Regs Permit Flexibile Basis in Stock Sales

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Normally, when one disposes of property, realized gain or loss is directly dependent upon basis.  Being closely related to initial cost, basis is a tax attribute over which the taxpayer generally has little control at the time of the property’s disposition.  An antique, for example, purchased by a casual investor in 1970 for $10,000 and sold in 1992 for $110,000 will produce a realized capital gain of $100,000.

Suppose, however, this casual investor also purchased 1,000 shares of IBX in 1970 and another 1,000 shares in 1980 and 1986.  Assume that he paid $50, $75 and $200, respectively, for those shares, that IBX is now worth $100 per share, and that the investor now wish to sell some of this stock.  By identifying the source of the particular shares being surrendered, the investor will be presented with the rare tax opportunity of unilaterally deciding whether to realize gain on this sale, or whether to realize loss.

Treasury Regulation 1.1012-1(c) provides generally that where the taxpayer purchased stock on different dates or at different prices, a sale of a portion of the taxpayer’s holdings will be charged against the earliest of such purchases.  This means that if the investor in our example sold 1,000 shares of IBX on January 1, 1993, he would be deemed to sell shares purchased in 1970. Consequently, he would realize a capital gain of $50 on each share sold.   However, an important exception exists where the taxpayer can identify the actual shares being sold:  If the stock certificates relating to a particular purchase are delivered to the (new) purchaser, then the stock sold is charged to the stock purchase attributable to the certificates delivered.  Thus, if the investor delivered the certificates from the 1986 purchase of IBX, then instead of realizing a capital gain of $50 on the sale, he would realize a capital loss of $100 on each share.  Moreover, even if the investor had not taken possession of the stock certificates, but had instead left them in the custody of his broker, he could still benefit from the “specific identification” rule, by specifying to the broker at the time of the sale which particular stock certificates should be sold.

The tax planning opportunities presented by this rule are apparent.  Suppose the taxpayer and his wife, as part of their estate tax plan, wish to make a gift of $20,000 each to their ten grandchildren, and wish to fund the transfer with the proceeds from the sale of the antique and 1,000 shares of IBX.  By claiming the annual exclusion, the transfer can be made gift tax-free.  By designating the IBX stock purchased in 1986 as that being sold, the transaction is also income tax-free.  Although the sale of the antique will generate $100,000 in capital gains, that gain will be exactly offset by the $100,000 in capital losses produced by the sale of the designated IBX stock purchased in 1986.  Of course, having sold the high basis stock, future sales will occasion less favorable tax consequences, since the taxpayer will have less desirable lots of stock from which to “cherry pick”.  This prospect is mitigated somewhat by the possibility of his holding the remaining stock until his death, at which time it would receive a step up in basis to fair market value.

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Electing S Corporation Status

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

In many respects, the S corporate form is a hybrid entity.  For most legal purposes, except taxation, an S corporation respects its lineage and is governed by the same laws that govern C corporations.    However, for tax purposes, S corporations display a tendency to be taxed similarly to partnerships.  This means that S corporate shareholders, like partners in a partnership, are taxed directly on their share of S corporation income, while generally the S corporation itself (like a partnership) reports no income taxes. Although the shareholder will be taxed once with certainty on S corporate earnings, this will be only instance in which corporation earnings are taxed.  Moreover, this proposition remains true whether or not the S corporation distributes its  earnings, since distributed earnings will constitute a tax-free return of basis to the shareholder.

This tax amnesty at the S corporate level, which leaves only one instance of taxation, at the shareholder level, best exemplifies the sea change in tax treatment where a C corporation elects S status, since C corporate earnings are normally taxed twice, first to the C corporation, and then again to the C shareholder when (and if) distributed, most likely as an ordinary income dividend. Tax is imposed on S shareholders in every year in which the S corporation reports (but pays no tax on) earnings, whether or not those earnings are actually distributed to S shareholders.  In contrast, C shareholders pay no tax until corporate earnings are distributed, either as dividends or in redemption of stock.  Although S shareholders are taxed immediately on corporate earnings, without the requirement, as exists in the C context, of there being an earnings distribution, S shareholders are nonetheless accorded the substantial tax privilege of inheriting from the S corporation the latter’s favorable income tax characterization.  For example, if the S corporation engaged in transactions that produced capital gains, those gains, as well as their characterization as capital gains, would flow through to S shareholders.  In contrast, dividends to C shareholders are characterized as ordinary income, and are therefore subject to higher tax rates, regardless of whether they had arisen from capital gains transactions at the corporate level.

S shareholders do not avoid reporting tax on corporate profits, but they do avoid reporting tax on corporate distributions, since the tax they incur on corporate profits increases their stock basis, which in turn permits those profits to be distributed tax-free.  Stock basis is also essential where an S shareholder wishes to report passed-through S corporation losses.  Although such losses flow through to S shareholders exactly as do corporate profits, losses are deductible only to the extent of the shareholder’s stock basis and the basis of any loan made by the shareholder to the S corporation.  To the extent losses exceed basis, the shareholder will be required to make a capital contribution or a corporate loan in order to deduct those losses currently.  Alternatively, unused losses may be carried forward until a future year when the S corporation reports profits.  In fact, if the shareholder expects to be in a higher tax bracket in the future, it may even be preferable to carry over losses to a later year.

Where differences in taxation exist, a partnership is generally taxed even more favorably than an S corporation.  However, liquidating an existing corporation in order to form a partnership may involve a high tax cost.  Similarly, liquidating a partnership (which cannot elect S status) and transferring its assets to a corporation may be costly.  It is therefore essential that small business owners contemplating the creation of a new business entity recognize that (1) favorable tax rules alone may not justify electing S status, since that objective could be accomplished more easily and more directly by choosing the partnership form, and (2) though important, tax savings alone may not justify the risk of personal exposure inherent in the partnership form.  Having said that, S corporate status might be an ideal vehicle for a start-up business that expects to lose money for the first few years.  Assume the following:  A group of ten investors each contributes $10,000 to develop real estate in Wyoming.  Since the partnership form is unappealing for nontax reasons, the business is incorporated, and S status is elected.

During years 1 through 4 the corporation incurs substantial start-up losses.  Those losses are passed through to the investor-shareholders.  (Had S status not been elected, those losses would have become “net operating losses,” frozen at the corporate level and carried forward until profits could offset them.)  During those years each S shareholder would be entitled to deduct his share of losses on his personal tax return, provided (1) the shareholder had sufficient stock or debt basis to cover such losses, and (2) the losses were not disallowed by the at-risk or the passive activity limitations on deductibility that apply to S corporations and their shareholders.  In year 5 the corporation turns a profit of $200,000, characterized at the corporate level as a capital gain. The corporation then distributes $20,000 to each shareholder.  The tax consequences in year five would entail (1) the S corporation itself reporting no income, but (2) each shareholder reporting $20,000 of capital gain on his tax return, after (3) adjusting his stock basis upward to reflect S corporation income, which upward basis adjustment would cause the distribution to be treated as a (4) tax-free return of capital.

Not every C corporation may elect S status, nor would this election be desirable in all cases in which it would be permitted.  In order to elect S status, a corporation must have no more than 35 shareholders, and must not have issued more than one class of stock.  Only individuals, estates and certain trusts may own S corporation stock; partnerships and corporations are ineligible S shareholders.  Lower corporate level tax rates apply to C corporations with up to $50,000 in income.  Consequently, if a C corporation in this lower tax bracket planned to retain earnings, electing S status in order to avoid shareholder taxation would probably be counterproductive since in this case it would result in a higher tax liability.

