Welcome to TaxView with Chris Moss CPA.

Did you know you can Section 1031 to the US Virgin Islands?  Now wait just a minute you say. IRS Code Section 1031 allows us to defer income tax on gains of our investment property sales, perhaps in many cases, forever, but the relinquished property and the replacement property have to both be located in the United States.  Are you sure of that? Just about 15 years ago the IRS issued private letter ruling 200040017 (PLR) pronouncing that the US Virgin Islands were indeed property “in the United States” for purposes of Section 1031 tax free exchange.  But dangerous waters lie ahead for the rest of us because PLRs cannot be cited or relied upon as precedent during an IRS audit. Indeed how you structure and contemporaneously document your unique sale and purchase to the Virgin Islands may determine if you win or lose in US Tax Court perhaps many years after your tax return has been filed.  So if you are interested in a US Virgin Islands Section 1031 Tax Free Exchange  (USVI 1031) stay with us here on TaxView with Chris Moss CPA to learn about the exciting new developments in these unchartered tropical waters of the US Virgin Islands and Section 1031.

The US Joint Committee on Taxation report published in 2013 says that the United States purchased the US Virgin Islands from Denmark in 1917 and codified the tax code there in 1954 to “mirror” the IRS Code in the United States.  While the report goes out of its way to define on page 253 the term “bona fide resident” regarding the US Virgin Islands, the Joint Committee never mentions Section 1031.  The report also makes clear that the US Virgin Islands is not part of the United States by defining the United States as the 50 States and the District of Columbia..  

So how do we structure a USVI 1031 when the Joint Committee in 2013 never bothers to mention a USVI 1031?  In order to create a bullet proof tax strategy for your USVI 1031 we then have to somehow overcome the simple fact that the US Virgin Islands is not part of the United States. We start with the PLR issued in 2000 about a taxpayer who acquired a 6 unit commercial building in the US held in a State land trust with a bank acting as trustee.  Four years later the property was sold through a USVI 1031 which in the 5th year became income producing.  The IRS is asked to comment on whether or not these facts qualify for Section 1031 tax free deferral.

PLR 200040017 ascertains the conflict between Section 1031, Section 932 and specifically gets the message of Section 1031(h) that investment property outside the United States is not “like kind” under section 1031.  Furthermore, the IRS also establishes that the law of Section 7701(a)(9) is clear: The United States “when used in a geographical sense” includes only the 50 states and the District of Columbia.  However, the IRS further reasons, in my view rather brilliantly, in PLR 200040017 that the legislative history of 1031(h) shows Congress did not want to override or otherwise modify Section 932 involving the tax treatment of the US and Virgin Island residents, citing Omnibus Budget Reconciliation Act of 1989 Report 101-386 dated November 21, 1989.   Further research would seem to support the IRS PLR 200040017. According to the Conference Committee Report, the House in their original bill said “Foreign real property is treated as not similar or related in service or use to US real property for purposes of Section 1031”.  The Senate amendment to the House bill had no provision for foreign real Section 1031 property.  So how did this play out in Conference you ask?  

In Joint Conference, perhaps behind close doors, the House and Senate decided to add the following provision: “No inference is intended to override or otherwise modify Section 932 of the Code (involving the tax treatment of US and Virgin Islands residents)”. See Page 614 of the Omnibus Budget Reconciliation Act of 1989, Conference Report dated November 21, 1989. Considering that the House reversed it's prior position on 1031 foreign real property that it had stated in the original House bill, one might ask how this new language could have been inserted into the Conference report without any explanation. Since neither the House Bill nor the Senate Amendment contained any of this new language, perhaps former House Ways Chairman Dan Rostenkowski or Senate Finance Chairman Lloyd Bentsen would have been able to explain what happened.  Unfortunately as they have both since passed we will most likely never know what really happened.

In conclusion, since there does not appear to be any case law yet established to support USVI 1031 tax strategy, before you can file an income tax return with a USVI 1031 tax deferral your tax attorney has to have some ruling or IRS regulation, other than the PLR 200040017 that allows her to structure a legal USVI 1031 and bullet proof the tax return from adverse IRS audit action.   In my view IRS regulations 1.932.1 perhaps might be all we need to support a USVI 1031 that connects to the Omnibus Budget Reconciliation Act of 1989 cited in PLR 200040017.   Deep within Regulation 1.932.1 you will find Section (g)(1)(i) which says that the United States generally will be treated as including the Virgin Islands.  Furthermore, section (g)(1)(ii)(E) says that application of the rule also includes property exchanged for 1031 property.  This regulation clearly says USVI 1031 is legal, even though Section 1031(h) says it’s not and the 2013 Joint Committee Taxation Report never mentions it.

