase is applied first to restore the reduction of basis of any debt repaid
in whole or in part during that taxable year.36
f. Repayment of shareholder debt when the shareholder's debt basis has been reduced
requires the shareholder to report as income some or all of the debt repayment.
1) If the shareholder's debt basis has been reduced to zero, the entire loan repayment is
included as shareholder income.
2) If the debt is evidenced by a note and the debt basis has been reduced, the repayment of
the note in excess of its basis is a capital gain.
3) If debt is not evidenced by a note, it is considered ‘open shareholder debt’ in which the
repayment in excess of basis is ordinary income.37
4) If the shareholder's debt is partially reduced, then the repayment is allocated partly to
return of basis and partly to income.38
5) Example – Written debt considered capital asset
Facts
Shirley Tinch's basis in a $50,000 loan to an S corporation was reduced to zero by the
absorbing of a net loss the prior year.
The debt was evidenced by a note. Several years later, the note was repaid.
Analysis
Shirley would recognize $50,000 as a long-term capital gain.
g. Partial repayment of written debt instruments - In the case of a debt that is repaid in part
during the corporation's taxable year, the basis is restored to those loans first to the extent
necessary to offset any gain that would otherwise be realized on repayment. The remaining
net increase, if any, is then applied to restore the basis of each outstanding debt that was
36
37
38
Treas. Regs. §1.1367-2(d)(1).
Rev. Rul. 68-537.
Rev. Rul. 64-162.
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not repaid in proportion to the amount that the basis of each debt has been reduced under
the basis reduction rules and not yet restored.
h. Open shareholder debt - All open shareholder debt is treated as a single debt for basis
purposes.39 Open accounts not in note form will generally result in ordinary income to the
shareholder when repayment of such debt exceeds tax basis.
1) Partial repayment of open, unwritten debt instruments - In the case of open debt that is
repaid in part during the corporation's taxable year, aggregation of all open advances is
treated as part of a single transaction.
4. 2009 Case illustrates lack of economic outlay in circular loan by shareholder 40
a. Facts - of a circular lending pattern in which notes are used in only two-thirds of the circle.
1) In 1986 Marvin and Thelma Kurzner formed the Highland Court Associates (HCA), a
partnership, with each owning a 50 percent interest. At the same time they also formed HCI,
an S corporation, with each owning a 50 percent shareholder.
2) HCA partnership borrowed funds to acquire and construct real property.
3) For each year from 1986 to 2001 HCA partnership lent money to the Kerzners, and they lent
money to the S corporation HCI. HCI in turn paid rent to HCA.
4) For each loan between HCA and the Kerzners and its subsequent loan from the Kerzners to
HCI, notes were drafted near the end of the calendar year and within a short time of each
other. Each note included the total outstanding loan balance and, therefore, revised and
superseded the loan notes issued in the prior year. Each note required no principal
payments until the end of the following year. Most of these notes stated an interest rate.
5) HCA booked the loan as “Other Current Assets” that were “Due from Partners.” The S
corporation HCI reflected the receipt of the Kerzner’s funds as “Loans from Shareholder.” To
complete the cycle, HCI paid equivalent amounts of rent to HCA.
b. Issues - Do the Kerzner’s have sufficient basis in indebtedness under §1366(d)?
c.
Holding and Analysis
1) The court found the Kerzner’s did not make an economic outlay on the yearly loans and did
not acquire basis in indebtedness in those amounts. In order to acquire basis in
indebtedness of an S corporation, the case law has required that:
a) The indebtedness run directly from the S corporation to the shareholder, and
b) The shareholder makes an actual economic outlay that renders him poorer in a material
sense.
2) In the case there is the same circular flow of cash beginning and ending with HCA. Each
year, HCA lent money to the Kerzners. They then lent the proceeds to HCI. To complete the
cycle, HCI paid rent to HCA. Viewed in its entirety, the transaction lacked economic
substance since the money wound up right where it started. The fact that purely paper debts
to two parties (HCA and Kurzners) were accumulating is not enough to give the transaction
substance.
3) The Kurzners made no economic outlay because they were merely a conduit through which
the money flowed and there was no real expectation that they would repay HCA. They
exercised complete control over both HCA and HCI, meaning neither would act in a manner
adverse to their interests.
4) In the case before us, there is no back-to-back loan situation. Instead, there is a circular flow
of funds.
39
40
Treas. Regs. §1.1367-2(a).
Marvin S. and Thelma S. Kerzner, et ux. v. Comm., TC Memo 2009-76; April 6, 2009.
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New proposed regulation on Basis of Indebtedness of S Corps to their Shareholders 41
On June 11, 2012 IRS issued proposed regulations that would provide that S corporation
shareholders increase their adjusted basis in any indebtedness of the S corporation to them—and
so allow them to deduct their pass-through deductions and losses—only if the indebtedness is
bona fide. The proposed regulations would apply to loan transactions entered into on or after final
regulations are published.
The Code does not define basis of indebtedness, but several courts have interpreted I.R.C.
§1366 as requiring that an investment in the S corporation be “an actual economic outlay” by
the shareholder in order to create basis of indebtedness.
Frequent disputes have arisen between S corporation shareholders and IRS on whether certain
loan transactions involving multiple parties create shareholder basis of indebtedness. These often
involve attempts by an S corporation shareholder to obtain basis of indebtedness by borrowing
from another person (typically, a related entity) and then lending the proceeds to the
S corporation (a back-to-back loan transaction). Alternatively, a shareholder might seek to
restructure an existing loan of the S corporation into a back-to-back loan by assuming the
S corporation's liability on the loan and creating a commensurate obligation from the
S corporation to the shareholder. Arguments arise as to when a back-to-back loan gives rise to
an actual economic outlay—that is, whether a shareholder has been made poorer in a
material sense as a result of the loan.
IV. Other income issues (#10)
A. Properly reporting income from hobbies
1. Practitioner errors in reporting
A common error made by practitioners in the hobby-loss area is to complete Schedule C, reporting
income and expenses from the hobby activity resulting in net $0.
If an activity is a hobby, a taxpayer does not reduce income on page one of Form 1040 by deductions.
Income from hobby activities should be reported as Other Income on Form 1040 line 21, and associated
deductions are claimed as itemized deductions on Schedule A.
B. National Mortgage Settlement Payments42
1. “Robo-signing” and other servicing violations
In February 2012, 49 state attorneys general and the federal government announced a historic joint statefederal settlement with the country’s five largest mortgage servicers:
• Ally/GMAC;
• Bank of America;
• Citi;
• JPMorgan Chase; and
• Wells Fargo.
The settlement will provide as much as $25 billion in relief to distressed borrowers in the states who
signed on to the settlement; and direct payments to signing states and the federal government.
41
42
REG-134042-07. Basis of Indebtedness of S Corporations to their Shareholders, June 11, 2012
See Rev. Rule 2014-2.
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Of the total award, up to $1.5 billion will be available to borrowers who lost their home due to foreclosure
between January 1, 2008 and December 31, 2011 and whose loans were serviced by one of the five
mortgage servicers that are parties to the settlement. The National Mortgage Settlement Administrator
mailed Notice Letters and Claim Forms in 2012, and payments were made in June 2013. The payments
approximated $1,480.
Note: Fannie Mae or Freddie Mac loans
Loans owned by Fannie Mae or Freddie Mac are not impacted by this settlement. The following
websites can be used to determine if a loan is owned by either Fannie Mae or Freddie Mac:
•
http://www.fanniemae.com/loanlookup
•
http://www.freddiemac.com/mymortgage
These sites also include information about mortgage and foreclosure programs mortgage holders
may be eligible to access.
2. Tax status of settlement payments
I.R.C. §61(a)(3) provides that gross income includes gains derived from dealings in property. However,
§121(a) generally provides that gross income does not include gain from the sale or exchange a
qualifying principal residence. The personal residence exclusion does not apply to that part of the gain
from the sale of any property that does not exceed the depreciation adjustments [§1250(b)(3)] attributable
to the property for periods after May 6, 1997.
The National Mortgage Settlement agreements provide that a payment is remedial and relates to the
reduced proceeds a borrower is deemed to have realized in a foreclosure because of the servicers’
allegedly unlawful conduct. The agreements do not consider the NMS Payment to be forgiven debt.
Example 1 -- Loss on a single-unit home
Facts
In 2006, Borrower A purchased a property for its fair market value of $230,000. A financed
$200,000 of the purchase price with a recourse first-lien mortgage loan that was secured by
the property, and A used the property as A’s principal residence.
During 2011, A’s principal residence was foreclosed on when its fair market value was
$125,000. The lender subsequently sold the principal residence and applied the proceeds
in final satisfaction of the principal balance of the first-lien mortgage loan, which was
$185,000.
A’s adjusted basis in the principal residence at the time of the foreclosure was $230,000.
In 2013, A received an NMS payment of $1,400 from the Fund.
Conclusion and analysis
In 2011, A’s amount realized on the foreclosure of the principal residence was $125,000, its
fair market value. A’s adjusted basis in the principal residence ($230,000) exceeded A’s
amount realized ($125,000).
Thus, A realized a $105,000 ($230,000 – $125,000) loss on the foreclosure. Under §165(c),
this loss is not deductible.
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The NMS payment of $1,400 that A received in 2013 reduces A’s nondeductible loss to
$103,600 and thus does not increase A’s taxable income.
Example 2 -- Gain on a single-unit home
Facts
In 1980, Borrower C purchased a property for $155,000. C financed $130,000 of the
purchase price with a recourse first-lien mortgage loan secured by the property. C
continuously used the property as C’s principal residence. C refinanced the mortgage loan
for an amount in excess of its outstanding principal balance with a new recourse first-lien
mortgage loan secured by the principal residence, and used the proceeds to pay for
educational expenses of C’s children and to purchase a boat for personal use.
In 2009, C’s principal residence was foreclosed on when its fair market value was
$160,000. The lender subsequently sold the principal residence and applied the proceeds
in final satisfaction of the principal balance of the new loan, which was $215,000.
C’s adjusted basis in the principal residence at the time of the foreclosure was $155,000.
In 2013, C received an NMS payment of $1,400 from the Fund.
Conclusion and analysis
In 2009, C’s amount realized on the foreclosure of the principal residence was $160,000, its
fair market value. C’s amount realized ($160,000) exceeded C’s adjusted basis ($155,000).
Thus, C had a $5,000 ($160,000 – $155,000) gain on the foreclosure of the principal
residence. C excludes this gain from gross income under §121 because C owned and used
the property as a qualifying principal residence.
The NMS Payment of $1,400 that C received from the Fund in 2013 increases C’s gain
(and the amount excluded under §121) on the foreclosure to $6,400.
Example 3 -- Single-unit home with gain less than prior depreciation
Facts
In 2000, Borrower D purchased a property for $155,000. D financed $130,000 of the
purchase price with a recourse first-lien mortgage loan secured by the property. D used a
portion of the principal residence as an office in D’s business and claimed depreciation
deductions of $10,000.
In 2009, D’s principal residence was foreclosed on when its fair market value was
$149,000. The lender subsequently sold the principal residence and applied the proceeds
in final satisfaction of the principal balance of the loan, which was $175,000 due to
subsequent refinancings.
D’s adjusted basis in the principal residence at the time of the foreclosure was $145,000. D
did not sell any other property during 2009.
In 2013, D received an NMS payment of $1,400 from the Fund.
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Conclusion and analysis
In 2009, D’s amount realized on the foreclosure of the principal residence ($149,000)
exceeded D’s adjusted basis in the principal residence ($145,000). Thus, D realized a gain
of $4,000 ($149,000 – $145,000) on the foreclosure of the principal residence. Under
§121(d)(6); however, because the $4,000 gain did not exceed D’s depreciation deductions
of $10,000, D could not exclude that gain from income under §121, and D includes the
$4,000 gain in income in 2009.
Similarly, under §121(d)(6), D may not exclude from income the additional $1,400 gain that
D realizes as a result of the NMS payment of $1,400 that D receives in 2013. The NMS
payment increases the gain on the property to $5,400, which does not exceed D’s
depreciation deductions. Thus, none of the $5,400 gain is excludable from gross income.
Under §61(a)(3), D must include the NMS payment of $1,400 in income on D’s federal
income tax return for 2013.
Example 4 -- Single-unit home with gain more than prior depreciation
Facts
The facts are the same as in Example 3, except that the fair market value of the property at
the time of the foreclosure was $154,500.
Conclusion and analysis
Because the amount realized on the foreclosure was $154,500, the NMS payment of
$1,400 increased the gain to $10,900 [($154,500 – $145,000) + $1,400], which exceeds the
depreciation deductions by $900.
Thus, D includes $500 of the additional gain resulting from the NMS payment in gross
income under §121(d)(6), and excludes the remaining $900 from gross income under
§121(a).
Practice Note: More mortgage settlements in 2014
On December 19, 2013, the Consumer Financial Protection Bureau announced another
settlement with the largest nonbank mortgage loan servicer, Ocwen Financial Corporation. The
settlement is expected to mirror the National Mortgage Settlement Program.
V. Itemized deductions
A. House donated to fire department – and the deduction goes up in smoke43
(#11)
1. Can you trust your relatives?
On November 27, 1996, Theodore R. Rolfs and Julia A. Gallagher (Rolfs & Gallagher) paid $600,000 for
a fee simple interest in a 3-acre lakefront property. A lake house, originally built in approximately 1900,
was located on the property. The lake house was in good condition and habitable yet they were initially
undecided regarding whether to remodel it or tear it down. Their deliberations were resolved when
Gallagher's mother, Beatrice Gallagher, suggested in late 1997 that Rolfs & Gallagher demolish the lake
43
Theodore R. Rolfs and Julia A. Gallagher, (CA 7 2/8/2012) 109 AFTR 2d ¶ 2012-427.