Posted in Corporate Tax, S Corporations | Leave a comment

Taxation of Property Transfers

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

The Internal Revenue Code taxes “gains derived from dealings in property.” However, two types of gains exist, and the Code taxes only one. “Realized” gains are not subject to taxation. This type of gain represents net appreciation in property that has not yet been sold or exchanged. For example, an astute taxpayer might own a Monet purchased many years ago for $10,000 and now worth $1,000,000, but as long as the painting were not sold, no tax would be occasioned.  On the other hand, that same person might own one share of LILCO, which when sold yields $1 of profit.  That dollar would be reportable, since not only was it “realized” in the tax sense, but it was also “recognized.”

In the preceding example, had the Monet been sold, it would have yielded a profit of $990,000. Taxable gain has some affinity to the concept of profit, but this general correlation is subject to a number of modifications which may ultimately render the two terms at polar extremes. While profit is important in the economic sense, it has less relevance in taxation.

Taxable, or recognized, gain is measured by the difference between the amount realized (AR) in the sale or other disposition of the property, and the property’s adjusted basis (AB). This concept can be represented by the following equation:  Gain = AR – AB. The amount realized is generally the fair market value of money or other property (including services) received in exchange for the property given up. Since maximization of the amount realized (AR) is almost always desirable for economic reasons, to minimize taxable gain one must also maximize adjusted basis (AB). Thus, maximization of basis is almost always a primary tax objective.

Not only does basis reduce gain upon eventual disposition of the property, but it also serves as the foundation for depreciation deductions. If depreciable property were purchased by a business for $10,000, and were not subject to expensing, the cost of the equipment could be recovered by yearly depreciation deductions. In five years the acquisition cost of “five year” property could be “written off” to zero. If the property still had residual value and were sold after having been fully depreciated, the entire sales price would constitute taxable gain.

Until now, we have discussed gain as if it were a unitary concept. In fact, the sale or exchange of noncapital assets yields ordinary gain, subject to the new higher income tax rates. However, the sale or exchange of “capital asset” property yields capital gains, which are taxed at a flat rate of 28 percent.

The Code defines capital assets by exclusion. Thus, all property held by the taxpayer is a capital asset, with the exception of inventory property, accounts receivable, and certain other property. Thus, the LILCO gain above would be a capital gain. The sale of the Monet would also produce capital gain, provided the seller was not in the business of collecting and trading art. Since the difference between $990,000 taxed as capital gain as opposed to ordinary gain (assuming a marginal rate of 39.6%) is $114,840, one would expect more frequent disputes between the Service and the taxpayer with respect to whether persons, such as the owner of the Monet, are casual collectors, or are in the business of collecting.

Suppose that the holder of the Monet wishes to pass on the value of the property represented by the painting to his son. Should he sell the painting and then give his son the proceeds, should he give his son the painting and let him sell it (or keep it), or should he hold the property until his own death, and bequeath it to his son?

If he bequeaths it to his son, the $990,000 of inherent taxable gain will vanish, since the basis of all property is “stepped up” to its fair market value at death. Thus, if the son sold the Monet one day after he inherited it for $1,000,000, he would report no capital gain. More than that, the son would realize no income upon his inheritance of the painting since for income tax purposes gross income does not include the value of property received by gift or bequest.

The tax consequences to the father’s estate in holding this property until death must also be considered. Even if the father had not yet made any use of his $600,000 lifetime exemption from transfer taxes, the retention of the painting worth $1,000,000 will occasion the levy of an estate tax of 38 percent on $400,000 (i.e., $1,000,000 fair market value at death of painting less $600,000 exemption equivalent), or $152,000.

Were the Monet instead sold outright, the sale would occasion a capital gains tax of $277,000 (i.e., $990,000 capital gain taxed at 28 percent). If the father lived 25 years, he could conceivably make yearly transfers that would qualify for the $10,000 annual exclusion, thereby preserving his $600,000 exemption equivalent. However, there is talk of the $10,000 annual exclusion being reduced to $3,000. There is also speculation that the $600,000 lifetime exemption from transfer taxes may be reduced.

What if the father simply gifted the painting to his son today? The son would be very happy, and further appreciation of the Monet would be removed from the estate, but the potential basis step-up would be lost. Instead, the son would take a “transferred” basis of $1,000 in the painting, setting the stage for a large potential capital gains tax. Moreover, since the gift tax, which is based on the fair market value of at the time of transfer, is also imposed at the time of transfer, the father would incur a gift tax of $152,000 today, calculated in a manner similar to that described for his estate, above.

In sum, if the father were willing to assume the risk that a substantial reduction in the $600,000 lifetime exemption would not occur before his death, he might consider holding the property until death. This would neutralize the potential capital gains tax (assuming the basis step-up provision is not repealed), and would also avoid the necessity of his being forced to make a painful prepayment of transfer taxes during his lifetime, which might cause liquidity problems if the gift were of the Monet itself, rather than its sale proceeds. This analysis also assumes that the benefit of removing potential appreciation of the Monet from the father’s estate is not so great as to tilt the scales back in favor of a lifetime gift.

Posted in Property Transactions, Timing of Income and Deductions | Leave a comment

Defusing IRS Tax Liens & Levies

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Once imposed, Federal tax liens threaten the taxpayer’s ability to continue in business, since creditors and potential purchasers may then shun dealings with the taxpayer. Tax levies may be even worse, since they result in the immediate deprivation of the taxpayer’s property.  The seriousness of these IRS measures literally forces the taxpayer to take some action, even if he has been dormant during the pendency of IRS assessment and collection procedures.

The IRS and the courts are generally unwilling to entertain the taxpayer’s substantive legal arguments that the tax lien or levy is improper.  However, relief may be predicated on other grounds, including hardship, gross IRS error, or procedural defects. Relief may take the form of agreements between the IRS and the taxpayer to permit payment to be made in installments. Occasionally, the IRS may release a tax lien if such an action would ultimately increase the likelihood of payment.

Taxpayers who have responded to IRS notices but have received no acknowledgment from the IRS may petition the Problems Resolution Office for a “taxpayer assistance order.”  Such an order may be granted where the taxpayer will suffer “significant hardship” on account of the manner in which the internal revenue laws are being administered.  Although such an order, if granted, is provisional in nature, it will serve to freeze any further IRS action pending review of the taxpayer’s problem.

At times, the taxpayer may concur with the I.R.S. with respect to taxes owed, but may be genuinely unable to pay. Recognizing that filing a notice of lien against the taxpayer’s property may adversely affect the taxpayer’s ability to pay, the Service may consider entering into a collateral agreement with the taxpayer, whereby the government’s interests are protected, but the taxpayer is allowed to stay in business. The installment agreement is one type of collateral agreement.  Specifically sanctioned by the Code, this arrangement permits the taxpayer to satisfy a tax liability in installments where the I.R.S. determines that such an agreement will “facilitate collection” of the liability.

Another type of collateral agreement is the “offer in compromise.”  This arrangement, which also finds its origins in the Code, permits the taxpayer to satisfy an outstanding tax liability for less than the full amount of the liability. The taxpayer who wishes to avail himself of an offer in compromise must furnish the Service with financial statements and other data, from which the Service may evaluate the taxpayer’s offer.

An offer in compromise may be predicated either upon the taxpayer’s inability to pay, or much less frequently, upon a doubt as to the underlying tax liability.  (Recall that even if faced with a tax lien, the taxpayer may satisfy the lien and then sue for a refund in the U.S. District Court.) A taxpayer who is truly insolvent and appears unlikely to improve on that status may be an ideal candidate for an offer in compromise, since in evaluating the offer, the I.R.S. must act like a “prudent businessperson.”

Tax liens may be filed erroneously. The Code requires that a lien be released where the liability has been fully satisfied, the liability has become legally unenforceable (e.g., the statute of limitations), or an acceptable bond has been furnished by the taxpayer. If any of these conditions is met, the Service must release the lien within 30 days of the taxpayer’s written application.