So what does all this mean for anyone who wants a USVI 1031 to the US Virgin Islands?  First, make sure your qualified intermediary (QI), who will control all your funds from start to finish, is a Certified Exchange Specialist and a member of the Federation of Exchange Accommodators (FEA). Conference your QI, tax attorney and real estate agent making sure they are all familiar with structuring a USVI 1031. Second ask your tax attorney for a written opinion as to the soundness of the USVI 1031 structure she is creating for you all.  Make sure your tax attorney cites IRS regulation 1.932.1 as support for your USVI 1031 structure and inserts that documentation into your tax return before filing along with her tax opinion which becomes part of any tax return you file that defers tax under Section 1031.  Finally, enjoy your visits to inspect your new investment property in the US Virgin Islands.   Perhaps I will meet up with you over at Island View Guesthouse.  In the meantime make sure you join us next time with Chris Moss CPA on TaxView when we discuss related party 1031 tax free exchange strategy.

Thank you for joining us on TaxView.

Kindest regards

Chris Moss CPA

Welcome to TaxView with Chris Moss CPA

Are you the adventuresome family that wants to make a lot of money and pay no tax?  No this isn’t a scam or bogus advertisement, but a realistic assessment of US tax law focused on relocating your business to the Virgin Islands; Specifically the US Virgin Islands, (the Islands) about 40 miles east of Puerto Rico, a short flight from most East coast cities, comprising four main islands, St Thomas, St John, Saint Croix and Water Island, as well as dozens of smaller islands. If you are a bona fide resident (BFR) of U.S. Virgin Islands for the entire taxable year, under IRS Code Section 932 your income is 90% tax free.  Perhaps you think this is too good to be true?  Hang on to your rum and coke mon because not only is this true but you can also 1031 tax free exchange over to the islands via Section 932 even though Section 1031 says you can’t do that.  But before you pack your family and head over to on ocean worthy yacht stay with us here on TaxView with Chris Moss CPA to see just how difficult the IRS makes their Island residence tax traps to trip up your trip before you ever leave town.

The question comes down to this: Are you a BFR of the US Virgin Islands?  You say yes, the IRS says no as was the case in Huff v IRS US Tax Court (2010) (Huff 1).  Huff lost a Motion to Dismiss in that case, but was back to Court in Huff v IRS US Tax Court (2012). (Huff 2). The facts in the case are simple: George Huff claimed to be a BFR of the Islands with his income excluded under Section 932(c)(4).  Huff filed his 2002, 2003 and 2004 tax returns with the US Virgin Islands Bureau of Internal Revenue (BIR) claiming no tax owed.  The IRS audited claiming that Huff was not a BFR and owed tax, over a quarter million dollars to more exact.  Huff appealed to US Tax Court in Huff v IRS US Tax Court (2010).

Judge Jacobs points out in Huff 1 that Congress created a “mirror tax” (Mirror) system for the Islands in 1921.  The Islands tax law had major changes in 1954 and 1986 Tax Reform Act, but the Mirror still remains intact. What allows you entry into the Mirror is your BFR status, but the term “Bona Fide Resident” is not defined by IRS Code Section 932.  Nor is it given any definition by the Joint Committee on Taxation.   

Just so you know, there have been what amounts to thesis like research in various law journals on what makes you a BFR.  The IRS requires completion of Form 8898 which you file to let the Government know when you begin or end a BFR but gives you little guidance on exactly when you begin as a BFR.  Due to the lack of definition of BFR, bogus Virgin Island tax shelters surfaced with the help of corrupt tax advisors in the early 21st century.  The IRS issued Notice 2004-45 to attack these tax scams.  In 2004 Congress added Section 937(a) providing for a minimum 183 day residency requirement which mirrors the US substantial presence test of 183 days as well.  Final regulations were issued by the IRS in 2006 but little Court provided case law had been provided at that time to help taxpayers and their tax counsel in BFR determinations prior to filing tax returns.

Huff could not have agreed more.  After his 2010 motion to dismiss was denied in Huff 1, he headed on back to Court again in Huff 2 and filed a motion to allow the Virgin Islands to intervene on his behalf.  Judge Jacobs denied the motion and Huff appealed to the United States Court of Appeals for the 11th Circuit in Huff v Commissioner (11th Circuit) decided February 20, 2014.  The 11th Circuit reversed Judge Jacobs and remanded the case back down to US Tax Court in what will most likely become Huff 3 with instructions to grant the Virgin Islands intervention status as an intervening party. As of this publication date, Huff 3 has yet to be decided on the merits.  However, there is new case law which seems to predict a Huff victory over the IRS as we look at Appleton v IRS US Tax Court (2013).