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house, build a new house to her specifications as her residence in its place, and then exchange the lake
property for her existing residence. They agreed to Mrs. Gallagher's proposal, and carried out the plan.
Sometime in the latter part of 1997 Rolfs & Gallagher determined that it would cost $10,000 to $15,000 to
demolish the lake house and remove the debris. Around the same time, they learned from a brother of an
acquaintance who had claimed a charitable contribution deduction for donating a residence to a local fire
department to be burned down.
In 1998 Rolfs & Gallagher donated the house on the property (but not the property) to their local volunteer
fire department (VFD) to be used in a rather quick manner for firefighter and police training exercises and
eventual demolition. Within several days, the VFD conducted two training exercises at the house and
burned it down. Approximately 5 weeks after the destruction of the lake house, Rolfs & Gallagher entered
into a contract to have a new residence constructed on the lake property at a cost of approximately
$383,000.
Rolfs & Gallagher claimed a deduction for a charitable contribution of $76,000 on their federal income tax
return for 1998 on account of their donation of the house to the VFD and amended their petition to assert
that they are entitled to deduct $235,350, the house's reproduction cost.
IRS contends that Rolfs & Gallagher are not entitled to any deduction because they received, in
exchange for the property donated, a substantial benefit in the form of demolition services, the value of
which exceeded the value of the property donated, a quid pro quo argument.
2. The error is in the details of what exactly was donated
Rolfs & Gallagher contend, and the IRS agrees, that the donation of the lake house to the VFD, without
conveyance of the underlying land on which it was sited, effected a “constructive severance” of the
structure from the land, recognized under Wisconsin law, even though the structure remained affixed to
the land. By transferring the lake house to the VFD without the underlying land, however, they created a
substantial restriction or condition on the property's marketability; namely, the lake house could not
remain indefinitely on the land upon which it was sited. Their appraisal expert opined that the lake house
had a “contributory value” of $76,000 on the basis of a “before and after” approach to value, which treated
the value of the donated lake house as equal to the difference between the fair market value of the lake
property with the lake house and the fair market value of the lake property without the lake house.
However, the IRS contends the $76,000 “contributory value” of the lake house at best reflects the value
of the lake house before taking into account its severance from the underlying land, the
prohibition on residential use, and the condition that it be burned down promptly. Consequently,
the property interest appraised is not comparable to the property interest that was donated.
3. Defining quid pro quo
A Quid Pro Quo Contribution is a payment a donor makes to a charity partly as a contribution and partly
for goods or services. For example, if a donor gives a charity $100 and receives a concert ticket valued at
$40, the donor has made a quid pro quo contribution. In this example, the charitable contribution part of
the payment is $60. Even though the deductible part of the payment is not more than $75, a disclosure
statement must be provided by the organization to the donor because the donor's payment (quid pro quo
contribution) is more than $75.
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4. The deduction goes up in smoke
The IRS found that the severance rendered the lake house virtually worthless. As for the impact on the
lake house's fair market value of the remaining conditions taxpayers imposed incident to the donation (the
restriction of use to firefighter and police training exercises and the condition that the structure be
promptly burned down), there is insufficient evidence in the record to support anything beyond
speculation. The impact on fair market value of the foregoing encumbrances would be adverse
rather than beneficial.
As for the possibility that the lake house as encumbered by the restrictions had a fair market value equal
to its salvage value, expert testimony indicated that the lake house's salvage value was zero. On the
basis of his examination of photographs and a video of the lake house, and a description of its features,
the expert opined that the value of any salvageable materials would be offset by the costs of removing
them. As a consequence the lake house had no salvage value.
Where do your clients get their best tax advice?
In this case Rolfs & Gallagher received and followed advice from Gallagher’s mother and from a
brother. Perhaps they could have consulted a professional?
B. Unreimbursed employee business expense deduction denied44 (#12)
1. A classic illustration of ‘whose expenses are these?’
Occasionally we cross paths with clients who believe that if they personally incur expenses related to
their jobs that they are automatically entitled to deduct those expenses as miscellaneous itemized
deductions on their personal returns. They believe they are automatically allowed to deduct such
expenses even though they could have been reimbursed if they had not been too overburdened with work
(lazy? negligent?) to submit an expense report to the company for full or partial reimbursement.
Following is a case that illustrates the classic failure of paying for the expenses of another
taxpayer – no one gets the tax deduction for the expenditures actually paid.
a. Oscar Contreras was a full time manager for FedEx Worldwide Services (FedEx) in 2001.
b. FedEx agreed to reimburse employees for reasonable expenses incurred for authorized FedEx
business activity as described in their policies. The allowable reasonable expenses included:
• Air transportation paid by the employee, hotel/lodging, employee business
meals/entertainment, and ground transportation (at the prevailing IRS standard mileage rate)
for reimbursing employees who used their personal vehicles for authorized business activity.
• The FedEx policies required management approval for all reimbursements for allowable
reasonable expenses.
• FedEx policies require original receipts for travel and entertainment expenses of $10 or more
and certain other normal business practices.
• Any waiver of either the original receipt policies or expense reimbursement policies must be
approved solely at the discretion of the vice president/controller.
c. Note that FedEx policy did not deny the employee expense reimbursement, it merely stated
that if the policies were not followed the expenses would still be reimbursed at the sole
discretion of the VP/controller.
44
Oscar R. Contreras v. Commissioner, T.C. Memo 2007-63 Docket No. 7901-05, 03/19/2007.
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d. Further, at times during 2001 FedEx imposed travel freezes on employee expenses.
However, during the travel freeze periods, employees could still be reimbursed for business
expenses incurred IF the VP/controller approved the expenses.
2. The blunder
a. During certain unidentified travel freezes in 2001, Contretas paid certain unidentified
expenses as a FedEx Worldwide Services employee for which he did not submit any
requests for reimbursement and for which he made no attempt to obtain the approval of a
vice president authorizing reimbursement of such expenses.
b. Contretas filed Form 2106 claiming $24,373 in job related expenses as follows:
Expense
Amount
Vehicle
$ 2,898 (@ standard mileage rates)
Transportation
1,150 (Parking, tolls, train, bus, etc.)
Travel
7,875 (lodging, airplane, car rental, etc.)
Business
9,618 (unspecified)
Meals
2,832 (after 50 percent reduction)
Total
$ 24,373
c. Not only did Contretas fail to submit his expenses to FedEx for reimbursement, the only
documentation he had was credit card statements showing the date, place and amount but
not the business purpose for the expenditure.
3. The law
a. A taxpayer is entitled to deduct under §162(a) unreimbursed employee expenses only to the
extent that the taxpayer demonstrates that such taxpayer could not have been reimbursed
for such expenses by such taxpayer's employer. 45
b. In addition a taxpayer’s claimed expenses relating to the use of his automobiles, for travel, for
meals, and for entertainment to be deductible, such expenses must satisfy the requirements of
not only §162(a) but also §274(d).
c. If the taxpayer shows such claimed expenses satisfy the requirements of §162(a) but fails to
satisfy his burden of showing that such expenses satisfy the recordkeeping requirements of
§274(d), the taxpayer will have failed to carry his burden of establishing that he is entitled to
deduct such expenses, regardless of any equities involved.46
d. A taxpayer is required to substantiate each element of an expenditure or use by adequate
records or by sufficient evidence corroborating his own statement.47
4. The conclusion and solution
a. The court held that Contretas did not submit any requests for reimbursement of employee
expenses that he paid during certain unidentified travel freezes in the year at issue and that he
made no attempt to obtain the approval of a vice president authorizing reimbursement of
any such expenses.
b. The court also held that the taxpayer failed to carry his burden of showing that a company vice
president would not have approved any employee expenses which he paid during such travel
freezes and for which he did not request reimbursement.
45
46
47
Podems v. Commissioner, 24 T.C. 21, 23 (1955); Putnam v. Commissioner, T.C. Memo. 1998-285; Marshall v.
Commissioner, T.C. Memo. 1992-65.
Treas. Regs. §1.274-5T(a), (Nov. 6, 1985).
Treas. Regs. §1.274-5T(b)(1).
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c.
So the moral of the story (like the partner who paid partnership expenses personally earlier in
today’s discussion) is if employees are entitled to reimbursement for company related expenses:
• Document the business expenses in accordance with company policy, and
• Submit the business expenses to the company for reimbursement in a timely manner.
d. If employees are reimbursed under an accountable employee reimbursement policy then the
reimbursed amount is not included in the employee’s compensation.
C. Meal allowances for police or fire workers on 24 hour shifts (#13)
1. Everyone in practice for enough years has been asked this question
Since a police or fireman work a 24 hour shift, they are away from home overnight. Do they therefore
receive the benefit of deductions for being away from home?
2. The urban legend
Police and firemen who provide their own meals at their 24 hour shifts may deduct the meal per diem as a
miscellaneous itemized deduction.
3. The law
Under I.R.C. §§162(a)(2) and 274(d), ordinarily, a taxpayer may not deduct personal expenses, such as
the costs of meals and lodging. However, if properly substantiated, traveling expenses, including meals
and lodging, incurred by a taxpayer during the taxable year while traveling away from home in the pursuit
of a trade or business are deductible.
A taxpayer's tax home is generally the area of the taxpayer's principal place of employment.
However, a taxpayer's tax home may be the taxpayer's personal residence if the taxpayer's employment
away from home is temporary, as opposed to indefinite, and if the taxpayer has a principal place of
business in the vicinity of the taxpayer's personal residence. 48
The Code specifically provides that a taxpayer shall not be treated as being temporarily away from home
during any period of employment if such period exceeds one year, but if the employment is initially
expected to last for one year or less and at some later point the employment is expected to exceed one
year, then the employment will be treated as temporary until the earlier of when the taxpayer's reasonable
expectations change or one year. 49
Revenue Ruling 56-49 specifically concludes the expenses incurred by a fireman for meals consumed at
a firehouse are not deductible as traveling or business expenses, but represent nondeductible living
expenses.
4. Conclusion and solution
A police or fireman is not traveling away from home in the pursuit of his trade or business while
performing services at his principal or regular post of duty, even though they work a 24-hour shift during
which they must remain at the post or firehouse overnight and cannot leave his station for meals. The tax
or business `home' of a police or fireman, as in the case of other taxpayers, is held to be his or her
principal or regular post of duty.
48
49
Farran v. Commissioner, T.C. Memo. 2007-151
Johnson v. Commissioner, T.C. Memo. 1999-153; Rev. Rul. 93-86, 1993-2 C.B. 71.
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Furthermore, a police or fireman who is assigned on different days to different locations within the same
city or general area is not `away from home,' because a taxpayer's principal or regular post of duty is not
limited to a particular building or property, but includes the entire city or general locality in which he
customarily carries on his or her trade or business.
On the other hand, one benefit can be found for here, if a firehouse provides meals to fireman,
generally the value of meals furnished to an employee by his employer shall be excluded from the
employee's gross income if two tests are met:50
• The meals are furnished on the business premises of the employer, and
• The meals are furnished for the convenience of the employer.
Meals furnished by an employer without charge to the employee will be regarded as furnished for the
convenience of the employer if such meals are furnished for a substantial noncompensatory business
reason of the employer. Meals will be regarded as furnished for a substantial noncompensatory business
reason of the employer when the meals are furnished to the employee during his working hours to have
the employee available for emergency call during his meal period.
If an employer provides meals which an employee may or may not purchase, the meals will not be
regarded as furnished for the convenience of the employer. Thus, meals for which a charge is made by
the employer will not be regarded as furnished for the convenience of the employer if the employee has a
choice of accepting the meals and paying for them or of not paying for them and providing his meals in
another manner.
VI. Other selected taxes
A. Accountant tries to deduct NOL carryover from self-employment income51
(#14)
1. Net operating losses from other years
DeCrescenzo is an accountant. In 2006 he received nonemployee compensation of $137,660 from his
accounting business. He failed to timely file a Form 1040, U.S. Individual Income Tax Return, so the IRS
intervened by preparing a substitute return and determined a deficiency, including Self-Employment Tax
of $15,207.
2. The mistake a practitioner makes
DeCrescenzo had an NOL carryforward from prior years and desires to use the NOL carryforward to
offset his self-employment income.
3. The law - §§1401 and 1402
A taxpayer's self-employment income is subject to self-employment tax. Self-employment income is
generally defined as the net earnings from self-employment derived by an individual.52 Net earnings from
self-employment means the gross income derived by an individual from any trade or business carried on
by such individual, less the deductions allowed that are attributable to such trade or business, plus his
distributive share (whether or not distributed) of income or loss from any trade or business carried on by a
50
51
52
I.R.C. §119.
DeCrescenzo v. Commissioner, TC Memo 2012-51
I.R.C. §1402(b).
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partnership of which he is a member; except that in computing such gross income and deductions and
such distributive share of partnership ordinary income or loss, among other items, the deduction for net
operating losses shall not be allowed.53 This point is reiterated in the regulations. Courts have repeatedly
held that the Code prohibits a taxpayer from offsetting net earnings from self-employment with an NOL
carryforward or carryback.54
Taxpayers with two or more businesses within the same tax year must combine net earnings from all
businesses to calculate net earnings from self-employment. A loss in one business reduces the income
from another.