Prior to seizure of the taxpayer’s property by levy, the taxpayer may challenge procedural deficiencies in court. Since declaratory judgments are generally precluded in tax matters, the better choice is to bring a quiet title action to determine whether there is a procedural defect in the government’s lien. The merits of a tax liability may not be raised in a quiet title action. One class of allegations often alleged by the taxpayer in such a proceeding involves mistakes in the mailing of the “notice of deficiency,” which apprises the taxpayer of the government’s proposed tax assessment.

Even if a levy has been commenced, the taxpayer may request that the levy be released, on the condition that he (1) furnish the I.R.S. with a satisfactory bond,  (2) enter into an installment payment agreement, or (3) execute an assignment of salary or wages.

If release of levy may not be predicated upon any of the above conditions, the taxpayer may have no alternative but to seek relief in the courts. However, the purview of the courts in this area is circumscribed: The Anti-Injunction Act bars any suit which seeks to restrain “the assessment and collection of any tax.” Nevertheless, this language has been interpreted as not to bar actions where relief is predicated upon procedural grounds. The taxpayer may seek an injunction against the government to prohibit the enforcement of a levy where the procedural requirements of the Code have not been followed.

Even in situations where a literal failure to comply with procedural requirements may not warrant initiation of a judicial proceeding, the Service may be more willing to negotiate with the taxpayer concerning the underlying tax liability where the taxpayer’s representative expresses to the Service an awareness of these deficiencies.

Posted in IRS, IRS Liens & Levies | Leave a comment

Revenue Reconciliation Act of 1993

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Though not constituting a sea change in the tax law, the Revenue Reconciliation Act of 1993 nevertheless deviates substantially from the tax course charted by the Tax Reform Act of 1986.

President Clinton has apparently kept his promise of not raising income taxes of the middle class, as new tax rates of 36 percent and 39.6 percent will affect only taxpayers who are at least modestly affluent. Thus, for married taxpayers (filing jointly) whose taxable income is less than $140,000, the top marginal income tax rate will remain at 31%.  Married taxpayers filing jointly whose taxable income does not exceed $250,000 will see their taxable income in excess of $140,000 being taxed at a new rate of 36 percent. Finally, a 39.6 percent tax rate (termed the “high income surtax”) will apply to taxable income in excess of $250,000. Taxpayers who wish may pay additional 1993 taxes attributable to the rate increases in three equal installments over the next three tax years. Since this provision in effect constitutes an interest-free loan from the government, it may be enticing to those who qualify.

Low-income taxpayers will benefit from the expansion of the earned income tax credit, which consists of a refundable credit available to qualifying persons whose income does not exceed a threshold amount. For the first time, this credit may also be claimed by taxpayers without children.

Of immediate interest to most taxpayers is the new 4.3 cents per gallon additional excise tax on all transportation fuels, effective October 1, 1993. The unpopular excise tax on luxury items has been repealed with respect to boats, aircraft, jewelry and furs, but persists with respect to automobiles. However, the threshold amount for automobiles is now indexed for inflation, retroactive to 1991, so the 10 percent excise tax will now operate by imposing a tax of 10 percent on that part of the purchase price in excess of $32,000.

The phase-out of the personal exemption for high-income taxpayers, which had been scheduled to expire in 1997, has now been made permanent. Similarly, the limitation on itemized deductions for high-income  taxpayers, set to expire in 1996, has also been made permanent. Under this provision, taxpayers having adjusted gross income above a threshold amount are required to reduce itemized deductions by up to 80 percent.

Significantly, the 1993 Act made no change in the 28 percent rate of tax imposed on capital gains. As a result, the rate differential of 11.6 percent between the top marginal ordinary income tax rates (i.e., 39.6 percent) and the 28 percent capital gains tax rate makes the flight to capital gains extremely attractive to many taxpayers.

The new tax law grants even more favorable capital gains  tax treatment to the disposition of certain small business stock. Thus, a noncorporate taxpayer who holds “qualified” small business stock for more than 5 years may exclude 50 percent of the gain on the sale or exchange of the stock. This translates to an effective capital gains tax of only 14 percent. Any business whose principal asset is the reputation or skill of its employees (e.g., health or law) will not constitute a qualified trade or business.

Recognizing that the 11.6 percent differential in capital and ordinary tax rates may invite abuse, two new Code provisions seek to prevent the “conversion” of ordinary income to capital gains, and to impede “rate arbitrage” involving the investment interest deduction.

The first of these provisions denies the 28 percent capital gain tax rate to gains that have a decidedly ordinary-income flavor. Thus, new Code Sec. 1258 taxes as ordinary income “capital gains” arising from an investment where “substantially all of the taxpayer’s return is attributable to the time value of the taxpayer’s net investment in the transaction.” The rationale for this provision is that the investment return above actually constitutes disguised interest, which, like other interest, should be taxed at the higher ordinary income rates. This provision is effective for “conversion” transactions entered into after April 30, 1993.

The second anti-abuse provision seeks to prevent “rate arbitrage” with respect to capital gains and the investment income deduction. Generally speaking, the Code permits a deduction from ordinary income for interest expenses attributable to investments. Congress had, even before the 1993 Act, limited the scope of the investment interest deduction to “net investment income.” Net investment income is  the excess of “investment income” over “investment expenses.”

The 1993 Act has excluded certain items from “investment income,” with the result that “net investment income” (which in turn defines the upper limit of the investment interest deduction), is reduced. Specifically, investment income no longer includes net capital gain from the disposition of investment property. Since gains attributable to property held for investment will no longer generate ordinary income deductions, rate arbitrage will no longer be possible.

Four changes in the tax law are of particular import with respect to retirment planning. First, for married taxpayers with “provisional” income (i.e., modified adjusted gross income plus one-half of the social security benefit) of $44,000 or more, up to 85 percent of the taxpayer’s social security benefit may now be includible in gross income. Second, a new limit has been placed on the amount of annual compensation that may be taken into account under qualified retirement plans. The new ceiling is $150,000, reduced from $200,000. This means that less of the taxpayer’s money can escape current taxation at the higher marginal rates. Third, for self-employed individuals, the 25 percent deduction for health insurance has been retroactively extended from July 1, 1992 through December 31, 1993. Fourth, effective January 1, 1994, the 1.45 percent Medicare portion of the Social Security tax will, for the first time, also be imposed on income in excess of $135,000.

With the new higher tax rates, charitable contributions will again become more attractive as tax shelters. Charitable contributions in excess of $250 must, under the new law, be substantiated with a “contemporaneous acknowledgment” furnished by the donee organization, which includes the value of any property the taxpayer received from the organization in consideration for the contribution.

Donee organizations must also now furnish every taxpayer who makes a “quid pro quo” contribution (i.e., a contribution in which the taxpayer receives something of value from the charitable organization) with a statement advising the  donor that only the net contribution is deductible for federal income tax purposes. On the bright side, contributions of appreciated property will no longer constitute a tax “preference” for alternative minimum tax purposes.

The 1993 Act also eliminates a complicated and unpopular provision which denied the use of a safe harbor for individuals making estimated tax payments. Under the new provision, estimated taxes may be based on the lesser of (1) 90 percent of the tax shown on the return for the taxable year, or (2) 100 percent of the tax shown on the previous year’s return (110 percent if the previous year’s return showed an adjusted gross income of more than $150,000).

Important changes have also been made with respect to taxpayer disclosure and the penalty for substantial understatement of income tax. A penalty tax of 20 percent is imposed on the amount of any understatement, but it is reduced to the extent that the taxpayer’s position is adequately disclosed on the return. The new law redefines the meaning of “adequate.” While under prior law a nonfrivolous position was deemed adequate, a disclosure now must be reasonable to be considered adequate for purposes of avoiding the 20 percent penalty for understatements.