Arthur Appleton claimed to be a BFR in 2002, 2003 and 2004 of the US Virgin Islands and filed his tax returns with the BIR in accordance with Section 932(c)(4).  Appleton claimed tax free income through a Virgin Islands partnership under Section 932(c)(2).  The IRS and BIR jointly audited Appleton and BIR made no adjustments but IRS said Appleton did not qualify for tax free treatment under Section 932 because under Notice 2004-45 he had participated in scam that lacked economic purpose. IRS assessed Appleton back tax of over a $1Million plus another $1Millon in penalty and interest, claiming Appleton was a nonfiler who should have filed his tax return in the United States.  Appleton appealed to US Tax Court in Appleton v IRS US Tax Court (2013) claiming he did file tax returns as required to the BIR and the statute of limitations had indeed expired. Appleton furthermore filed a Motion for Summary Judgment claiming there was no genuine issue of any material fact in dispute.

Judge Jacobs still handling the Huff remand was assigned Appleton’s Motion for Summary Judgment.  The Court points out that section 932(c)(2) directs bona fide residents of the Virgin Islands to file income tax returns with the Virgin Islands BIR and section 932(c)(4) exempts both U.S. source income and Virgin Islands source income from U.S. taxation if all of the requirements of section 932(c)(4) are met.  Assuming for purposes of Summary Judgment that these requirements of 932(c)(4) were not met, then Appleton would fall back into the regular IRS income tax filing system that covers most all other American taxpayers.  Appleton claimed that in the “Where to file” section in the 1040 instructions a footnote said: Permanent residents of the Virgin Islands should mail to: V.I. Bureau of Internal Revenue, 9601 Estate Thomas, Charlotte Amalie, St. Thomas, VI 00802 when filing their Form 1040 individual income tax returns.  However the Government countered to Judge Jacobs that anyone with common sense would have known to file Form, 1040 with zeroes on it to the Philadelphia Service Center. The Court found the IRS arguments unpersuasive and ultimately granted Appleton’s Motion for Summary Judgment. Appleton wins, IRS loses.

Considering the outcome in Appleton, you would think the IRS would have stopped litigating these statute of limitation cases.  But if Appleton was not enough to stop the IRS then surely the Estate of Travis Sanders v IRS (2015) just decided last week in February of 2015, with the US Virgin Islands intervening, sent a strong signal to the IRS to reconsider its BFR strategy.  The facts in Sanders are simple: In 2002 Sanders became a professional consultant for a company organized in the Islands which required Sanders to become a resident there. Sanders filed his 2002 2003 and 2004 income tax returns with BIR not the IRS.  The IRS audited and claimed Sanders was not a BFR sending Sanders a bill for over $600,000 in back taxes claiming the statute of limitations had not run since no returns were ever filed with the IRS.   The Estate of Sanders appealed to US Tax Court in Sanders v IRS US Tax Court (2015).  Judge Kerrigan who frequently cites Appleton and Huff 2 clearly supports Sanders in what amounts- finally- to a case which actually gets around to defining the true meaning of residency in the US Virgin Islands.

Citing Sochurek v IRS 300 F.2d 34 (7th Circuit 1962), the Court looks towards 11 factors to determine your claimed residency.  Applying Sochurek factors and arranging these factors in “groups” as the Court did in Vento v BIR 715 F.3d 455 (3rd Circuit 2013), the Court concludes that Sanders was in fact a bona fide resident of the Islands because he intended to remain indefinitely or at least for a substantial period, citing Vento v BIR 715 F.3d 455 (3rd Circuit 2013) at page 470.  Sanders wins IRS loses.

What does this all mean for anyone interested in doing tax free business in the US Virgin Islands? First, regarding forward 1031 and reverse 1031 tax free investments in the Virgin Islands, tune in next week on TaxView with Chris Moss CPA when we explore in more detail your tax free 1031 roadmap to the US Virgin Islands.  Second, while your tax attorney may want to wait and see what happens in Huff 3, in my view, Sanders, Sochurek and Vento are all your tax attorney needs to bullet proof your tax return before filing a Section 932 Form 1040 in 2015.  Finally, regardless of what happens in Huff 3-whenever,if ever, that may be- your tax attorney will use Appleton, Sanders, Sochurek and Vento to defend your tax return positions in compliance with Section 932 from adverse IRS audit attack if the Government should happen to select your return for examination.   