4. Timing is everything
The Tax Court held that DeCrescenzo was not entitled to offset his self-employment income from his
accounting business with his NOL carryforward. 55 Keep in mind that the NOL carryforward was allowed
as an income-tax deduction to reduce DeCrescenzo’s taxable income even though it was not allowed for
purposes of the self-employment tax.
Timing is everything. Had the losses been incurred in the same tax year in a separate business,
DeCrescenzo could have calculated self-employment income by offsetting the income from one business
with the loss of the other. But he cannot use the losses from a prior year even from the same business to
offset the current income of that same business.
VII. Things professionals do not like to hear!
A. Is that Form 1099 (inadvertently) issued to an employee? (#15)
“Forewarned, forearmed; to be prepared is half the victory.” 56
An applicable large employer means, with respect to a calendar year, an employer who
employed an average of at least 50 full-time employees on business days during the preceding
year. Beginning in 2014, if any applicable large employer fails to offer to its full-time employees
(and their dependents) the opportunity to enroll in minimum essential coverage under an
eligible employer-sponsored plan, they may be imposed an assessable payment (penalty). A
full-time employee means, with respect to any month, an employee who is employed on
average at least 30 hours of service per week.
In anticipating employers’ potential to (inadvertently) misclassify employees as independent
contractors, the IRS has increased attention to the “Employee vs. Independent Contractor” arena.
With the advent of new rules in 2014, the increased attention may become resolute.
1. Background on issue
Generally, a worker who received a Form 1099 for services provided as an independent contractor must
report the income on Schedule C and pay self-employment tax on the net profit using Schedule SE.
However, if the worker was actually an employee, rather than an independent contractor, the worker is
not required to pay the full self-employment tax, and expenses can only be deducted as an itemized
deduction.
53
54
55
56
I.R.C. §1402(a)(4).
Ding v. Commissioner, T.C. Memo. 1997-435, etc…holding that the taxpayer did not make an overpayment of selfemployment tax in prior years because the taxpayer could not offset net earnings from self-employment with an NOL
carryback).
DeCrescenzo v. Commissioner, TC Memo 2012-51
Cervantes – “Don Quixote.”
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One postulate of agency law is an agent is employed to act on principals behalf. Tax law must determine
if the agents employ is one of a master-servant (employer-employee) or principal-agent (employerindependent contractor).
Subtitle C or the Internal Revenue Code contains Chapter 21 – Federal Insurance Contributions Act
(FICA). Subchapter A refers to the tax on employees, subchapter B the tax on employers, and
subchapter C general provisions. Since the FICA act was passed, employers have found it an easy tax to
avoid by classifying workers as independent contractors, thus avoiding FICA, state unemployment tax,
federal unemployment tax, workers compensation insurance, health insurance benefits, retirement
benefits etc., enjoyed by employees.
It did not take long for independent contractor status to be challenged. In the late 1940’s, two landmark
Supreme Court cases57 preceded decades of narrow rulings identifying certain attributes which would
indicate an employer-employee relationship.
2. A big but common mistake
Improperly classifying employees as independent contractors.
3. The law, conclusion, and solution
Rev. Rule 87-41 formalized previous court precedent and narrow rulings in a detailed list of 20 common
law attributes used to determine if a workers relationship is one the is an employee relationship or an
independent contractor relationship.58 The 20 common law attributes are the foundation for Form SS-8,
which is completed by workers and the employer to be reviewed by the IRS, and use to make a finding on
the relationship. The 20 common law attributes detailed in Rev. Rul. 87-41 are as follows:
a. Is the worker given instructions?
b. Is the worker provided training?
c. Are the workers services an integral part of the business operations?
d. Are services rendered personally?
e. Who hires, supervises and pays assistants?
f. Is there a continuing relationship?
g. Is there a set hours of work?
h. Is full time required?
i. Is work completed on employer's premises?
j. Is there an order or sequence set?
k. Are oral or written reports required?
l. Is payment by hour, week, or month?
m. Who pays for business and/or traveling expenses?
n. Who furnishes tools and materials?
o. Is there a significant investment?
p. Can the worker realize profit or loss?
q. Does the worker work for more than one firm at a time?
r. Are workers services available to general public?
s. Does the employer have a right to discharge the worker?
t. Does the worker have the right to terminate without incurring liability?
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58
United States vs. Silk 331 US 704 (1947) and Bartels vs. Birmingham 332 US 126 (1947).
Rev. Rul. 87-41, 1987-1 CB 296.
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Section 530 of the Revenue Act of 1978 provides a safe harbor for classifying an independent contractor
if all information returns are filed and the taxpayer maintained reasonable reliance under one or more of
the following statutory tests:
a. Judicial precedent, published rulings, technical advice or letter rulings;
b. A past IRS audit of the taxpayer in which there was not assessment attributable to the treatment
of individual;
c. Long standing recognized practice of a significant segment of the industry in which such
individual was engaged.
4. The conclusion and solution59
The Internal Revenue Service has developed a new form for employees who have been misclassified as
independent contractors by an employer. Form 8919, Uncollected Social Security and Medicare Tax on
Wages, will now be used to figure and report the employee’s share of uncollected social security and
Medicare taxes due on their compensation.
Generally, a worker who receives a Form 1099 for services provided as an independent contractor must
report the income on Schedule C and pay self-employment tax on the net profit, using Schedule SE.
However, sometimes the worker is incorrectly treated as an independent contractor when they are
actually an employee. When this happens, Form 8919 will be used beginning for tax year 2007 by
workers who performed services for an employer but the employer did not withhold the worker’s share of
social security and Medicare taxes.
In addition, the worker must meet one of several criteria indicating they were an employee while
performing the services. The criteria include:
a. The worker has filed Form SS-8, Determination of Worker Status for Purposes of Federal
Employment Taxes and Income Tax Withholding, and received a determination letter from the
IRS stating they are an employee of the firm.
b. The worker has been designated as a section 530 employee by their employer or by the IRS prior
to January 1, 1997.
c. The worker has received other correspondence from the IRS that states they are an employee.
d. The worker was previously treated as an employee by the firm and they are performing services
in a similar capacity and under similar direction and control.
e. The worker’s co-workers are performing similar services under similar direction and control and
are treated as employees.
f. The worker’s co-workers are performing similar services under similar direction and control and
filed Form SS-8 for the firm and received a determination that they were employees.
g. The worker has filed Form SS-8 with the IRS and has not yet received a reply.
By using Form 8919, the worker’s social security and Medicare taxes will be credited to their social
security record. To facilitate this process, the IRS will electronically share Form 8919 data with the Social
Security Administration.
In the past, misclassified workers often used Form 4137 to report their share of social security and
Medicare taxes. Misclassified workers should no longer use this form. Instead, Form 4137 should now
only be used by tipped employees to report social security and Medicare taxes on allocated tips and tips
not reported to their employers.
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IR-2007-203, Dec. 20, 2007.
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5. The Voluntary Classification Settlement Program (VCSP)60
The Voluntary Classification Settlement Program (VCSP) is a new optional program that provides
taxpayers with an opportunity to reclassify their workers as employees for future tax periods for
employment tax purposes with partial relief from federal employment taxes for eligible taxpayers that
agree to prospectively treat their workers (or a class or group of workers) as employees. To participate in
this new voluntary program, the taxpayer must meet certain eligibility requirements, apply to participate in
the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into
a closing agreement with the IRS.
Practice Note - Voluntary Classification Settlement Program:
The VCSP is part of a larger “Fresh Start” initiative at the IRS to help taxpayers and businesses
address their tax responsibilities by allowing employers the opportunity to get into compliance by
making a minimal payment covering past payroll tax obligations rather than waiting for an IRS
audit.
Form 8952 must be filed at least 60 days before an employer wants to begin treating certain
workers as employees. Employers accepted into the program will pay an amount effectively
equaling just over one percent of the wages paid to the reclassified workers for the past year.
No interest or penalties will be due, and the employers will not be audited on payroll taxes
related to these workers for prior years.
6. Voluntary Classification Settlement Program procedures 61
The VCSP is available for taxpayers who want to voluntarily change the prospective classification of their
workers. The program applies to taxpayers who are currently treating their workers (or a class or group of
workers) as independent contractors or other nonemployees and want to prospectively treat the workers
as employees. To be eligible, a taxpayer must62
•
Have consistently treated the workers as nonemployees,
•
Must have filed all required Forms 1099 for the workers for the previous three years,
•
The taxpayer cannot currently be under audit by the IRS,
•
The taxpayer cannot be currently under audit concerning the classification of the workers
by the Department of Labor or by a state government agency.
A taxpayer who participates in the VCSP will agree to prospectively treat the class of workers as
employees for future tax periods. In exchange, the taxpayer will pay 10 percent of the employment
tax liability that may have been due on compensation paid to the workers for the most recent tax
year, determined under the reduced rates of §3509; will not be liable for any interest and penalties on
the liability; and will not be subject to an employment tax audit with respect to the worker classification
of the workers for prior years. Additionally, a taxpayer participating in the VCSP will agree to extend the
period of limitations on assessment of employment taxes for three years for the first, second and third
calendar years beginning after the date on which the taxpayer has agreed under the VCSP closing
agreement to begin treating the workers as employees.
In addition to the application, the name of a contact or an authorized representative with a valid Power of
Attorney (Form 2848) should be provided. The IRS will contact the taxpayer or authorized representative
to complete the process once it has reviewed the application and verified the taxpayer’s eligibility. The
60
61
62
IR-2011-95, Sept. 21, 2011.
Announcement 2011-64, September 21, 2011.
A taxpayer who was previously audited by the IRS or the Department of Labor concerning the classification of the workers
will only be eligible if the taxpayer has complied with the results of that audit.
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IRS retains discretion whether to accept a taxpayer’s application for the VCSP. Taxpayers whose
application has been accepted will enter into a closing agreement with the IRS to finalize the terms of the
VCSP and will simultaneously make full and complete payment of any amount due under the closing
agreement.
Under the VCSP, the taxpayer then pays 10% of the amount calculated under §3509(a).
Example:
In 2012 employer paid $1,500,000 to workers that are the subject of the VCSP.
All of the workers that are the subject of the VCSP were compensated at or
below the Social Security wage base (e.g., under $110,100 for 2012). Employer
submits the VCSP application on October 1, 2013 and Employer wants the
beginning date of the quarter for which Employer wants to treat the class or
classes of workers as employees to be 1/01/2014. Employer looks to amounts
paid to the workers in 2012 for purposes of calculating the VCSP amount, since
2012 is the most recently completed tax year at the time the application is being
filed. Under §3509(a), the employment taxes applicable to $1,500,000 would be
$154,200 (10.28% of $1,500,000).63
Under the VCSP, the payment would be 10% of $154,200, or $15,420, without
interest or penalty.
Practice Note – Do not send payment with Form 8952:
The payment is submitted later with the signed closing agreement. Submitting payment with Form
8952 may cause a processing delay.
7. All workers not required to be reclassified under VCSP
The VCSP permits taxpayers to reclassify some or all of their workers. However, once a taxpayer
chooses to reclassify some of its workers as employees, all workers in the same class as those workers
must be treated as employees for employment tax purposes.
Example:
Duck Empire is a construction firm that currently contracts with its drywall
installers, electricians, and plumbers to perform services at housing construction
sites. Duck determines it wants to voluntarily reclassify its drywall installers as
employees, and submits an application. Duck’s application is accepted into the
VCSP and enters into a closing agreement with the IRS to reclassify its drywall
installers as employees for future periods.
Once the VCSP closing agreement is executed, Duck Empire must treat all
drywall installers as employees for employment tax purposes.
8. Current developments with Form I-9
Employers have certain responsibilities under immigration law during the hiring process, including:
• Verification of the identity and employment authorization of each person hired after November 6,
1986; and
• Completion and retention of a Form I-9 for each employee required to complete the form.
The U.S. Citizenship and Immigration Services (USCIS) has revised the Employment Eligibility
Verification Form I-9. All employers are required to complete the revised Form I-9 for each employee
hired in the United States beginning in May 2013.
Applicable percentage equal to the sum of 1.5% FWT, 0.84% employee SS tax, 6.2% employer SS tax, 0.29% employee
Medicare tax, 1.45% employer Medicare tax.
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Penalties for hiring or continuing to employ a person, or recruiting or referring for a fee, knowing that the
person is not authorized to work in the United States range from a minimum of $375 to a maximum of
$3,200 per worker for a first offense. Subsequent offenses result in much larger penalties.
Although voluntary for most businesses, the E-Verify system is an Internet-based system that compares
information from an employee’s Form I-9, Employment Eligibility Verification, to data from U.S.
Department of Homeland Security and Social Security Administration records to confirm employment
eligibility. E-Verify is the only free, fast, online service of its kind that verifies employees’ data against
millions of government records and provides results within as little as three to five seconds.
On February 24, 2014, a new Interactive Voice Response (IVR) system was added to the E-Verify
Customer Support service. The system is designed to expedite access to E-Verify, Form I-9, and Self
Check information. Callers will use their voice or touch tone phone to navigate to automated answers or a
customer services representative.
Practice Note -- Live E-Verify assistance:
E-Verify Customer Support offers FREE live assistance Monday through Friday from 8:00 a.m.
EST to 5:00 p.m. local time, except on federal holidays. Employers call 888-464-4218 and
employees call 888-897-7781.