The 1993 Act seeks to impose a larger share of the tax burden on businesses and corporations. Thus, effective in 1994, the corporate tax rate for  taxable income in excess of $10 million will be increased to 35 percent, from 34 percent. Also effective in 1994, corporations will no longer be permitted to deduct executive compensation in excess of $1 million, subject to a few narrow exceptions. Nor will business executives be permitted the present 80 percent business meal deduction: Effective December 31, 1993, the deductible portion of otherwise allowable business meals will be reduced to 50 percent. Club dues of any kind will also cease to be deductible as of that date.

Another important new tax provision will permit businesses to amortize the cost of many intangibles, including goodwill and going concern value, neither of which had been previously amortizable. Under new Code Sec. 197, qualifying intangible property will become amortizable (i.e., deductible) ratably over a 15-year period, irrespective of the actual useful life of the property.

Many rental real estate operations will also fare considerably better under the 1993 Act. The passive activity loss rules had been especially restrictive with respect to rental real estate, since developers had been denied the right to net losses from real estate operations with other active income. Provided certain participation standards are met, the new law permits losses from rental real estate to offset nonpassive income of the taxpayer. This change is effective for tax years after 1993.

Small businesses will enjoy an increased Section 179 deduction under the 1993 Act. Effective December 31, 1992, the dollar limitation on Section 179 property that may be expensed rather than depreciated is increased to $17,500, from $10,000. This entitlement is rapidly phased out once property placed in service during the taxable year exceeds $200,000.

The 1993 Act did not materially affect the imposition of gift and estate taxes. However, a scheduled reduction in the top transfer tax rate to 50 percent was retroactively aborted; that rate remains at 55 percent for transfers in excess of $3 million. Speculated reductions in both the $10,000 annual exclusion and the $600,000 lifetime exemption from transfer taxes both failed to materialize. Given the comparatively small amount of revenue estate and gift taxes produce, Mr. Clinton might conclude that an attempt to reduce these entitlements, which seem to genuinely offend few, is either not warranted, or is not worth the contentious debate that such an attempt would engender.

Posted in From Washington, Tax News & Comment | Leave a comment

Death-Terminating Installment Notes Held to Generate Taxable Income

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

The Court of Appeals for the 8th Circuit, affirming the decision of a divided Tax Court, has found that installment notes which terminate upon the death of the obligee generate taxable income to his estate. Frane v. Commissioner, 93-2 USTC 50,386.  Prior to this decision, “Death terminating installment notes” were thought by some to be possessed of favorable income tax consequences.

[Ed. Note: When an installment sale is made, the seller agrees to accept payment for the property over period of years. If the installment sale meets criteria specified in Code Sec. 453, the seller must report gain on the “installment method” unless he affirmatively elects otherwise. Under this method, the seller reports gain ratably, according to a statutorily defined formula which ensures that once all payments have been received, all realized gain will have been reported. According to Code Sec. 453B, if an installment obligation is disposed of “other than at its face value,” the portion of the gain that had been deferred by reason of the installment sale provisions becomes immediately taxable.]

The estate had argued that the cancellation of an installment note by reason of the seller’s death would not constitute a taxable disposition under Code Sec. 453B(a), since the cancellation of the note was predicated upon express contractual language, rather than being the result of an extraneous event.

Its analysis presaged with the admonition that the taxpayer faced an “uphill battle,” the Court found that the statute, as well as the clearly articulated Congressional intent, left no doubt that Congress did not intend for the unreported tax to forever escape taxation. Thus, cancellation of the note at death was held to constitute a taxable disposition pursuant to Code Sec. 453B(f)(1), which in turn caused all of the unreported gain to become immediately taxable.

The Court was, however, vague with respect to the basis of the purchasers in the note. Normally, the purchasers of a note would be entitled to a full cost basis. The Court noted, however, that the obligors of this type of note might not be permitted to take a cost basis because the death-terminating feature made the note “contingent or indefinite.” Yet, if the obligors were not allowed a full cost basis, the gain might be taxed twice.

The Court suggested that  injustice would occur only if the tax treatment accorded to the obligor and obligee were “inconsistent,” and then appeared to suggest that  contingent or not, the obligor would take a full cost basis in the note if the obligee’s estate were required to report gain on the disposition. Nevertheless, the Court shed no light on the crucial issue of the timing of the basis adjustment:  Should the obligor’s basis be “stepped-up” in unison with the estate’s recognition of gain, or should the obligor be entitled to take a full cost basis at the time of the initial sale?

The Appeals Court disputed the Tax Court’s finding with respect to the proper taxable entity, holding that the “unambiguous language” in Code Sec. 691(a)(5)(iii) provides that cancellation occurring by reason of death of the obligee is taxable to the estate, rather than to the decedent.

Posted in Federal Income Tax, Installment Reporting, SCINs | Leave a comment

Taxation of Stock Options

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Stock options permit the investor to magnify the change in stock price during a specified, usually short, period of time. In exchange for the right to control large amounts of stock, the option holder assumes the risk that if the expected volatility does not materialize, the option will expire worthless. Since every stock option may eventually be exercised, an actual stockholder must normally exist to grant stock options, in exchange for a consideration termed the premium.

An option is, therefore, nothing more than a contract between the owner of the stock (i.e., the writer), and the purchaser, in which the purchaser is granted the right to buy or sell a specified amount of stock at a predetermined exercise or strike price at a future date, termed the expiration date. A “call” is defined as a right to purchase 100 shares of stock from the option writer at the expiration date; a “put” grants the holder a similar right to sell 100 shares of the underlying stock to the writer at the strike price on the expiration date.

Assume, for example, the owner of 10,000 shares of IBM, which is currently trading at $42, wishes to write calls on the stock as a method of increasing its effective yield. Another investor, who believes that IBM will make a sharp upward move in the near future, purchases 10 calls at a strike price of $45 and an expiration date of November, for a premium of $1,000. By January, IBM has indeed risen to $47 and, nearing the expiration of his options, the investor sells the options on the open market for $2,000. Of course, the investor might instead have decided to exercise his right to purchase the underlying shares at the expiration date for $45,000, in which case he would own 1,000 shares of IBM.

If the option itself is sold prior to expiration, taxable gain is simply the difference between the premium paid for the option and the proceeds of the sale, or $1,000. Since the options here were held for only three months, capital gain will be short-term. Alternatively, if the option is exercised at the expiration date, no taxable event will occur until the underlying stock is eventually sold. The holding period for determining eventual gain or loss would be determined by reference to the date the option to purchase the IBM was exercised. Moreover, the $1,000 premium paid for the option is not deductible. Rather, it is added to the cost basis of the stock purchased in determining eventual gain or loss.

The tax consequences to writer depend upon whether the calls are exercised or whether they lapse unexercised. In the latter case, the premium received by the writer is held in a deferred account until the option expires, at which time they are recognized as short-term capital gain. If, as here, the call is exercised, the amount realized on the sale is the sum of the premium initially received plus the exercise proceeds, less commissions. If the IBM were originally purchased for $40,000 in 1991, the writer would report a long-term capital gain of $6,000 (i.e., $45,000 + $1,000 – $40,000), reduced by commissions.

Posted in Incentive Stock Options | Leave a comment

Life Insurance Trusts

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Life insurance can be an invaluable estate planning tool. It can provide a broad measure of financial security for loved ones as well as provide the liquidity necessary to meet tax and other estate settlement obligations.