Thank you for joining us on TaxView with Chris Moss CPA.

See you next time on TaxView with a 1031 tax free excursion to the Islands mon. Perhaps I will see you there soon? 

Kindest regards,

Chris Moss CPA 

Welcome to TaxView with Chris Moss CPA

For anyone who has tasted a victory in litigation and eventually receives a cash settlement there is one bitter fact:  Your entire damage award is probably taxable, even the one-third portion that went to pay your attorney.  To add insult to injury, attorney fees are not a guaranteed offset to your monetary award. How do you know whether your award is taxable or not?  How can the settlement be structured so you can deduct attorney fees?  IRS Code Section 104 says that damages are not taxable if for personal physical injury or physical sickness.   The IRS 2011 Audit Guide based on the Small Business Job Protection Act of 1996 is also informative.  But at the end of the day, your settlement agreement is going to determine whether or not the award is taxable. So if your litigation is about to settle for lump sum or long term payout commencing in 2015, please stay tuned to TaxView with Chris Moss CPA to see how your settlement agreement should be structured for maximum tax savings for you and your family.

Our first case, Stadnyk v IRS US Tax Court (2008) involves an damage award concerning a used car sale..  Mr. and Mrs. Stadnyk bought a used car on December 11, 1996 for $1100 which broke down hours after the sale. Stadnyk failed to resolve the issue with Nicholasville Auto, so she stopped payment on her Bank One check. When Nicholasville Auto discovered that their check was no good, they filed a criminal complaint against Stadnyk. On February 23, 1997 a Fayette County Sheriff arrested Mrs. Stadnyk at her home, handcuffed, photographed and sent her to jail where she was undressed, searched, and forced to wear an orange jumpsuit.  Stadnyk was eventually indicted for theft by deception in April of 1997 but the charges were subsequently dropped.

Stadnyk sued Nicholasville Auto and Bank One, alleging breach of fiduciary duty of care, fraudulent misrepresentation and malicious prosecution, abuse of process, false imprisonment and outrageous conduct.  The parties mediated and settled for $49,000. Stadnyk received Form 1099-MISC from Bank One reporting the payment of the $49,000 settlement for the 2002 tax year. Stadnyk did not report the settlement proceeds on her 2002 tax return.  The IRS audited and claimed the entire settlement was taxable.  Stadnyk appealed to US Tax Court in Stadnyk v IRS US Tax Court (2008).

Judge Goeke found that under Kentucky law, a tort had been committed against Stadnyk, the first of a two-prong test required for nontaxable treatment of the award. But the second test, whether the injury created by the tort was physical was more problematic. Because the settlement agreement did not address the issue of whether or not there was physical injury the Court had to look at the facts and evidence presented by Stadnyk.  Unfortunately, while Stadnyk endured emotional distress, mortification, humiliation, mental anguish, and damage to her reputation, according to her own testimony, she did not incur a “physical injury” requiring immediate or even longer term medical attention. IRS wins, Stadnyk loses.

Our next case, Simpson v IRS US Tax Court (2013), is about a physical injury in the work place damage award:  The facts are simple:  Simpson a long term employee of Sears Roebuck and was eventually promoted in October 2000 to run a large troubled store in Fairfield, California which required her to work 50-60 hours a week in addition to her 3 hour daily commute.  She also had to engage in strenuous physical activity including receiving unpacking and stocking merchandise.  She incurred injury to her shoulders, knees and neck, became exhausted, lost weight and considered suicide.  Simpson approached Sears’s human resource manager in 2002 and asked for a transfer to another position.  However this request was never communicated to anyone within Sears.  Simpson was eventually terminated..

Simpson retained attorney David Anton to file an employment discrimination suit on the basis of gender, age, and harassment.  Sears settled in 2009 and paid Simpson $12,000 for lost wages, $98,000 for emotional distress and physical disability and $152,000 to Simpson for attorney fees.  In the settlement agreement, Anton attributed 10% to 20% of the $98,000 to work related physical illness.  Simpson never filed a workers’ comp claim and Sears never submitted the settlement agreement to the California Workers Comp Appeals Board for approval.  Simpson reported $152,000 of the settlement and then netted out $152,000 of attorney fees on her 2009 Form 1040 which had been prepared by H&R Block. The IRS audited and claimed the entire settlement was taxable and disallowed all the attorney fees.  Simpson appealed to US Tax Court in Simpson v IRS US Tax Court (2013).