Officials from the Department of Homeland Security, employees from the Office of Special Counsel for
Immigration-Related Unfair Employment Practices at the Department of Justice (DOJ), and employees
from the Department of Labor (DOL) may inspect an employer’s Forms I-9. Employers will generally
receive a written Notice of Inspection at least three days before the inspection. These officials will inform
the owner, designee, senior management official, or registered agent of the business entity of an
inspection in person or by certified U.S. mail, return receipt requested. Officials may also use subpoenas
and warrants to obtain the forms without providing three days’ notice.
When officials arrive to inspect an employer’s Forms I-9, the employer must:
• Retrieve and reproduce electronically stored Forms I-9 and any other documents the officer
requests.
• Provide the officer with the necessary hardware and software to inspect electronic documents.
• Provide the officer with any existing electronic summary of the information recorded on the
employer’s Forms I-9.
Employers who refuse or delay an inspection will be in violation of the law. Penalties for failure to comply
with Form I-9 requirements range from $110 to $1,100 per form.
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B. Form 2848 - Power of attorney issues (#16)
1. 2012 revisions
Shortly after issuance of an October 2011 revision, a newer version of Form 2848, Power of Attorney and
Declaration of Representative, was released in March 2012. Beginning March 1, 2012 the IRS’s three
Centralized Authorization File (CAF) processing sites stopped processing all powers of attorney that are
not submitted on either the October 2011 or March 2012 versions.
2. Separate Form 2848 for joint returns
The Form 2848 instructions state spouses or former spouses who filed a joint return must submit
separate Forms 2848 even if authorizing the same representative(s) to represent them. This does not
mean that one spouse cannot grant authority for a representative to act on their behalf for all tax related
issues specified on the Form 2848 regarding their taxpayer identification number.
It is not necessary for both spouses to have a POA on file with the same representative or that
representative to have authority to act on behalf of one spouse only.
Practice Note: Powers of Attorney for LLCs
It is often difficult for the business and/or the practitioner to know who should sign the POA since
different types of person(s) can sign a POA for an LLC depending on its election to be a
corporation, partnership, or disregarded entity. Guidance on who in an LLC should sign a POA
can be found on IRS.gov (http://www.irs.gov/uac/Powers-of-Attorney-for-LLCs).
3. Revocation or withdrawal of power of attorney upon dismissal of clients
Many professional offices are quite familiar with the reasoning and process of obtaining Power of
Attorney. However offices may be lax in withdrawal of a Power of Attorney upon the dismissal of a
client.
To revoke an existing power of attorney without naming a new representative, or if a representative wants
to withdraw from representation, mail or fax a copy of the previously executed power of attorney to the
IRS, or if the power of attorney is for a specific matter, to the IRS office handling the matter.
If the representative is withdrawing from the representation, the representative must write
“WITHDRAW” across the top of the first page with a current signature and date below this annotation. If
the taxpayer is revoking the power of attorney, the taxpayer must write “REVOKE” across the top of the
first page with a current signature and date below this annotation.
If a copy of the power of attorney to be revoked or withdrawn is not available, send a statement to the
IRS. The statement of revocation or withdrawal must indicate that the authority of the power of attorney is
revoked or withdrawn, list the matters and periods, and must be signed and dated by the taxpayer or
representative as applicable. If the taxpayer is revoking, list the name and address of each recognized
representative whose authority is revoked. When the taxpayer is completely revoking authority, the form
should state “remove all years/periods” instead of listing the specific tax matter, years, or periods. If the
representative is withdrawing, list the name, TIN, and address (if known) of the taxpayer.
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To revoke a specific use power of attorney, send the power of attorney or statement of revocation to the
IRS office handling the case, using the above instructions.
Under certain circumstances, a student who is supervised by a practitioner may request permission to
represent another person before the IRS. A power of attorney held by a student will be recorded on the
CAF system for 130 days from the receipt date. If a taxpayer is authorizing a student to represent them
after that time, they will need to submit a current and valid Form 2848.
Practice Note: Disengagement letters
Withdrawal of Power of Attorney is a prudent practice for practitioners who disengage clients;
however, it is only one step in the severing process.
Surgent offers several business letters that practitioners may find a valuable reference in drafting
their engagement letters, disengagement letters, and disclosure letters. Products annually
updated for each tax season include the following:
• Individual Tax Engagement Letter and Client Questionnaire;
• Business Tax Engagement Letter and Client Questionnaire;
• Engagement Letters for Estates and Trusts: Forms 706 and Form 1041; and
• Disengagement Letters.
Visit www.cpenow.com for more details.
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C. Failing in advance to protect taxpayers from increased 1099 penalties (#17)
1. Updated Publication 1586 – Reasonable Cause Regulations
In 2011, two new questions were added to both Schedule C and Schedule E. In the first question,
taxpayers must answer “yes” or “no” if the corporation made any payments that would require it to file
Form(s) 1099. The follow-up question queries, if the taxpayer made such payments, were the Forms
1099 actually filed?
New Question Practice Note:
One would assume answering the first question as “yes” and the second question as “no” would
not be an advised practice.
IRC §6721 imposes up to $100 ($250 for intentional disregard) penalty for information returns after
January 1, 2011 for each of the following infractions related to information returns:
• Filed with a missing/incorrect taxpayer identification number (TIN);
• Filed untimely;
• Filed on incorrect media;
• Filed in an incorrect format; or
• Any combination of the above.
If a taxpayer fails to file a correct information return by the due date and cannot show reasonable cause,
a penalty may be assessed.64
The amount of the penalty is based on when the taxpayer files the correct information return. The penalty
is:65
• $30 per information return if correctly filed within 30 days (by March 30 if the due date is February
28); maximum penalty $250,000 per year ($75,000 for small businesses);
• $60 per information return if correctly filed more than 30 days after the due date but by August 1;
maximum penalty $500,000 per year ($200,000 for small businesses); or
• $100 per information return if filed after August 1 or not filed; maximum penalty $1,500,000 per
year ($500,000 for small businesses).
Small business amounts apply if the average annual gross receipts for the three most recent tax years (or
for the period in existence, if shorter) ending before the calendar year in which the information returns
were due are $5 million or less.
Other information returns include the following:
• Form 1042S, Foreign Person’s U.S. Source Income Subject to Withholding.
• Form 3921, Exercise of an Incentive Stock Option Under Section 422(b).
• Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under
Section 423(c).
• Form 1099 K, Merchant Card and Third-Party Payments.
64
65
I.R.C. §6721.
If the failure is due to intentional disregard of the filing requirement (or the correct information reporting requirement), the
penalty may be increased.
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2. Final regulations on reporting health care coverage 66
The IRS has issued final regulations that provide general and alternative reporting methods designed to
simplify and reduce the cost of reporting for employers subject to the information reporting requirements
under §6056 (generally, employers with at least 50 full-time employees, including full-time equivalent
employees). Under §6056, employers are required to report to IRS information on the health care
coverage (if any) offered to full-time employees and such information to their employees. The information
is utilized so the IRS may administer the §4980H – “Employer shared responsibility provisions” and allows
their employees determine any premium tax credit under a §36B they may claim on their personal income
tax returns.
For years beginning after 2013, §6055(a) requires every health insurance issuer, sponsor of a selfinsured health plan, government agency that administers government-sponsored health insurance
programs, and other entity that provides minimum essential coverage to file annual returns reporting
information for each individual for whom minimum essential coverage is provided.
Practice Note:
If health insurance coverage is provided by a health insurance issuer and consists of coverage
provided through a group health plan of an employer, it is anticipated that the regulations would
make the health insurance issuer responsible for the reporting.
In addition, also effective for years beginning after 2013, §6056 directs every applicable large
employer that is required to meet the shared employer responsibility requirements during a calendar year
to file a return with the Service that reports the terms and conditions of the health care coverage provided
to the employer’s full-time employees for the year. Section 6056(b) generally provides that the return
used to satisfy the requirements under §6056 must:
• Include the name and Employer Identification Number (EIN) of the applicable large employer;
• Include the date the return is filed;
• Certify whether the applicable large employer offers its full-time employees (and their
dependents) the opportunity to enroll in minimum essential coverage under an eligible employersponsored plan67 and, if so, certify:
1. The duration of any waiting period68 with respect to such coverage,
2. The months during the calendar year when coverage under the plan was available,
3. The monthly premium for the lowest cost option in each enrollment category under the plan,
and
4. The employer’s share of the total allowed costs of benefits provided under the plan.
• Report the number of full-time employees for each month of the calendar year;
• Report, for each full-time employee, the name, address, and taxpayer identification number (TIN)
of the employee and the months (if any) during which the full-time employee (or any dependents)
were covered under the eligible employer-sponsored plan; and
• Include such other information as may be required by the Secretary of the Treasury.
Section 6056(c) provides that, no later than January 31 the applicable large employer will furnish to
each full-time employee whose information is required to be reported to the Service under §6056(b) a
written statement that includes:
66
67
68
T.D. 9661, 03/05/2014, Treas. Regs. §§301.6056-1 and -2.
As defined in §5000A(f)(2).
As defined in §6056(b)(2)(C).
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•
•
•
The applicable large employer’s name and address;
The applicable large employer’s contact information (including a contact phone number); and
The information relating to coverage provided to that employee (and dependents) that is required
to be reported on the §6056 return.
3. Front-end advisory required to meet the Reasonable Cause Regulations
IRS Publication 1586, Reasonable Cause Regulations & Requirements for Missing and Incorrect
Name/TINs, was revised in April 2012. Practitioners should review the publication for information needed
to avoid penalties for information returns filed with missing or incorrect taxpayer identification numbers
(TINs). The publication also describes how to request a TIN, and explains the requirements for
establishing reasonable cause.
To support the showing that the failure was due to reasonable cause and not willful neglect, filers must
establish that they acted in a responsible manner both before and after the failure occurred, and
that:
• There were significant mitigating factors; or
• The failure was due to events beyond the filer’s control.
Acting in a responsible manner before the failure occurs includes making an initial solicitation (request)
for the payee’s name and TIN and, if required, an annual solicitation. Taxpayers will first receive Notice
972CG - proposing the penalty. A reasonable cause answer must be filed within 45 days or
assessment of the full amount of the proposed penalty and a balance due notice will occur.
VIII. Practitioner practice points
A. Practitioners Priority Service (#18)
1. Conduit between taxpayers and the IRS
The Practitioner Priority Service (PPS) is a professional support line (1-866-860-4259) staffed by IRS
customer service representatives specially trained to handle practitioners’ accounts questions. PPS is
available to all tax professionals with valid third-party authorizations, i.e., Forms 2848, 8821, and/or 8655.
The Practitioner Priority Service (PPS) may be a first point of contact for account-related issues. PPS
service hours are weekdays:
• 7:00 a.m. to 7:00 p.m. local time (Alaska and Hawaii follow Pacific time).
• 8:00 a.m. to 8:00 p.m. local time for Puerto Rico.
Depending on a response to the initial prompt, a call is routed to one of five PPS locations and routing is
based on an evaluation of the lowest expected wait time.
• Questions regarding client's individual tax accounts (IMF) are handled by one of three campus
sites: Brookhaven, NY; Memphis, TN; and Philadelphia, PA.
• Questions regarding client’s business accounts (BMF) are handled by two campus sites:
Cincinnati, OH and Ogden, UT.
Services provided by PPS assistors are:
• Locating and applying payments.
• Resolving taxpayer account problems on active accounts.
• Explaining IRS communications (i.e., notices and letters).
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•
•
•
Providing general procedural guidance and timeframes.
Providing one of the self-help methods to obtain forms and publications.
Providing transcripts of taxpayer accounts (including income verification), when the tax
professional is calling in regards to an account related issue.
2. 2014 changes to Practitioner Priority Services
Over the past few years, a growing number of customers who were not tax professionals used this
service. Effective January 6, 2014, the IRS will limit Practitioner Priority Service to responding only to
requests from tax professionals who are actively working with their clients to resolve tax account issues.
Allowable tax professionals include Circular 230 Representatives, Registered/Unenrolled Return
Preparers with Forms 2848 or 8821, or Reporting Agents with a Form 8655. PPS will no longer be able
to respond to account information requests from tax practitioners or other third parties for non-tax matters,
such as transcript requests for monitoring client financial history, made via live telephone applications.
Issues outside the scope of the PPS employees’ authority are transferred or referred to the appropriate
IRS functions such as:
• Tax Law questions.
• Accounts assigned to Automated Collection Services (ACS) or Automated Under Reporter (AUR).
• Accounts assigned to a Revenue Officer or Revenue Agent.
If the PPS assistor cannot transfer the call, the assistor will provide the caller with the appropriate contact
telephone number.
Practice Note -- “Get Transcript”:
Early in 2014, a new online request option called “Get Transcript” on IRS.gov will allow individual
taxpayers with an SSN to instantly view and print a copy of their tax transcripts. With Get
Transcript, taxpayers will save both time and effort. Transcript requests will generally be referred
to the online tool. Taxpayers will be able to use the tool to authenticate, view, and print copies of
their transcript in one session. Taxpayers will still also be able to request that a transcript be
mailed to their address of record by using the existing online tool or sending in Form 4506T. The
tool will be available for five types of transcripts: tax account, tax return, record of account, wage
and income, and verification of non-filing.
However, the IRS has stopped processing transcript requests through the Transcript Delivery
System (TDS) if an Identity Theft Indicator is on the taxpayer’s account. As described by the
agency, under the new procedure, a taxpayer will receive a notice regarding any request for a
transcript and instruct the taxpayer to contact the Identity Protection Specialized Unit at 1-800908-4490. “Once proper authentication has been performed, the IRS will issue a transcript
directly to the taxpayer,” the IRS said.