Ownership of a life insurance policy by either a new or preexisting trust also endows the policy with the many attractive legal features of the trust vehicle. For example, since the trust instrument will itself provide for the disposition of the insurance proceeds following death, it will be part of the decedent’s nonprobate estate. Moreover, the flexibility of the trust vehicle can grant the purchaser broader discretionary latitude than the insurance policy standing by itself could provide in the distribution of benefits.

Income and transfer tax consequences of life insurance trusts are also generally quite favorable, although the tax treatment depends in substantial part upon the nature and extent of rights retained by the grantor. The more “incidents of ownership” the insured retains during his lifetime, the more likely it is that the trust will be subject to estate taxes in his estate. Thus, for example, although a revocable life insurance trust, like its irrevocable counterpart, will not be part of the insured’s probate estate, the  proceeds of the policy will nevertheless constitute part of the insured’s taxable estate.

Income tax consequences of an irrevocable life insurance trust are extremely attractive. The distribution of insurance proceeds to beneficiaries is nontaxable under the Code. Moreover, unlike  investments that are subject to capital gains tax based on appreciation in asset value, the internal build up of corpus in an insurance policy is not taxed. Not being part of the decedent’s taxable estate, an irrevocable transfer in trust will receive no basis step-up at the decedent’s death. However, since benefits are distributed in cash, this basis step-up is unnecessary and its loss will occasion no unfavorable tax consequences.

Transfer tax consequences of life insurance trusts are more complicated and require careful planning to meet gift and estate tax objectives. When a life insurance policy is transferred to an irrevocable trust, the purchaser is giving up “dominion and control” of the policy, and a taxable gift occurs at that instant. However, that transfer may qualify for the $10,000 annual gift tax exclusion.  If so, the insured’s $600,000 lifetime exemption for transfer tax purposes will not be diminished by reason of the transfer in trust. Future premiums may also qualify for the annual exclusion, depending upon how the trust is drafted.

Provided the transfer has occurred more than three years before insured’s death, the irrevocable transfer in trust of the policy will take it out of the taxable estate of the insured. Where the insured is not expected to survive for 3 years, adverse estate tax consequences may be avoided  by having the beneficiary or trustee take out the insurance policy, perhaps using funds originating from the insured and transferred by gifts qualifying for the $10,000 annual exclusion.

As previously indicated, if the insured does not retain incidents of ownership of the policy during his life, the transfer will be deemed complete for transfer tax purposes and no estate tax will be occasioned upon the death of the insured. Another advantage of an irrevocable insurance trust is that its appreciation, which may be quite substantial, is also removed from the insured’s estate. Care must be exercised to ensure that the purchaser has not retained any prohibited “incidents of ownership” after nominally transferring the policy into an irrevocable trust. Retention of these prohibited attributes, even if inadvertent, would bring the entire policy proceeds back into the insured’s taxable estate, with potentially drastic estate tax consequences. Prohibited powers include, but are not limited to, the power to change beneficiaries, to cancel the policy, to revoke an assignment or to obtain a loan against the policy.

The insured must avoid “incidents of ownership” that might cause inclusion of the policy in his taxable estate upon death. Yet the raison d’etre for the transfer in trust is to permit the insured greater control over the benefits of the policy. These competing objectives may be reconciled. For example, the trust might provide that insurance proceeds be distributed only upon the death of the insured’s spouse. By granting the surviving spouse a lifetime income interest together with a special power of appointment at her death, inclusion of the policy in the insured or his spouse’s estate will be avoided.

The trust may also permit the trustee to purchase assets from the insured’s estate or to make loans to the estate. Estate obligations may thereby be paid with a portion of the insurance proceeds, without the necessity of perhaps selling a family business or other asset that might be difficult of valuation, unlikely to bring full value in a forced sale, or illiquid.

None of these techniques made possible by use of a trust would, if properly administered, cause prohibited “incidents of ownership” to remain with the insured. Yet the trust vehicle will have enabled the insured to possess greater control over the timing and distribution of life insurance proceeds, while at the same time providing needed liquidity for the estate’s obligations.

Posted in Life Insurance Trusts, Trusts | Leave a comment

IRS Statutes of Limitations

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

The prudent taxpayer will file an accurate and timely return  whether or not the stated tax liabilities are satisfied by payment at the time of filing.   Only by doing so will the taxpayer “trip” the period of limitations for I.R.S. assessment of taxes.

The I.R.S. must assess taxes  relating to a deficiency in income taxes within 3 years of the prescribed filing date. An assessment is nothing more than a formal demand for taxes made by a government having the right and power to collect those taxes. Naturally, the expiration of the 3-year assessment period is a welcome event for the taxpayer who has filed an accurate return and paid his taxes.

To be considered a return for purposes of the filing requirement, the document must disclose all items of income, deductions and credits required to compute the tax. The return need not actually either actually calculate the tax or be accompanied by payment.

If the return is not reasonably “accurate,” the statute of limitations for assessment increases to 6 years.  A return is not “accurate” if it contains a “substantial omission” from gross income. An omission is considered “substantial” if it exceeds 25% of the income required to be reported. However, the Code provides that an omission cannot exist with respect to any item which is disclosed on the return or in an accompanying statement. Thus, an aggressive position taken on a return will not, in and of itself, result in the loss of the 3-year assessment period so long as the position is disclosed.

In two circumstances the I.R.S. is never barred from assessing taxes.  The first is where the taxpayer files no return; the second is where the taxpayer files a fraudulent return. Surprising or not, filing no return is far less damaging than filing a fraudulent one, since a filing omission may later be cured by filing the return and paying the remaining tax, if any. (Of course, the taxpayer may be faced with penalties for failure to file and failure to pay, and perhaps interest penalties.)

Filing a fraudulent return is, however, under the tax law, considered to be a fait accomplis, and a taxpayer who commits this act cannot generally be liberated from tax purgatory. One exception to this rules allows a taxpayer who files a “fraudulent” return to file an amended return before the original return due date. Filing a “truthful” return at later time will not generally curry favor with the I.R.S., which may instead consider the second return an admission of the fraudulent character of the first.  Nor will filing a fraudulent return trip the period of limitations for assessment:  the Code penalizes the taxpayer who files such a return by permitting the I.R.S. to assess taxes relating to that return forever.

*          *          *

Just as surely as night follows day, demand follows  assessment.  The government’s demand begins politely with the “30-day letter” and escalates to the “90-day letter.” After being notified of a “proposed deficiency” in the 90-day letter, the taxpayer must either file a petition in Tax Court to prevent the assessment, or he must pay the proposed assessment. Filing a Tax Court petition stays I.R.S. collection until that tribunal renders a final decision. If the assessment is paid, the taxpayer may sue the I.R.S. in district or claims court (but not the Tax Court) within 2 years for taxes erroneously or illegally assessed, together with interest thereon. When faced with this choice, most taxpayers opt to keep the wolf away from the door by filing a Tax Court petition.

If the I.R.S. prevails in Tax Court, it will invariably proceed to collect the assessed tax, which now includes interest. Following a formal written demand, a tax lien arises by operation of law on all of the taxpayer’s real and personal property. To facilitate collection, the I.R.S. is empowered to employ summary administrative levy. Unlike other secured creditors, the I.R.S. is not required to “perfect” its lien by obtaining a court judgment before levying on the taxpayer’s property.

The taxpayer who owns no property may be unimpressed with the Service’s summary administrative powers, which last for 6 years. Near the expiration of those 6 years, the Department of Justice may initiate an action to reduce the lien, which is a quasi judgment, to a formal judgment.  Although this action will greatly extend the period of collection, it will not extend the 6-year period for administrative levy.  After that time, the Service, like other judgment creditors, must enlist the courts’ aid in enforcing judgments.

Periods of limitations for assessment and collection, though jurisdictional, may be extended by agreement. Circumstances may justify consent to extend the period of assessment where the Service is evaluating the taxpayer’s return or legal position. Consent to extend the collection period may likewise be warranted where an “offer in compromise” has been submitted by the taxpayer. The Service may predicate its evaluation of the taxpayer’s financial condition — and offer to satisfy the assessment by paying only a fractional part thereof  — upon the taxpayer’s grant of additional time for I.R.S. collection.

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Deductibility of Business Expenses

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Since personal expenses are not deductible under the tax law, deductibility of an expense requires that the expense be a business or investment expense. Generally, such expenses relate to activities that are engaged in for profit. While business and investment expenses both  constitute ordinary losses, the deductibility of investment expenses is somewhat limited.

Therefore, characterization of an expense as a business expense is ordinarily preferable, since business expenses reduce gross income (i.e., ordinary income and capital gains income) dollar-for-dollar. In contrast, investment expenses suffer from the infirmity of being a “miscellaneous itemized deduction,” which deductions are allowable, but only to the extent that they exceed 2% of the taxpayer’s adjusted gross income (AGI).

Generally, a business expense requires “economic activity,” whereas an investment expense does not. For example, subscriptions to investment trade publications made by a tax attorney in order to manage a portfolio of investments might constitute an investment expense.  These deductible expenses, relating as they do to the “production of income” or the “maintenance and conservation of income-producing property” would be allowed (i.e., reportable) only to the extent they exceeded 2% of AGI. Conversely, expenses incurred in subscribing to tax journals would constitute an “expense incurred in a trade or business” and would be reported as business expenses.

The Code mandates that business and investment activities be “engaged in for profit,” a phrase amplified by the Regulations, which specify the following factors to be considered in this inquiry: (1) the taxpayer’s expertise, (2) the time and effort expended on the activity, (3) the taxpayer’s success, (4) the demeanor of the taxpayer, (5) the taxpayer’s financial status and (6) the taxpayer’s history of income or losses related to the activity. The Regulations also provide that a rebuttable presumption arises that the activity was engaged in for profit if the activity has shown a profit in any 3 of the preceding 5 years.

Having established a profit motive, the business or investment expenses must also constitute “ordinary” expenses.  Again, the Regulations provide guidance by requiring that “ordinary” expenses be both reasonable in amount and bear a proximate relationship to the income-producing activity or property. The Supreme Court has added that the expense must be “customary or usual in the context of [the] business community.”

Finally, an “ordinary” expense must also be “necessary.”  Necessary means “appropriate or helpful” and not indispensable. Whether a cost is “ordinary” seems to involve a qualitative assessment; whether a cost is necessary seems to involve a more quantitative assessment.

Posted in Business Expenses, Deductions | Leave a comment

Deductibility of Medical Expenses

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Expenses incurred for medical care are deductible to extent they exceed 7.5% of the taxpayer’s adjusted gross income, as provided by Code Sec. 213.  Accordingly, a taxpayer with $75,000 of adjusted gross income would be allowed no deduction for medical expenses until those expenses exceeded $5,625.  Only unreimbursed amounts actually paid for medical care constitute deductible medical expenses.

Medical care relates to (1) the diagnosis, treatment or prevention of disease, (2) a capital expenditure whose primary purpose is medical care, (3) transportation expenses “primarily for and essential to the rendition of medical care,” or (4) in-patient hospital care.

For purposes of Code Sec. 213, cosmetic surgery is not “medical care,” and amounts spent therefor will not qualify for a deduction, unless that surgical procedure also “meaningfully promote[s] the proper function of the body or prevent[s] or treat[s] illness or disease.”  Deductibility of medicine is also circumscribed: To constitute a deductible medical expense, medicine must “require” a prescription.

Consider the following example:  In January, the taxpayer, in back pain, purchases aspirin and buys a heating pad.  Still in discomfort, the taxpayer consults an orthopedist, who advises the taxpayer to continue taking aspirin; he also prescribes other medicine and suggests that the taxpayer acquire a whirlpool in his home to treat his condition.  In February, the taxpayer vacations in the Caribbean.  All of the measures help, and by June the taxpayer feels much better.  None of the expenses is reimbursed by the taxpayer’s insurance.  (Note that even if otherwise deductible, no deduction will be allowed for any reimbursed medical expense.)

Since the physician’s fee and the cost of prescribed medicine constitute “medical care” and are not reimbursed to the taxpayer, they may be deducted by the taxpayer, subject to the 7.5% floor.  Since the aspirin, though prescribed by the physician does not “require” a prescription, it would appear by negative implication not to constitute a deductible medical expense under Code Sec. 213(d)(3).  However, the heating pad, even though not procured upon the advice of the physician, would nonetheless appear to qualify as a valid medical expense, since the heating pad is for the mitigation of pain, serves no purpose other than a therapeutic one, and neither the Code nor Regulations predicate the deductibility of all medical expenses on a physician’s or other expert’s recommendation.

The whirlpool that the taxpayer was advised to install in his home required an outlay of $2,000, and increased the value of the taxpayer’s home by $1,500.  According to Treasury Reg. 1.213-1, while the whirlpool “would not ordinarily be for the purpose of medical care,” since it is “related directly to medical care” it could qualify as a medical expense to the extent that the expenditure exceeds the increase in the value of the property, or $500.  Finally, although travel to a warmer climate helps the taxpayer’s condition, since it was not prescribed by the physician, and since it promotes only the taxpayer’s “general” health, it cannot constitute a deductible medical expense.

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Tax Refund Litigation

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

To commence a lawsuit against the I.R.S. seeking the refund of federal taxes erroneously or illegally assessed or collected, a taxpayer must select a court of proper jurisdiction.  Jurisdiction to hear federal tax cases is conferred by federal statute, and different jurisdictional prerequisites exist depending upon in which of the three possible forums the taxpayer chooses to litigate.

The first and most common forum is the Tax Court, whose popularity is attributable to the fact that once filed, a Tax Court petition operates to bar the I.R.S. from assessing disputed taxes until a final Tax Court judgment.  In contrast, the District and Claims Courts, other forums, may hear tax disputes only after the taxpayer has paid the entire disputed amount.

To commence suit in Tax Court for a “redetermination” of tax liability, Code Sec. 6213 requires the taxpayer to petition that Court within 90 days of receipt of an I.R.S. “notice of deficiency.” Since Tax Court jurisdiction is predicated upon a deficiency, the taxpayer may not pay the disputed tax before filing a Tax Court petition.  On the other hand, once the petition is filed, the taxpayer may elect to pay the disputed tax in order to avoid the running of interest, currently 7% for “underpayments”.

Taxpayers opting to litigate in the District or Claims Court must pay the disputed tax up front and, if they ultimately prevail in court, be awarded a judgment against the I.R.S. for taxes that had been erroneously assessed.   Aside from the foregoing “full payment” requirement, two other jurisdictional prerequisites exist for the taxpayer to commence District or Claims Court litigation:  First, Code Sec. 7422(a) bars any suit for recovery of federal taxes “until a claim for refund … has been duly filed.”  A claim for refund is made directly to the I.R.S., typically on a Form 1040x amended return.  Code Sec. 6511 superimposes upon 7422(a) the additional requirement of timeliness in making a refund claim:  Refund claims must be made within three years from date the return was filed, or within two years from the date when the tax was paid, whichever is later.  The second remaining jurisdictional requirement is found in Code Sec. 6532, which requires the taxpayer to wait at least 6 months from the date of filing a claim for refund, but not more than 24 months from the date of I.R.S. response to that refund claim, before commencing suit.