B. Protecting Seasoned Return Preparers Identity (#19)
1. Identity Theft
In 2013, identity theft has repeated as leader of the Dirty Dozen list. Identity theft occurs when someone
uses personal information, Social Security Number (SSN), or other identifying information, without
permission, to commit fraud or other crimes. In many cases, an identity thief uses a legitimate taxpayer’s
identity to fraudulently file a tax return and claim a refund.
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2. Form 14039, Identity Theft Affidavit -- two reasons to file
To assist in combating identity theft and refund fraud, the IRS has introduced Form 14039, Identity Theft
Affidavit. Filers will be issued an identity protection personal identification number (IP PIN) to be included
near the signature line of Form 1040. The IP PIN is good for only one year and a new one will be
issued as long as the identity theft indicator is on the tax account.
Form 14039 is filed by an individual falling into two possible scenarios. First, Section A, Checkbox 1
should be checked by a victim of identity theft whose tax records are affected. Check this box if, for
example, if a taxpayers attempt to file electronically was rejected because someone had already filed
using the Social Security Number (SSN), ITIN, or the individual received a notice or correspondence from
the IRS indicating someone was otherwise using their number.
The second group of Form 14039 filers (Section A, Checkbox 2) are individuals who have experienced
an event which may affect tax records in the future, such as the misuse of personal identity
information to obtain credit. This second category is utilized if personal information is breeched so that it
could result in identity theft. Examples include a lost/stolen purse or wallet, home robbery, etc.
3. Identity Theft Affidavit for seasoned preparers
The PTIN was created in 1999 to protect the privacy of tax return preparers. Prior to the implementation
of the PTIN, preparers were required to include their Social Security Numbers on all returns they filed. An
example from 1998 follows:
Beginning in 1999, the IRS gave preparers the option of using either their SSNs or PTINs, which has
evolved to fully eliminate the Social Security Number requirement.
Therefore, preparers signing returns prior to the PTIN introduction have released their personal
Social Security Number hundreds if not thousands of times. Such individuals may desire to file Form
14039. An example for a practitioner signing returns (and listing SSN) beginning in 1982 until receipt of a
PTIN follows:
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4. Combating identity theft and refund fraud
The IRS has taken special steps to assist victims. For the 2013 tax season, the IRS has put in place a
number of additional steps to prevent identity theft and detect refund fraud before it occurs. The IRS has
a comprehensive and aggressive identity theft strategy employing a three-pronged effort focusing on
fraud prevention, early detection, and victim assistance. During 2012, the IRS prevented the issuance of
$20 billion of fraudulent refunds, including those related to identity theft, compared with $14 billion in
2011.
The IRS has a special section on IRS.gov dedicated to identity theft issues, including YouTube videos,
tips for taxpayers, and an assistance guide. For victims, the information includes how to contact the IRS
Identity Protection Specialized Unit. For other taxpayers, there are tips on how taxpayers can protect
themselves against identity theft.
5. Law Enforcement Assistance Program expands nationally
As part of its comprehensive identity theft strategy, the IRS is expanding the law enforcement assistance
program designed to help law enforcement obtain tax return data vital to their local efforts in investigating
and prosecuting specific cases of identity theft. The expansion from nine states now covers all 50 states
as well as the District of Columbia and went into effect March 29, 2013. 69
The IRS has seen continued progress on several areas involving identity theft, including resolution of
more victim cases and continued emphasis on criminal investigations. Since the start of 2013, the IRS
has worked with victims to resolve and close more than 200,000 cases. This is in addition to the
69
The initial pilot program commenced in Florida in April of 2012, was expanded to Alabama, California, Georgia, New
Jersey, New York, Oklahoma, Pennsylvania, and Texas later in 2012.
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expanded Identity Protection PIN (IP PIN) pilot, an initiative to protect victims with previously confirmed
cases of identity theft by creating an additional layer of security on these accounts. The IRS issued more
than 770,000 IP PINs to identity theft victims at the start of the 2013 tax filing season. Since October
2012, there have been more than 670 criminal identity theft investigations opened. The criminals being
sentenced are spending an average of four years in custody with sentences as long as 20 years.
Under the Law Enforcement Assistance program, state and local law enforcement officials with evidence
of identity theft involving fraudulently filed federal tax returns will be able to have identity theft victims
complete a special IRS disclosure form. Taxpayers must give their permission for the IRS to provide law
enforcement with the returns submitted using their Social Security Number. Law enforcement officials will
need to contact the identity theft victims in order to request and secure the victims’ consent for disclosure
of the records. In certain instances, the IRS will assist law enforcement in locating taxpayers and soliciting
their consent.
Law enforcement would then submit a disclosure authorization form, which the IRS created solely for use
by victims of identity theft for this program, to the Criminal Investigation (CI) Division of the IRS, along
with a copy of the police report and the IRS Identity Theft Affidavit if available. It is important that
identity theft victims still submit the original copy of the IRS Identity Theft Affidavit to the IRS according
to the instructions on the back of the form that fit their specific circumstances.
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IX. Retirement issues
Retirement planners frequently state a secure retirement income rests on the three primary sources hence the concept of the three legged stool. If any one of the three “legs” of the stool is missing it
makes it very uncomfortable to sit down for long. The three primary sources of income for retirement
are:
• Social Security Benefits;
• Personal Savings and Investments; and
• Company Retirement Benefits
A multitude of financial planning bloopers may unquestionably affect each leg of the stool. Some
items are not in an individual’s control, such as the stability of the social security system, or absence of a
company retirement plan. The following topics detail a few of the trends or items that may be within an
individual’s control and an update on maximizing retirement benefits.
A. Social Security issues (#20)
Note: 2014 Social Security Benefits
For 2014 the Maximum Social Security benefit for a worker retiring at Full Retirement Age (FRA)
is $2,642 per month.
The 2014 estimated average monthly Social Security benefits for all retired workers is $1,294,
and $2,111 for a couple with each receiving benefits.
Practice Note: Annual Statements no longer mailed to all workers
In February 2012, Social Security resumed mailing paper Statements to workers age 60 and
older if they are not already receiving Social Security benefits. However, In light of the current
budget situation, the “Request a Social Security Statement” service has been suspended.
Since statements may be in an “on again-off again” phase, practitioners planning with clients
seeking the statement must have the client request an online version of the Social Security
Statement, available at www.socialsecurity.gov. The online Statement provides eligible workers
with access to their Social Security earnings and benefit information. Practitioners may find the
online “Retirement Estimator” a useful tool in Social Security planning.
1. The Moment of Truth70 - The Deficit Reduction Commission Report
In order to control costs, the Commission proposes gradually moving to a more progressive benefit
formula that slows future benefit growth, particularly for higher earners. Currently, initial benefits are
calculated using a progressive three-bracket formula that offers individuals 90 percent of their first $9,000
of (wage-indexed) average lifetime income, 32 percent of their next $55,000, and 15 percent of their
remaining income, up to the taxable maximum. The Commission recommends gradually transitioning to a
four-bracket formula by breaking the middle bracket in two at the median income level ($38,000 in 2010,
$63,000 in 2050), and then gradually changing the replacement rates from 90 percent, 32 percent, and 15
percent to 90 percent, 30 percent, 10 percent, and 5 percent. This benefit formula change proposal is to
be phased in very slowly, beginning in 2017 and not fully phasing in until 2050. Because all bend point
70
“The Moment of Truth” is the subtitle of the Report of the National Commission on Fiscal Responsibility and Reform;
December 2010.
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factors will continue to be wage-indexed, future beneficiaries will continue to have inflation-adjusted
benefits larger than those received by equivalent beneficiaries today.
2. Enhanced Minimum Benefit for low-wage workers
The Commission believes Social Security reform must ensure that the program can continue to meet its
basic mission: to prevent people who can no longer work from falling into poverty. The Commission
recommends creating a new special minimum benefit which provides full-career (30-year) minimum wage
workers with a benefit equivalent to 125 percent of the poverty line in 2017 and wage-indexed thereafter.
The minimum benefit would phase down proportionally for workers with less than 30 but more than 10
years of earnings.
3. Enhanced Benefits for the very old and the long-time disabled
The oldest old population – those over age 85 – is projected to expand rapidly over the coming decades:
from 5.8 million this year to 19 million in 2050. To better insure against the risk of outliving one’s own
retirement resources, the Commission proposes a new “20-year benefit bump-up” that offers a benefit
enhancement, equal to five percent of the average benefit, 20 years after eligibility. The enhancement is
phased in over five years (one percent per year). Eligibility is defined by the earliest eligibility age (EEA)
for retirees and the determination of disability for disabled workers.
4. Gradually increase early and full retirement ages, based on increases in life expectancy
To account for increasing life expectancy, the Commission recommends indexing the retirement age to
gains in longevity. The effect of this is roughly equivalent to adjusting the retirement ages by one month
every two years after the NRA reaches age 67 under current law. At this pace, the NRA would reach 68
in about 2050, and 69 in about 2075; the Early Eligibility Age (EEA) would increase to 63 and 64 in step.
This approach would also maintain a constant ratio of years in retirement to years in adulthood; as life
expectancy grows by one year, individuals will still be able to spend an additional four months in
retirement, as compared to today.
5. Give retirees more flexibility in claiming benefits and create a hardship exemption for those
who cannot work beyond 62
As workers approach retirement, they are faced with varying needs, and different retirement patterns
make sense for different workers and their families. In recognition of these diverse experiences, the
Commission’s proposal introduces significant new flexibilities and protections in addition to an indexed
retirement age.
First, the Commission proposes allowing beneficiaries to collect up to half of their benefits as early as age
62, with applicable actuarial reduction, and the other half at a later age (therefore incurring a smaller
actuarial reduction). This increased flexibility should provide for a smoother transition for those interested
in phased retirement, or for households where one member has retired and another continues to work.
Second, the Commission proposes a hardship exemption for those who may not qualify for disability
benefits, but are physically unable to work beyond the current EEA. A recent RAND analysis reported
that 19 percent of early retirees claimed a work-limiting health condition that would have limited their
ability to continue in the paid labor force. To protect this population, the Commission proposal sets aside
adequate resources to fund a hardship exemption for up to 20 percent of retirees. This exemption would
allow beneficiaries to continue to claim benefits at age 62 as the EEA and NRA increase, and hold them
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harmless from additional actuarial reduction resulting from increased NRA. The Commission is charging
the Social Security Administration with designing a policy over the next ten years that best targets the
population for whom an increased EEA poses a real hardship, and considering relevant factors such as
the physical demands of labor and lifetime earnings in developing eligibility criteria.
At the same time, the Commission recommends eliminating a provision that allows retirees who claim
benefits early to withdraw a benefit application and return benefits received – even years after claiming –
without paying interest or inflation, before reapplying for benefits at a later age and with a smaller
actuarial reduction. This loophole is in effect an interest-free loan for wealthier retirees able to take
advantage of it.
6. Gradually increase the taxable maximum to cover 90 percent of wages by 2050
As recently as the early 1980s, the Social Security payroll tax covered 90 percent of wages (in other
words, nine of every ten dollars in wages were subject to the payroll tax). Since then, however, the
taxable maximum wage cap (currently $106,800) has not grown as fast as wages above the cap; as a
result, less than 86 percent of wages were subject to the payroll tax in 2009, and less than 83 percent will
be subject to the tax by 2020. The Commission proposes to gradually increase the taxable maximum so
that it covers 90 percent of wages by 2050. This recommendation would result in a taxable maximum of
about $190,000 in 2020, versus approximately $168,000 in current law. The proposal will also de-link
increases in the taxable maximum from increases in the Cost of Living Adjustment (COLA), allowing the
taxable maximum to increase even in zero-COLA years.
7. Miscellaneous other recommendations
•
Adopt improved measure of CPI. Use the chained CPI, a more accurate measure of inflation,
to calculate the Cost of Living Adjustment for Social Security beneficiaries. This item is given
more emphasis as it is included in President Obama’s 2014 proposed budget (however it
has been removed from the 2015 proposed budget?). It has previously been included in
House Congressional Budgets.
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Hot topic: Chain Weighted CPI
Nearly 10 years ago, the Bureau of Labor Statistics introduced chained CPI as a calculation to
include the adjustment of consumers substituting less expensive items as products or services
become more expensive. The chain weighted CPI; therefore, incorporates changes in both the
quantities and prices of products.
For example, suppose in the course of a year an individual spends $312 on snacks, purchasing
52 chocolate candy bars at a cost of $2 per bar and 52 bags of potato chips at a cost of $4 per
bag. Further assume the price of a chocolate bar increases 25 percent to $2.50 per bar, and the
price of potato chips increase by 5 percent to $4.20 per bag.
Standard CPI calculations would indicate an inflation rate of 11.67 percent:
[(52 x $2.50) + (52 x $4.20)] / [(52 x $2) + (52 x $4)] = 1.1167.
However, if the consumer changes his or her snack mix due to the price inflation to 50
chocolate bars and 48 bags of chips for the year, the chain weighted CPI calculations would
indicate inflation of only 4.68 percent:
[(50 x $2.50) + (48 x $4.20)] / [(52 x $2) + (52 x $4)] = 1.0468.