Naturally, the taxpayer who does not wish to pay the disputed tax liability before a final court adjudication will litigate, if at all, in the Tax Court.  A decision to litigate before paying results in economic consequences identical to those that would obtain had the taxpayer borrowed the entire disputed amount from the United States at the beginning of the dispute and agreed to pay (nondeductible) interest at the rate of 7%, (1) until an adverse Tax Court judgment became final, or (2) until a favorable Tax Court judgment became final, but with the government then forgiving the entire amount of principal and interest.

The Tax Court is located in Washington and is staffed by 29 judges, many of whom travel throughout the country and hear cases locally. Therefore, it is not usually necessary for the taxpayer to travel to Washington.  Decisions of the Tax Court are appealable to the Court of Appeals for the District in which the taxpayer resides.  In rendering its decision, the Tax Court must also apply the law of the Court of Appeals to which an appeal from the Tax Court would lie.  Tax Court judges are tax specialists with a reputation for being fair, although not for being pro-taxpayer.  Recourse to a jury trial may not be had in the Tax Court; consequently, all cases are decided by the Tax Court judges.  The Tax Court also contains a branch that settles small cases, where the amount in controversy is less than $10,000.  Decisions from this branch are not appealable.

District Courts, like the Tax Court, are bound in their decisions by the law of the Appeals Court in which the District Court lies, and to which an appeal from the District Court would lie.  District Court judges are tax generalists, since in addition to hearing tax cases, they hear all types of civil and criminal cases.  Jury trials are available in District Court and are often demanded in cases involving Code Sec. 6672 responsible person penalties, Code Secs. 6694 and 6695 return preparer penalties, Code Sec. 166 bad business debts, and valuation issues.

The Claims Court is perhaps the most sympathetic forum the taxpayer can find to hear a tax claim.  Unfortunately, the taxpayer must travel to Washington in order to commence suit in this Court.  As in the Tax Court, no recourse to a jury may be had in Claims Court and, as in the District Court, taxpayers wishing to litigate in Claims Court must prepay the entire tax deficiency.

As an illustration, consider a taxpayer who, in 1995, is audited on a 1992 tax return that was filed on April 15, 1993.  That return claimed substantial losses relating to the sale of rental unit that recently been converted from a principal residence.  Unable to settle the matter informally with the I.R.S. during the audit stage, the taxpayer receives a notice of deficiency in the amount of $25,000 on March 15, 1996.  (The I.R.S. has three years from the date the return was filed in which to propose a deficiency.)  The taxpayer decides that instead of petitioning the Tax Court for a redetermination of the deficiency (and thereby barring immediate I.R.S. assessment) it would be preferable to make a full payment of the disputed amount, file a claim for refund, and then (assuming the claim for refund is denied), bring suit in District Court, seeking a judgment against the I.R.S. for the disputed amount, plus interest at the rate of “overpayment”, currently 6%, and legal costs.

The taxpayer therefore remits to the I.R.S. $25,000 in full payment of the disputed liability on June 10, 1996 (i.e., within 90 days of receipt of a notice of deficiency) and thereafter files a claim for refund on January 1, 1997 (well within the two year period from which the date the tax was paid).   Although the taxpayer may commence a suit for refund as early as June 1, 1997, he delays instituting suit until the I.R.S. notifies him on February 1, 1998 that his claim for refund has been disallowed in full.  The taxpayer then has until February 1, 2000 (i.e., two years from the mailing of the notice of disallowance of the refund claim) in which to file a complaint against the I.R.S. in District Court, seeking a judgment for taxes erroneously or illegally collected in 1993.

Posted in Federal Tax Litigation, Tax Refund Litigation | Leave a comment

Partnership Taxation

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

A partnership, for tax purposes, is defined by negative implication.  It is a “joint venture” or similar organization engaged in business that is not classified as a trust, corporation or estate. Partnerships, unlike corporations, generally pay no income taxes. Taxes are instead paid byn the partners the partners, who are taxed on their share of partnership income, deductions and losses.

For reporting purposes, each partner receives a Schedule K-1, which indicates the partner’s “share” of partnership income. Partners are taxed on their “distributive shares” of partnership income regardless of whether the partnership actually makes any distribution to any of the partners, or even whether the partnership has any assets to distribute. For example, an asset of accrual basis partnership might consist of a large account receivable. This would constitute income to the parnership for which each partner would be required to report his distributive share.

The characterization of partnership income is determined, and frozen, at the partnership level. Thus, the sale of a partnership asset meeting all capital gains requirements would be reported as capital gain on the individual partner’s 1040. (By contrast, distributions of corporate earnings, whatever their source, are characterized as ordinary income at the shareholder level.)

A partner’s “distributive share” of partnership income, deductions and losses is itself determined by reference to the partnership agreement. Since the partners themselves draft the partnership agreement, the partnership form accords the partners great flexibility in determining the incidence of taxation at the partner level. For example, if partner A does not expect income in year one, the partnership agreement could allocate losses in that year to other partners who could better make use of those losses. One sizeable constraint imposed upon the partnership agreement lies in the requirement that allocations enumerated therein comport with economic reality. Thus, two partners could not, consistent with this rule, each contribute $10,000 to an oil venture and allocate all of the losses to one partner and all of the income (if any) to the other.

Another attractive feature of the partnership form is the ability of the partnership to generate losses which can be currently utilized by its partners. (In contrast, shareholders of a C corporation cannot deduct the corporation’s losses for the year. Before they can realize any of the corporation’s losses, they must actually sell their interest in the corporation.) This characteristic often makes the partnership form a good vehicle for the traditional tax shelter, where large losses are expected in the early years. If the venture later becomes profitable, the entity can be changed to a corporation. At that point, the former partners (now shareholders) would no longer be taxed on their distributive shares of income; of course, the corporation would itself be required to pay income tax at that point.

A partner’s basis fluctuates throughout the life of the partnership. Initially, a partner’s basis is the sum of the partner’s capital contributions to the partnership plus his share of the partnership’s liabilities. For reasons which are discussed below, a partner’s basis in the partnership is increased by his distributive share of partnership income and decreased by his distributive share of partnership losses.

A partner’s allowable “distributive share” of partnership losses equals, but cannot exceed his “basis” in the partnership. Once a partner has exhausted his basis (e.g., by claiming losses or receiving distributions), he may not claim further partnership losses until his basis is increased, either by a contribution or by a new partnership liability. This rule prevents a partner from claiming losses in excess of his actual economic stake in the partnership.

Distributive share income reported by individual partners creates basis which will later permit partners to receive partnership destributions tax-free. Partnership distributions are generally not a taxable event since distributions simply reduce the partner’s basis in the partnership. The interplay of the income and basis rules in partnership taxation have as their unifying theme the object to impose tax at the partner level on partnership income, without regard to whether, when or how partnership assets are actually distributed to the partners.

Deciding whether to operate a business as a partnership requires careful consideration of nontax consequences attendant upon this choice of business form. A partnership will usually have a closer nexus to its partners than does a corporation to its shareholders. Consequently, just income and losses of a general partnership flow out to the partners, so too do the obligations and debts. Unlike corporate shareholders, general partners are in a very real sense personally liable for the partnership’s obligations. Another unique feature of the general partnership lies in the authority of each partner to legally bind the partnership.

Partnerships will not automatically continue in existence following the death, bankruptcy, retirement or resignation of a partner. Moreover, because of their close legal ties, partners are given a right to choose their associates. Partners may also have the right to dissolve the partnership at will and withdraw their capital, thus declining to participate further in the risks and ventures of the partnership. In contrast, shareholders of a corporation must continue their investment unless the corporation is liquidated or purchasers for their stock can be found. Another characteristic that distinguishes partnerships from corporations is the usual lack of free transferability of interests in the former. Partners can transfer their entire partnership interest only if all other partners consent. No such constraint exists with respect to the transfer of corporate stock.