Reading between the lines, in a world of “fixed income” the consumer may switch to a generic
brand candy bar or a smaller size bag of chips and continue to spend the exact same dollar
amount. Suppose in this case the consumer chooses to adjust consumption to 24 candy bars
and 60 bags of chips; therefore, spending a fixed $312 each year. The chained index would
calculate 0 percent inflation, even though we all know prices have increased:
[(24 x $2.50) + (60 x $4.20)] / [(52 x $2) + (52 x $4)] = 1.0.
Obviously, given the number of products in the mix and the breadth of the calculation, many feel
the chained CPI is a better indication of true inflation. Others disagree.
•
•
•
Cover newly hired state and local workers after 2020. Mandate that all newly hired state and
local workers be covered under Social Security, and require state and local pension plans to
share data with Social Security.
Direct SSA to better inform future beneficiaries on retirement options. Direct the Social
Security Administration to improve information on retirement choices, better inform future
beneficiaries on the financial implications of early retirement, and promote greater retirement
savings.
Begin a broad dialogue on the importance of personal retirement savings.
8. House Ways and Means Committee -- Proposed Tax Reform Act of 2014
In an early salvo, the House Ways and Means Committee announced a proposed 2014 major tax bill.
Specifically, Section 1502 of the proposed bill addresses the determination of net earnings from selfemployment. The provision reads as follows:
Under the provision, the SECA tax would be clarified to apply to general and limited partners of a
partnership (including limited liability companies) as well as to shareholders of an S corporation to the
extent of their distributive share of the entity’s income or loss (subject to the exclusions for certain
types of income described above under current law).
In determining net earnings from self-employment, partners and S corporation shareholders would be
allowed a new deduction designed to approximate the return on invested capital. The effect of the
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deduction would be that partners and S corporation shareholders who materially participate in the
trade or business of the partnership or S corporation would treat 70 percent of their combined
compensation and distributive share of the entity’s income as net earnings from self-employment (and
thus subject to FICA or SECA, as applicable) and the remaining 30 percent as earnings on invested
capital not subject to SECA.
For partners and S corporation shareholders who do not materially participate in the trade or business
(i.e., passive investors), the effect of the deduction would be that no amount would be treated as net
earnings from self-employment.
B. Determining when it is best to claim your Social Security
1. Reduced retirement benefits commencing at age 62
Bill is age 62, healthy, and does not like the word “retired.” Rather, he claims he has recently moved
to life in the “slow-lane.” His former hobby has just become his next vocation, which generates about
$1,000/month net income. He has a significant personal portfolio, two homes, and a large retirement
account balance. Bill calls you to inquire about claiming Social Security. Many individuals are
reluctant to pass up the opportunity to collect a monthly cash payment from Social Security rather than
dip into their nest-egg. The first question from Bill is, “Should I begin now?” The second question is,
“If not now, WHEN?”
a. Deciding when to retire from a financial perspective is a question of whether one is better off
making 75 percent of the primary insurance amount (PIA) at 62 or waiting to get 100 percent
at age 66 (for those reaching full retirement in 2012). Generally, the future value of full
retirement payments commencing at age 66 will not equal the future value of reduced
retirement benefits commencing at age 62 until many years in the future.
Full Retirement and Age 62 Benefit By Year of Birth
Year of Birth
Full (normal)
Retirement Age
1937 or earlier
1938
1939
1940
1941
1942
1943-1954
1955
1956
1957
1958
1959
1960 and later
65
65 and 2 months
65 and 4 months
65 and 6 months
65 and 8 months
65 and 10 months
66
66 and 2 months
66 and 4 months
66 and 6 months
66 and 8 months
66 and 10 months
67
Age 62
Reduction
Months
36
38
40
42
44
46
48
50
52
54
56
58
60
Total %
Reduction
20.00
20.83
21.67
22.50
23.33
24.17
25.00
25.83
26.67
27.50
28.33
29.17
30.00
84
A $1000 retirement
benefit would be
reduced to
$800
$791
$783
$775
$766
$758
$750
$741
$733
$725
$716
$708
$700
Total %
Reduction
(spouse3.)
25.00
25.83
26.67
27.50
28.33
29.17
30.00
30.83
31.67
32.50
33.33
34.17
35.00
Spouse's $500
benefit would
be reduced to
$375
$370
$366
$362
$358
$354
$350
$345
$341
$337
$333
$329
$325
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2. Delayed retirement
Chart of Delayed Retirement Credit Rates
If you reached full retirement
age...
Prior to 1982
1982-1989
1990-1991
1992-1993
1994-1995
1996-1997
1998-1999
2000-2001
2002-2003
2004-2005
2006-2007
2008 or later
Then your monthly percentage
is...and
1/12 of 1%
1/4 of 1%
7/24 of 1%
1/3 of 1%
3/8 of 1%
5/12 of 1%
11/24 of 1%
1/2 of 1%
13/24 of 1%
7/12 of 1%
5/8 of 1%
2/3 of 1%
Your yearly percentage
is...
1%
3%
3.5%
4%
4.5%
5%
5.5%
6%
6.5%
7%
7.5%
8%
3. When to retire?
a. Example: based upon 2014 retirement at age 66 years.
Assume a client has been subject to the maximum Social Security tax since the 1950s, and
the primary insurance amount is $2,150 per month or $25,800 annually; the reduced PIA for
early retirement is $1,612.50 ($2,150 x 0.75) per month, or $19,350 annually.
It takes the normal retiree about 16 years to catch up in total benefits paid—the higher the
compounding rate, the longer the catch-up period; the lower the compounding rate, the shorter
the catch-up period.
b. From an actuarial viewpoint, assuming everyone lives to the 22.5-year average life
expectancy of a 62-year-old, it seems that retirement that begins at 66 years with full benefits
has an advantage. Individuals in poor health or those able to produce after-tax returns higher
than five percent may be better off opting for benefits at 62.
c. If returns are less than five percent, the present value will be reduced and one may be better
off working to age 66.
4. 2014 Earnings limits
a.
May Earn up to :
If in Excess,
the amount withheld
Younger than
Full Retirement Age
$15,480/year
($1,290/month)
$1 for every $2 over the
annual limit
The year reaching Full
Retirement Age
$41,400/year
($3,340/month)
$1 for every $3 over the
annual limit
Once reaching the month of
Full Retirement Age
No limit
No limit
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C. Failure to consider delayed retirement
1. Normal or delayed
a. As the preceding has indicated, a participant (and a spouse) may choose to take Social
Security benefits along a continuum stretching from age 62 to age 70. Baby boomers are soon
approaching the lower bound of this range and are faced, in many cases with an election that
should be the result of an assessment of needs and a financial assessment.
Planning point: Retirement Estimator – useful tool
Social Security has an online calculator that provides immediate retirement benefit estimates to
help in retirement planning. The online Retirement Estimator may be a usable tool for
practitioners in client planning, as it allows “what if” scenarios, changing “stop work” dates and/or
expected future earnings to create and compare different retirement options.
2. Evaluation of the choice
a. It is important in this (as well as the early versus normal retirement decision) to take into
account the investment profile of the client because the after-tax yield of the Social Security
benefits received bears on the net present value of the benefits from the starting date for the rest
of the client’s life. In deciding when to start taking Social Security benefits, the anticipated
investment returns on the after-tax Social Security benefits that will be invested and the
nature of the taxation of the annual earnings from those investments must be considered. In
general, because of the higher yield on capital gains and dividends the greater the value of the
earlier years and thus the “break-even” lifetime for later starting Social Security. A computer
model is necessary to take into account actuarial factors and different investment performance.
3. An approximation, based upon taxpayer born in 1950 71
The Journal of Accountancy, January 2009 issue included the following chart depicting the monthly and
annual benefit for a taxpayer born in 1950.
Retirement
Age
Born 1/1/50
Monthly
Benefit
Today’s
Dollars
Monthly
Benefit
Future
Dollars
Annual
Benefit
Today’s
Dollars
Annual
Benefit
Future
Dollars
Annual
Benefit
Total @ 70
Future
Dollars
Annual
Benefit
Total @ 85
Future
Dollars
62
66
70
$1,601
$2,189
$2,969
$1,800
$2,758
$4,223
$19,212
$26,268
$35,628
$21,600
$33,096
$50,676
$27,326
$37,250
$50,676
$42,629
$58,034
$78,952
The sample boomer in this study is 59 years old and may begin receiving reduced benefits in only four
years. The chart calculates the future value of the annual benefit if the boomer continues to receive
benefits through age 85. Accountants can calculate a simple break-even, which in most studies occurs
before the average 22.5-year additional average life expectancy of a 62-year-old. However to be more
accurate and practical in advising taxpayers as to when they should begin receiving social security
benefits, one must consider health, inflation, tax rates, investment options and returns, spousal benefits
as a function of the primary insured amount, and so on.
71
For assumptions and parameters of the chart, see Journal of Accountancy, January 2009.
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The Wall Street Journal ran an article on this very point on April 23, 2003 in which it claimed that despite
rising life expectancies, most retirees have taken Social Security before reaching normal retirement age.
As noted, people now in their 80s would “give anything to have a bigger Social Security check. It is the
only income they have that is adjusted every year for inflation.” 72
4. The big “however”
The above has assumed that the decision as to when to take retirement benefits was made by a single
person. As these materials have repeatedly emphasized, the decision to take an early retirement will
have a consequence for the spousal benefit as well where the retiree is married. Therefore, two
adjustments have to be made where the spouse is not eligible to retirement benefits as a worker. First,
any delay magnifies the total benefit received by the couple. Second, the life expectancy to be
contemplated is a joint life rather than a single life. This brings the break-even points down by several
years.
Different considerations come into play when the Social Security cards of both spouses are at work.
There is a conflict between the higher dollars in paychecks one can collect if benefits are deferred with
the higher number of paychecks available by collecting benefits as soon as one is eligible. Remember a
spouse cannot take spousal benefits until the worker claims his benefits, but can take benefits on
her own card, albeit at a reduced level. However, while a spouse cannot take higher spousal benefits (if
one-half of the other spouse’s benefits are higher) if the worker has not claimed the worker’s own
benefits, the spouse can succeed to such benefits once the claim is made.
D. Medicare issues (#21)
Note: Medicare
Medicare Part B helps pay for doctors’ services and outpatient care. It also covers other medical
services, such as physical and occupational therapy, and some home health care. For most
beneficiaries, the government pays about 75 percent of the Part B premium and the beneficiary
pays the remaining 25 percent.
Medicare prescription drug coverage helps pay for prescription drugs. For most beneficiaries, the
government pays a major portion of the total costs for this coverage and the beneficiary pays the
rest. Prescription drug plan costs vary depending on the plan.
1. If delaying Social Security, don’t forget Medicare
For taxpayers planning or presently delaying receiving benefits should sign up for Medicare three months
before reaching age 65, regardless of when they reach full retirement age. Otherwise Medicare medical
insurance, as well as prescription drug coverage could be delayed and higher premiums rates may be
charged.
2. 2012 CCA regarding deduction of Medicare premiums as self-employed health insurance73
Section 162(l) allows an individual who is an employee within the meaning of §401(c)(1) to take a
deduction in computing adjusted gross income. Sole proprietors, partners in a partnership, and 2-percent
shareholders in an S corporation are employees for this purpose.
72
73
Quoting Henry Hebeeler, author of J.K. Lasser’s Your Winning Retirement Plan and founder of a Web site devoted to
retirement issues, www.analyzenow.com.
Chief Counsel Advice 201228037; July 13, 2012.
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The deduction in §162(l) is for amounts paid during the taxable year for insurance that constitutes medical
care for the taxpayer, his or her spouse, dependents, or a child. The deduction is not allowed to the
extent that the amount of the deduction exceeds the earned income derived by the taxpayer from the
trade or business with respect to which the plan providing the medical care coverage is established.
Also, under §162(l), the deduction is not allowed for amounts during a month in which the taxpayer is
eligible to participate in any subsidized health plan maintained by an employer of the taxpayer or of the
spouse of the taxpayer.
In a recent memo, the Chief Council determined that Medicare is insurance that constitutes
medical care under §162(l). Therefore, all Medicare premiums are similar to other health insurance
premiums and can be used to compute the deduction under §162(l). This rule also extends to Medicare
premiums for coverage of a self-employed individual's spouse, dependent, or child. Thus, for a 2-percent
shareholder, and by extension, a partner in a partnership, the shareholder or partner may claim the
deduction under §162(l) only if the requirements of Notice 2008-1 are satisfied.
a. A partner in a partnership may pay the premiums directly and be reimbursed by the partnership,
or the premiums may be paid by the partnership. In either case, the premiums must be reported
to the partner as guaranteed payments, and the partner must report the guaranteed payments as
gross income on his or her Form 1040.
b. A 2-percent shareholder-employee in an S corporation may pay the premiums directly and be
reimbursed by the S corporation or the premiums may be paid by the S corporation. In either
case, the premiums must be reported to the 2-percent shareholder-employee as wages on Form
W-2 and the 2-percent shareholder-employee must report this amount as gross income on his or
her Form 1040.
c. Sole proprietors must pay the Medicare premiums directly.
Practice Note: Amending prior year returns
The instructions to Form 1040 for 2010, p. 28, indicate that Medicare premiums can be used to
compute the deduction under §162(l). The instructions to Form 1040 for 2009 and prior years
omit mention of Medicare premiums. Self-employed individuals who failed to deduct Medicare
premiums in prior years may file an amended return to claim a refund (subject to the statute of
limitations).
3. Appealing Medicare premiums
To determine the 2013 income-related monthly adjustment amounts, income from a tax return filed in
2012 for tax year 2011 is generally used. For higher-income beneficiaries, the law requires an
adjustment (increase) to the monthly Medicare Part B (medical insurance) and Medicare prescription drug
coverage premiums.