Since partnerships generally produce fewer tax revenues for the Treasury, the IRS may seek to tax as corporations entities which are characterized by the taxpayer as  partnerships. Even failure to incorporate under state law will not deter the IRS in this regard.  Before imposing corporate tax rules on the entity, the IRS must demonstrate that the entity more closely resembles a corporation for federal tax purposes than it does a partnership. Treasury Reg. § 301.7701 explicitly provides that if at least three of the following four factors are present, the IRS can tax the entity in question as a corporation, rather than a partnership: (1) continuity of life, (2) centralization of management, (3) limited liability, and (4) free transferability of interests.

Posted in Partnership Taxation, Tax Decisions, Tax News & Comment | Leave a comment

Substantiation Required for Charitable Contributions

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Two significant statutory limitations now restrict the deductibility of charitable contributions. These limitations, the result of changes made in the tax law in 1993, impose new requirements relating to substantiation and disclosure.

Amended Code Sec. 180(f)(8) now requires that all charitable contributions of $250 or more be substantiated with a contemporaneous acknowledgement provided by the donee organization substantiating the amount of cash and a description (but not the value) of any property contributed. The substantiation provided by the donee organization must also include a description and good faith estimate of the value of any goods and services which the donee organization may have provided in exchange for all or part of the contribution. The requirement that the acknowledgment be contemporaneous is satisfied if it is procured on or before the date (including extensions) on which the taxpayer files a return for the taxable year in which the contribution was made.

One important exception exists with respect to the substantiation requirement:  Substantiation is not required if the donee organization files a return with the IRS reporting information sufficient to substantiate the amount of the deductible contribution.

The second important change governing charitable contributions imposes new reporting requirements on the charitable organization with respect to quid pro quo contributions. Thus, charitable organizations receiving a quid pro quo contribution contribution in excess of $75 (i.e., a payment exceeding $75 made partly as a contribution and partly in consideration for goods and services provided to the donor by the donee organization) is required to provide a written statement to the donor that  informs the donor that the amount of the contribution which is deductible for federal income tax purposes is limited to the excess of the amount of any money (and the value of any property other than money) contributed by the donor over the value of the goods or services provided by the organization (i.e., the net contribution). The statement must also provide the donor with a good faith estimate of the value of goods or services furnished to the donor by the organization.

The reporting requirement is suspended where de minimis or token goods or services are provided to the donor. Similarly, the donee organization need not issue any statement if the donor received only an “intangible religious benefit” not generally sold in the commercial context.

The Congresional Report which accompanied the legislation provides that for purposes of the $75 threshold, separate payments for separate fundraising events made during the year will not be aggregated. However, the Report also remarks that the quid pro pro reporting requirement cannot be avoided by the simple expedient of writing multiple checks on the same date, since “contributions that are part of a single transaction will be aggregated for purposes of the $75 threshold.” [Reference: Revenue  Reconciliation Act of 1993, Senate Committee Report]

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Consumption Taxes?

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Our tax system relies primarily on the imposition of income taxes imposed upon persons and entities to fund governmental operations. Estate and gift taxes play a minor role in revenue collected by the Treasury. For  some time, consumption taxes have been discussed as a method of simplifying the tax system, while at the same time improving the equity of that system.

Consumption taxes are not new; nor are they popular. Gasoline, liquor, tobacco and sales taxes are but a few of the consumption taxes which are presently imposed by the federal and state governments.  Consumption taxes are also regressive, in that they disproportionately impact low income individuals. This is so because low income taxpayers spend a higher portion of their disposable income on items which are subject to consumption taxes.

In light of the regressivity of consumption taxes, it is somewhat surprising that some tax economists posit that a broad-based consumption tax, imposed in lieu of an income tax, would promote greater “equity” within the tax system. This argument is based principally on the notion that the present income tax regime penalizes those who save, rather than those who consume.

As an example, consider two individuals, each of whom has $10,000. The first individual spends the money on a cruise around the world, while the second invests the money in a bond paying 10 percent interest. Those who support a consumption tax would argue that the person who invests the money is treated inequitably vis à vis the person who takes the trip, since investor must  report interest income while the traveller enjoys his cruise without the imposition of any tax on the “benefit” conferred by the voyage.

The consumption tax advocates also argue that a tax system based primarily on income taxes encourages consumption, and discourages investment. In support of this assertion, they point out that if in the preceding example, a ten percent tax were imposed on the cruise, but no tax on the investment income, then more people would save rather than spend. However, while it may not seem inherently offensive to tax the consumer rather than the investor — in fact, much could probably be said for encouraging savings — this still does not justify the imposition of additional consumption taxes, for the following crucial reasons:

First, consumption taxes, even if they would accomplish the goal of increasing savings and reducing consumption, would also impose a significant hardship on those persons who are least affluent. Conversely, those with wealth and high incomes would benefit almost exclusively from a consumption tax. No longer would those persons be taxed on their salary income or on the income earned from investments. Although they would pay more in consumption taxes, the windfall they would reap, by reason of there being no tax imposed on their income, would more than offset the new consumption taxes.

Second, with no tax imposed on income, the disparity between wealthy and  nonwealthy persons would continue to grow. Thus, wealthy individuals would be able to engage in endless realization transactions without the gains ever being subject to a taxable event. High income individuals would be able to invest savings tax-free forever. With the immense tax savings realized by reason of the absence of an income tax, wealthy individuals could continue to consume and still fare better in a consumption tax regime.

To illustrate the inequity of imposing broad-based consumption tax in place of the presently existing progressive income tax, consider the case of  two individuals. The first individual, A, has $10,000, and the second, B, has recently inherited $1,000,000. A invests $5,000 in stock paying a dividend of 5 percent, and with the other $5,000 he purchases a sailboat. B invests $900,000 in secure Treasury Bonds yielding 5 percent. With the other $100,000, B buys a Porche.

Consider first the tax treatment under the present income tax system:

A reports dividend income of $250 at the end of year one. His purchase of the sailboat has no tax consequences. His total tax liability, since he is in the 31 percent income tax bracket, is $78.

B reports interest income of $45,000 on the Treasury bonds, and, being in the 40 percent income tax bracket, pays an income tax of $18,000. With respect to the purchase of the Porche, B pays a luxury tax of 10 percent on that portion of the purchase price which exceeds $32,000, or $3,200.  B’s total tax liability is $21,200.

Now assume that broad-based consumption tax of ten percent is imposed in place of an income tax:

A pays no tax on his stock dividend income, but pays a consumption tax of $500 on his sailboat purchase.

B pays no tax on his $45,000 of interest income, but pays a tax of $10,000 on his automobile purchase. In slightly more than two years, B will recoup his entire $1,000,000, even after purchasing the Porche and paying consumption taxes thereon. B clearly benefits by reason of a change to a consumption tax.

A, on the other hand, fares poorly under the consumption tax. Under the present income tax, A pays a $250 tax on dividend income. With the imposition of a consumption tax, it is true A pays no tax on his dividend income; however, he pays substantial consumption tax on the purchase of the sailboat.

Since B has a larger initial cash reserve, he can spend much more on consumables while still retaining, and even augmenting his wealth and future income. A, poorer to begin with, must spend a larger percentage of his available wealth on a consumable item. This leaves A with less money to invest in tax-favored ways. A derives little, if any real benefit from the absence of an income tax. B, on the other hand, clearly benefits from the change to a broad-based consumption tax.

Consumption taxes are regressive, inequitable, and tend to increase the disparity between wealthy and nonwealthy persons. The present income tax regime, though far from perfect, prevents exaggerated accumulations of wealth by reason of the mandated tax holiday on all business and investment income, which the consumption tax celebrates. Placing a disproportionate tax burden, as the consumption tax would, on those persons who are least able to pay, is both unfair and imprudent.

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