2014 Medicare Premiums
Modified Adjusted Gross Income for 2012
Premium 2014
File individual tax return
File joint tax return
$85,000 or less
$170,000 or less
$104.90
above $85,000 up to $107,000
above $170,000 up to $214,000
$146.90
above $107,000 up to $160,000
above $214,000 up to $320,000
$209.80
above $160,000 up to $214,000
above $320,000 up to $428,000
$272.70
above $214,000
above $428,000
$335.70
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If an individual disagrees with the decision regarding the income-related monthly adjustment amounts,
they have the right to appeal. Request an appeal in writing by completing Form SSA-44, Medicare
Income-Related Monthly Adjustment Amount Life-Changing Event--Request for Use of More
Recent Tax Year Information, by contacting the local Social Security office to file the appeal. 74
Practice Note -- Medicare Income-Related Monthly Adjustment - Life-Changing Event:
A Medicare premium payer does not have to complete this form in order to request information
about modified adjusted gross income for a more recent tax year. If one prefers, they may call
1-800-772-1213 and speak to a representative from 7 a.m. until 7 p.m. on business days to
request an appointment at a field office.
Types of life changing events include the following:
• Marriage, divorce, or became widowed;
• Work stoppage or reduced work hours;
• Loss of income-producing property due to a disaster or other event beyond individual’s control;
• The individual experienced a scheduled cessation, termination, or reorganization of an
employer’s pension plan; or
• The individual received a settlement from an employer or former employer because of the
employer’s closure, bankruptcy, or reorganization.
E. In a self-directed IRA, who is responsible for Madoff losses?75 (#22)
1. I can’t think of anything that's my fault
This putative class action concerns allegations of various holders of self-directed IRA administered by
Fiserv, Inc.
a. As set forth in various agreements underlying their IRAs, the account owners made all investment
decisions.
b. Fiserv gave no financial or investment advice, conducted no valuations or due diligence, and
charged only nominal annual fees to prepare tax paperwork and provide specified, limited
administrative services.
c. Pursuant to instructions received from account owners, Fiserv sent funds to Bernard
Madoff's brokerage firm for investment in securities.
d. The account owners' funds were ultimately lost in Bernard Madoff's infamous Ponzi scheme.
2. How dare they follow my directions
The self-directed IRA owners filed suit against Fiserv under a negligence claim. The claim sites “extreme
departures from the standards of ordinary care….in that (Fiserv) failed to preserve, to retain control over,
to hold, to safe-keep the Trust assets which each owners entrusted to them.” They also allege that Fiserv
issued account statements that misstated / misrepresented the value of their IRAs and misrepresented
the safety of their investments, among other failures.
In addition, the self-directed IRA owners assert a claim for Breach of Fiduciary Duty under ERISA.
74
75
The appeal form can be found online at http://www.socialsecurity.gov/online/ssa-44.pdf.
Mandelbaum, Rochelle v. Fiserv, Inc. (3/29/2011, DC CO) 107 AFTR 2d 2011-1651.
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3. The Law
ERISA requires a fiduciary to act “with the care, skill, prudence, and diligence under the circumstances
then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the
conduct of an enterprise of a like character and with like aims.
However, unfortunately for the self-directed IRA owners, IRA plans are explicitly excluded from coverage
under Title I of ERISA. In this case, the IRA owners counsel acknowledged that none of their clients IRA
accounts qualify as ERISA plans.
4. Conclusion and solution – who is responsible, - look in the mirror
The various IRA Agreements contain clearly-stated and explicit provisions that indemnify the Trustee
Fiserv from liability resulting from any claims arising from the accounts at issue. These IRA Agreements
also clearly state that the investors are solely responsible for making investment decisions in connection
with their funds and that the Fiserv will not provide any investment advice. The court found that the IRA
trustees owed no additional duty to the IRA owners independent of those in the IRA agreements.
F. A self-directed IRA miscue eliminates bankruptcy exemption76 (#23)
1. Can I borrow from my IRA?
In the personal bankruptcy of Ernest W. Willis (“Willis”), he claimed the full value of three IRAs as exempt
assets per bankruptcy regulations.
a. The three accounts amounted to $1,499,000. The accounts only permitted withdrawals and
deposits, and the agreement stated “the Tax Code prohibits you from using your IRA to engage in
certain transactions under penalty of losing your tax-deferred status. For example, you may not
borrow from your account, sell property to it or buy property from it.”
b. On December 20, 1993, Willis transferred $700,000 from his IRA to a Sun Bank Account. Willis
then used the IRA funds to purchase the assignment of the Ocean One Property Mortgage.
Willis did not place the mortgage into an IRA account. In 1998 Willis sold the Ocean One
Property for approximately $1,200,000 and deposited the sum into his personal account.
c. In order to repay the IRA, Willis borrowed funds from five friends and family members, and on or
about February 22, 1994, he returned $700,000 into the IRA.
d. Beginning in February 1997, Willis engaged in a series (more than one) of transfers from and to
the IRA in order to cover a shortfall in a joint brokerage account. Willis in essence borrowed
money from the IRA to put into a joint brokerage account, so he could then write another check to
the IRA in an attempt to avoid tax on the IRA withdrawals by returning funds within 60 days. This
series of transactions had the effect of providing an extension of credit between the IRA and
Willis.
2. Taxpayers always have two reasons for doing anything: a good reason and the real reason
Willis claimed he withdrew funds from the IRA, and subsequently “re-deposited” funds, but he did not
“borrow.”
a. In bankruptcy proceedings, the Trustee and a Creditor presented evidence to establish Willis
used the IRA funds in a manner as to make them taxable, and therefore, ineligible for exemption
from the bankruptcy estate.
76
Willis v. Menotte, (CA 11 4/21/2011) 107 AFTR 2d ¶ 2011-752; 105 AFTR 2d 2010-1877, 04/06/2010.
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b. In short, the Trustee claims Willis used funds from an IRA to purchase an assignment of
mortgage, and also used funds from the IRA to cover a shortfall in a joint personal stock
brokerage account.
3. The Law
Per bankruptcy regulations IRA funds may be excluded from a bankruptcy estate. 77
I.R.C. §408(e)(1) allows that any individual retirement account is exempt from taxation unless such
account has ceased to be an individual retirement account. Loss of exemption is detailed in §408(e)(2),
which states - In general, if, during any taxable year of the individual for whose benefit any individual
retirement account is established, that individual or his beneficiary engages in any transaction prohibited
by §4975 with respect to such account, such account ceases to be an individual retirement account as of
the first day of such taxable year. In any case in which any account ceases to be an individual retirement
account as of the first day of any taxable year, the account is treated as if there were a distribution on
such first day in an amount equal to the fair market value of all assets in the account.
Generally, a prohibited transaction is any improper use of an IRA account or annuity by the taxpayer or
any disqualified person.78 Some examples of prohibited transactions with an IRA are:
a. A sale or exchange, or leasing, of any property between a plan and a disqualified person;
b. Lending of money or other extension of credit between a plan and a disqualified person;
c. Furnishing of goods, services, or facilities between a plan and a disqualified person;
d. Transfer to, or use by or for the benefit of the income or assets of a plan by a disqualified person;
e. Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a
plan in his own interest or for his own account; or
f. Receipt of any consideration for his own personal account by any disqualified person who is a
fiduciary from any party dealing with the plan in connection with a transaction involving the
income or assets of the plan.
g. Borrowing on an IRA annuity contract.
h. Pledging an IRA account as security.
i. Investment in Collectibles79, such as art works, rugs, antiques, metals, gems, stamps, coins,
alcoholic beverages, and certain other tangible personal property.
Tax exempt rollovers may only occur once per year, per §408(d)(3)(B).
A “disqualified person” includes a “fiduciary” including any person who exercises: (1) any discretionary
authority or discretionary control of the management of the plan; or (2) any authority or control of the
management or disposition of plan assets. Examples of disqualified persons include the trustee/fiduciary
and members of the taxpayer’s family (spouse, ancestor, lineal descendant, and any spouse of a lineal
descendant).
4. Conclusion and solution – Bankruptcy Court, District Court, and Court of Appeals all agree
Section 408,80 governs IRAs. In addition to other requirements, the law identifies events that disqualify
accounts from tax-exempt status such as borrowing against the IRA, pledging the account as security,
77
78
79
80
U.S. Bankruptcy Code §522(b)(4)(A)'s.
I.R.C. §4975.
An exception is provided for one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins
minted by the Treasury Department, and certain platinum coins and certain gold, silver, platinum or palladium bullion.
Which is referred to in §522(b)(4) of the Bankruptcy Code.
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and commingling IRA accounts with common funds. Under §4975(c)(1)(D), any direct or indirect transfer
to, or use by or for the benefit of a disqualified person of the income or assets of a plan constitutes a
prohibited transaction.
In its analysis, the bankruptcy court first considered whether Willis was a “disqualified person.” Because
he exercised discretionary authority and responsibility over the administration of his IRA, the court
properly determined Willis to be a fiduciary and thus, a disqualified person.
The bankruptcy court then evaluated the account activity for prohibited transactions and correctly found
Willis had engaged in two such transactions: the direct or indirect “transfer to, or use by or for the benefit
of a disqualified person of the income or assets of a plan,” and “lending of money or other extension of
credit between a plan and a disqualified person.” Consequently, the Court finds that Willis engaged in a
prohibited transaction under §4975(c)(1)(B) by borrowing $700,000 from the IRA to acquire the
assignment of the Ocean One Property Mortgage. Willis personally benefitted from the use of IRA funds
because the use of funds enabled him to later sell the Ocean One Property for approximately $1,200,000.
Willis claims the bankruptcy court erred in concluding he “borrowed” from his IRA. Willis provides no legal
argument to support the claim, but points the Court to testimony regarding the nature of the account.
Because the account only permitted withdrawals and deposits, Willis argues the word “borrow” was an
incorrect characterization of his use of the IRA funds. The argument is superfluous; the fact of the matter
is Willis withdrew funds from an IRA, used them improperly, and then re-deposited them. “Borrowed” or
not, the bankruptcy court arrived at the correct conclusion: the IRA became nonexempt, and any
purported roll-overs from the IRA into other IRA accounts were also non-exempt.
Practice Note: protecting an IRA bankruptcy exclusion:
Practitioners have always informally preached the importance of protecting IRA investments from
penalties. However, for clients that may be in torment with the possibility of pending bankruptcy,
practitioners may be more attentive to the protection of IRA status. The downside risk for such
clients is not just taxable income and penalty, but also the loss of the bankruptcy exemption for
IRA funds.
G. 2014 case -- IRS levy on pension account -- excepted v. exempt property81
(#24)
1. An abundance of caution
Stuart Gross filed a petition under Chapter 7 of the Bankruptcy Code. He listed his interest in the
Director's Guild of America (the DGA plan, an ERISA-qualified pension plan) valued at $300,000 on
Schedule B and Schedule C of his bankruptcy petition. He attached as an explanation: “This is an ERISA
Qualified Pension Plan which is not property of the estate but in an abundance of caution has been
listed herein and exempted.”
Practice Note:
Gross did not need to list the asset in bankruptcy, an ERISA-qualified pension plan account is per
se excluded from the bankruptcy estate -- the exclusion is mandatory. It could not be included
in the bankruptcy estate, not even for the sole purpose of listing it as exempt.
81
Gross v. Comm., (CA 9) 113 AFTR 2d 2014-529, 02/25/2014.
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At the time of his bankruptcy petition, Gross owed federal income taxes totaling $270,041.15.
2. Was the pension excluded from, or included and exempted in bankruptcy estate
Gross argues that the exclusion of his interest in an ERISA-qualified pension plan is permissive, and that
he properly included the DGA plan account in his Chapter 7 bankruptcy estate and claimed it as exempt
without objection. Therefore, he contends that the IRS may not levy on the DGA plan account because
they did not file a valid lien.
3. The law
Under §6321, when a person owes tax liabilities, a lien automatically attaches to the taxpayer’s property
in favor of the IRS. The IRS need not release a valid tax lien when the underlying tax debt is discharged
in bankruptcy.
The filing of a petition in bankruptcy automatically creates a bankruptcy estate consisting of “all legal or
equitable interests of the debtor in property as of the commencement of the case.” The bankruptcy estate
includes all of the debtor’s prepetition property and rights to property except property excluded from the
estate, including an interest in an ERISA-qualified pension plan. In addition, a debtor is allowed to
exempt from his bankruptcy estate certain property, including retirement funds, to ensure that the debtor
has at least some property with which to make a fresh start.
Nonetheless, with regard to assets that are part of the bankruptcy estate but exempt from the bankruptcy
proceedings, the Bankruptcy Code provides that such property: “is not liable during or after the case for
any debt of the debtor that arose... before the commencement of the case, except a debt secured by a
tax lien, notice of which is properly filed under I.R.C. §6323.”
Unlike liens on exempt assets, liens on prepetition assets that are not included in the bankruptcy estate
(i.e., excluded property) are not affected by the bankruptcy proceeding. 82
Practice Note:
Unlike exempt property, excluded property never becomes part of the bankruptcy estate and is
therefore never subject to the bankruptcy estate trustee’s or the debtor’s power to avoid the
§6321 lien. Thus, if a §6321 lien on excluded property has not expired or become unenforceable,
it survives the bankruptcy.
4. The unfortunate result
Simply listing an ERISA-qualified pension plan account, an excludable asset, on Schedule C is not
necessarily sufficient to claim an exemption if all of the facts, including any statements made on the
bankruptcy schedules, indicate that the debtor excluded the ERISA-qualified pension plan account from
his bankruptcy estate.
The IRS maintains a valid lien on Gross’ interest in his ERISA-qualified pension plan. The Supreme
Court held that an ERISA plan is properly excluded from a bankruptcy estate under 11 U.S.C.
§541(c)(2).83 Here, Gross’ Chapter 7 schedules explicitly state that his ERISA plan is not part of the
estate. Although the schedules go on to suggest that the ERISA plan might be “exempted,” any
ambiguity in a bankruptcy schedule is construed against the debtor.
82
83
Rains v. Flinn, 428 F.3d 893, 905–06 (9th Cir. 2005).
Patterson v. Shumate, 504 U.S. 753, 759–60 (1992).
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Because Gross’ ERISA plan was not part of Gross’ Chapter 7 estate, the bankruptcy proceedings did not
affect the IRS’ §6321 lien. Accordingly, the lien remains attached to Gross’ interest in the ERISA plan,
and the IRS may levy this asset.
Practice Point: Is repayment of First Time Home Buyers Credit dischargeable?
In an unrelated case,84 a taxpayer who had received a first-time home buyer credit in a year prior
to filing for bankruptcy, claimed the tax credit was in essence an interest free loan (repayment at
6.67 percent of the credit amount for 15 years), and her obligation to repay it was discharged by
her bankruptcy.
Unfortunately in this case, the taxpayer learned the repayment is imposed as an increased tax
rather than a general obligation, it is therefore not dischargeable pursuant to the Bankruptcy
Code.
X. Can we avoid distribution penalties? (#25)
Unfortunately, many taxpayers leap into IRA transactions before they look. Practitioners are then
asked to “fix” the error. If they would just call us before they leap.
A. A property settlement is not per se a QDRO
1. Background facts – common war, uncommon battle
a. To finalize the division of marital assets as part of taxpayer’s divorce judgment, husband was
instructed to make a $29,000 cash payment to ex-wife. Unfortunately, husband was months
behind in mortgage payments, had little or no equity in his residence, and had exceeded the
credit limit on each of his credit cards. The only funds he could access were $33,000 in two of
his IRAs.85
b. During a Family Court session which included yelling, screaming, and complaining on both
sides, husband was given 30 days to pay the $29,000 judgment, under threat of Court
contempt charges. Thirty days hence, the Family Court found him guilty of contempt for
failure to pay and ordered him to pay it by 4pm the next day under threat of $100/day
sanction.
c. That day, husband called his IRA custodian and directed them to transfer $29,000 from his
IRAs to his ex-wife’s IRA. She refused to accept the IRA transfers arguing (and the Family
Court agreed) the divorce judgment required a cash payment directly to her, not a rollover to
her IRA account. The judgment and sanctions were up to $3,300 at this point.
d. Husband then withdrew $20,300 from one of his IRAs and sent the check to his ex-wife. His
other IRA was “lost electronically” so he could not tap into the remaining $8,000 balance due.
Two months later, still owing at least the $8,000, he was arrested and incarcerated.
e. A week later, he withdrew and transferred cash of $8,000 from his other IRA to his ex-wife.
He was released from jail the same day.
2. The blooper
a. On his income tax return husband did not include the IRA distributions in taxable income.
b. He believes the cash transfers were distributions under a Qualified Domestic Relations
Order; therefore not taxable or subject to the 10 percent penalty.
84
85
Bryan, Dawn, Bankruptcy Court CA, 113 AFTR 2d 2014-558, February 27, 2014.
CA-1, Richard David Czepiel v. Commissioner, Doc. No. 00-1257, 12/5/2000.
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3. The law
a. Most are aware §72(t) requires any taxpayer who receives an early distribution from a
qualified retirement plan shall also be subject to a penalty equal to 10 percent of the portion
which is includible in gross income.
b. Fortunately, exceptions apply, and in this case taxpayer desires §72(t)(2)(C) to negate the
penalty as payments to alternate payees pursuant to qualified domestic relations orders
(QDRO).
c. In general, a QDRO means a qualified domestic relations order which creates or recognizes the
existence of an alternate payee's right to, or assigns to an alternate payee the right to, receive
all or a portion of the benefits payable with respect to a participant under a plan.
d. The term "domestic relations order" means any judgment, decree, or order (including
approval of a property settlement agreement) which relates to the provision of child support,
alimony payments, or marital property rights to a spouse, former spouse, child, or other
dependent of a participant, and is made pursuant to a State domestic relations law.
e. A domestic relations order meets the requirements of this paragraph only if such order
clearly specifies—
1) The name and the last known mailing address (if any) of the participant and the name and
mailing address of each alternate payee covered by the order,
2) The amount or percentage of the participant's benefits to be paid by the plan to each such
alternate payee, or the manner in which such amount or percentage is to be determined,
3) The number of payments or period to which such order applies, and
4) Each plan to which such order applies.
f. In addition, the order—
1) Does not require a plan to provide any type or form of benefit, or any option, not otherwise
provided under the plan,
2) Does not require the plan to provide increased benefits (determined on the basis of actuarial
value), and
3) Does not require the payment of benefits to an alternate payee which are required to be paid
to another alternate payee under another order previously determined to be a qualified
domestic relations order.
4. Conclusion and solution
a. A property settlement is not per se a QDRO.
b. In this case, the divorce judgment was not, in substance, a QDRO so the distributions were
fully taxable to the husband and subject to the 10 percent penalty.
c. The case appears to include severe difficulties with each side of the divorce. Starting with
screaming and yelling is one thing, but progressing to sitting in a jail cell is quite another.
Many accounting and tax practitioners have a war story about a difficult break-up. We can only
hope that these are few and far between, and that calm, fairly minded clients can reasonably
discuss some equitable solutions to problems such as the ones in this case.
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B. Inherited IRA cashed86
1. Illustration of rollover foot faults, near saves, then disaster
a. Taxpayer’s mother died designating her son (Son) as the named beneficiary of IRA #1. The
Son received a full distribution of IRA #1 then, subsequently rolled over a portion of the
distribution into IRA #2 which was designated a ‘Beneficiary IRA Rollover to be maintained
for the benefit of (FBO) Son.’
b. Son also rolled over the remaining portion of the distribution into IRA #3, maintained at a
different company, which was designated a rollover contribution.
c. Both IRAs #2 and #3 were set up using the Son’s social security number.
d. Since mother’s IRA was now fully liquidated, the custodian that maintained her IRA issued a
Form 1099-R to the Son for the date of death value of mother’s IRA.
2. The taxpayer blooper No. 1 – he is not Oedipus Rex
a. Son rolled over his mother’s IRA to himself, this treatment is only available for spouses. 87
b. The ability to rollover an IRA to one’s own IRA is limited to a surviving spouse designated
beneficiary. The spouse may then defer required minimum distributions (RMDs) until they
reach the required beginning date.
c. Son did not desire to report the income noted on the Form 1099-R and requested a private
letter ruling to approve of his rollovers.
3. The IRS blooper
a. Originally, the IRS ruled Son was allowed to roll over the IRA inherited from his mother into
two separate IRA accounts maintained in Mom’s name for his benefit.88 The Service stated that
the transfers were in accordance with Rev. Rul. 78-40689 and further met the requirements of Rev.
Proc. 89-5290 and thus would not be considered taxable distributions. In addition, the Service
said that the new IRAs would retain the status of IRAs maintained in Mom’s name for the
benefit of the son.
b. Both of Son’s IRA custodians assured Son that they would, upon receipt of a favorable
letter ruling, take the steps necessary to treat the rollover transactions as trustee-to-trustee
transfers, including correction of bookkeeping entries, correction of 1099’s, and renaming the
IRA accounts. Of course, in their wildest dreams, the custodians never thought Son would
receive such a favorable ruling.
c. The custodians therefore did not follow through on these actions even after the IRS issued
Son’s favorable ruling.
4. The taxpayer blooper No. 2
a. Son therefore requested a second private letter ruling to force the IRA custodians to correct
the paperwork.
86
87
88
89
90
PLR 200228023.
Do not confuse this rollover rule with greater portability provided by the Pension Protection Act, see paragraph 6b, c and
d.
PLR 200204048.
Rev. Rul. 78-406, 1978-2 CB 157.
Rev. Proc. 89-52, 1989-2 CB 632.
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5. The law
a. Only surviving spouses may roll over inherited IRAs into their own accounts.91 Generally,
the surviving spouse makes this election by re-designating the account into his or her own name
as the new owner of the IRA at any time after the death of the account owner. 92
6. Conclusion and solution
a. Apparently the second private letter ruling request was assigned to another agent! The Service
quickly revoked the first erroneous letter ruling and replaced it with PLR 200228023 which
rejected both requests resulting in taxable income to Son at the time the transfers were
originally made.
b. The Pension Protection Act of 2006 (PPA) did not change this non-spouse rollover rule.
What PPA does permit is greater portability and investment options for the beneficiary. A nonspouse beneficiary was essentially stuck in the custodian/trustee operating the account at the
death of the owner because funds could not be transferred out of the account.
c. Effective for distributions after December 31, 2006, PPA allows a designated beneficiary
other than a surviving spouse to transfer inherited retirement plan distributions directly to an
IRA with a custodian the beneficiary chooses. The IRA is treated as an inherited IRA of the
non-spouse beneficiary. For example, distributions from the inherited IRA are subject to the
distribution rules applicable to beneficiaries. The provision applies to amounts payable to a
beneficiary under a qualified retirement plan, governmental §457 plan, or a tax-sheltered annuity.
To the extent provided by the Secretary, the provision applies to benefits payable to a trust
maintained for a designated beneficiary to the same extent it applies to the beneficiary.
d. Only spouse beneficiaries maintain the ability to roll over an IRA into their own IRA and
defer distributions until the surviving spouse reaches the required beginning date.
C. Bad IRS advice? Nah, never happens!
1. A verbal commitment is not worth the paper it is written on 93
A taxpayer was not yet 59½ years old, took a lump-sum distribution of $15,347 from her IRA and
used at least $10,000 of the distribution to buy her first home. New York Life Assurance and Annuity
Corporation issued a 1099-R showing a gross and taxable distribution of $15,347.
a. The taxpayer was not sure of the proper tax treatment on her personal return and decided to
call the IRS help line. Taxpayer claims she was told by an unnamed IRS employee that, if
her IRA distribution was for the purchase of a new home, it was not taxable and there would
be no penalties.
b. The taxpayer reported the gross distribution on her tax return but reported $10,000 less as
the taxable amount. She also did not report any of the distribution as subject to the 10 percent
early distribution penalty.
2. The blooper
Let’s face it, the taxpayer blundered here by trusting the IRS ‘oral advisor.’
91
92
93
I.R.C. §408(d)(3)(C)(ii)(II) and Treas. Regs. §1.408-8, Q&A-5.
Treas. Regs. §1.408-8, Q&A-5(a).
Debra Sue Tussey v. Comm., TC Summ. Opinion 2003-47, Doc. No. 2777-02s, 4/30/2003.
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As practitioners, we have heard the horror stories of IRS centers fielding taxpayers questions give
incorrect answers — or no answer at all — close to 50 percent of the time. The treasury itself
tests their agents with similar results. Unfortunately, this taxpayer was not aware of the track record.
In fact, we joke that IRS Taxpayer Assistance Phone Number is ‘1-800-429-5050’ because that’s
about the odds you’ll have of getting the correct answer. 
3. The law
a. The Service does not issue rulings or determination letters on oral requests. National
Office officials and employees ordinarily do not discuss a substantive tax issue with a taxpayer
before written request for ruling is received since oral opinions or advice are not binding on
the Service. This does not prevent a taxpayer from asking whether the Service will rule on a
particular issue. In such cases, however, the name of the taxpayer and identifying number must
be disclosed. The Service also will discuss questions relating to procedural matters about
submitting a request for a ruling.
b. A taxpayer may seek oral technical assistance from a Taxpayer Service Representative in a
District Office or Service Center when preparing a return or report under other established
procedures. Oral advice is advisory only and the Service is not bound to recognize it in the
examination of the taxpayer's return.94
c. The Code provides the Secretary shall abate any portion of any penalty or addition to tax
attributable to erroneous advice furnished to the taxpayer in writing by an officer or employee
of the Internal Revenue Service, acting in such officer's or employee's official capacity; only if—
1) The written advice was reasonably relied upon by the taxpayer and was in response to a
specific written request of the taxpayer, and
2) The portion of the penalty or addition to tax did not result from a failure by the taxpayer to
provide adequate or accurate information.95
4. Conclusion and solution
The Tax Court held that the entire amount received by the petitioner must be included in her gross
income. However, since she did use $10,000 of the IRA distribution to buy a new home, and that
she qualified for the first-time homebuyer exclusion, the 10 percent penalty is charged only on the
amount over $10,000 (which was $5,347).
The Tax Court held that erroneous advice given by IRS employees is not binding on the
Commissioner and the Court cannot disregard statutory terms even when the result seems
harsh.
Practice Point:
Practitioners and taxpayers may still desire to confirm any oral advice received from IRS
personnel through the proper authority. At times, written file notes of an oral conversation
with IRS personnel including the date, time of day, and name, identification and phone number of
the IRS person may be of importance in future correspondences, oral or written.
94
95
Rev. Proc. 85-50 1985-2 C.B. 717.
I.R.C. §6404(f).
98
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