Judge Laro looked at State law and the wording of the settlement agreement, applying the facts of the case to guide the Court as to whether the award was taxable or not.  The Settlement agreement was not detailed enough to help the Court. However, the Court found both Simpson and Anton to be credible witnesses.  They testified that the award was settlement for Simpson’s work-related physical injury and sickness which would have been excluded from taxation under Section 104(a)(1) and regulations 1.104-1(b). But the IRS countered that Simpson failed to submit the award for approval to the California Workers Comp Board as required by California state law.  The Court ultimately ruled to give both the IRS and Simpson a partial victory:  In a victory for the IRS, the Court decided that only 10% of the settlement payment of $98,000 was not taxable. However in a victory for Simpson, attorney fees of $152,000 were deductible against $152,000 of taxable settlement under Section 62(a)(20).  IRS and Simpson both win in a compromise decision.

What does this mean for anyone out there about to settle litigation for damages?  First, your settlement agreement must be specific enough to describe exactly why you are receiving your award.  Each of you will have a different unique set of facts that should detailed in the settlement agreement, If the Courts cannot use the settlement agreement to understand whether the injury was physical or not, then the Court will look to the facts and circumstances of your law suit as well as interpret State law for further clarification.  Second, make sure your litigation attorney conferences with your tax attorney at the time the law suit is filed, during litigation and finally upon settlement of the case so your award if at all possible could be structured tax free with your attorney fees tax deductible.  Finally, have your tax attorney include in your tax return a written opinion as to why the award is not subject to taxation.  During an IRS audit years later you will be glad you did.

Thank you for joining us on TaxView with Chris Moss CPA.

See you next time on TaxView

Kindest regards

Chris Moss CPA

Welcome to TaxView with Chris Moss CPA.

Are you receiving tax free deferrals from 1031 exchanges?  If your 1031 exchange gets audited by the Government the first question the IRS auditor will most likely ask you is--Do you hold your real estate for sale or do you hold your real estate for investment?  How you answer this question and what evidence you have to support your answer may determine whether you win or lose the audit and whether your transfers will be taxable or tax free. Indeed, if you hold the property for investment you win but if you hold the property for sale you lose. So if you are involved in 1031 real estate exchanges, either forward, reverse or leaseback, and want to protect the tax free deferral of your gains, stay tuned to TaxView with Chris Moss CPA to learn how to structure your 1031 deals so can provide the evidence to the IRS you need to prove you own your real estate for investment and not for sale.

So what does “held for investment” (HFI) mean and how can you create the facts and evidence in your 1031 tax free exchanges to support the HFI best practice evidence needed to win an IRS HFI audit? Moreover, the definition of what constitutes HFI property is not easily found and neither the IRS Code nor the regulations define HFI. Neal Baker found out the hard way in Neal Baker v IRS US Tax Court (1998).

The facts were simple: Neal Baker Enterprises was a construction company incorporated in 1957 in California by Neal Baker. The company restructured in 1969 to acquire real estate for investment and development. In 1989 Baker sold some of the land that had been developed and reported on its corporate tax return 1120 a deferred nontaxable gain of $428,806 under Section 1031. The IRS audited and disallowed the tax free deferral claiming that the exchange did not qualify as a nontaxable exchange under Section 1031(a) because the real estate was primarily for sale and not HFI.  Baker appealed to US Tax Court in Baker v IRS US Tax Court (1998) arguing that their original intent was to construct rental apartment units on the property in question and to hold to units for long term investment.

Judge Wright notes that the plan that Baker submitted to the County called for subdivision of the property into 48 lots for the construction of single family residential homes and would not have allowed for multi-family residential zoning.  Baker claimed his intent changed years after the plans were submitted to the County.  The Court agreed that “intent is subject to change” but only if there is written evidence, citing Cottle v IRS US Tax Court (1987).

The Court saw “no evidence of actions by Baker’s Board of Directors to corroborate Baker’s statement that he was no longer subdividing land.”  The Court finds that Baker’s mere statements that his company intended to discontinue the development business are not enough to change the characterization of the Exchange Property, citing Tollis v IRS US Tax Court (1993). Indeed on each of its tax returns from years 1982-1991 Baker chose “real estate subdivider and developer” as its principal business activity on business tax form Form 1120 even though he could have chosen “real estate operator and lessor of buildings”. To make matters worse for Baker, the Government argued that Baker’s accounting records had recorded the Exchange Property as a fixed asset under “construction in progress”. Baker countered that the accountants were in error, but regrettably for Baker, the accountants never testified in court to explain, verify, or discuss why the real estate was classified incorrectly. IRS wins Baker Loses

What if you have a mix of HFI and for sale property as did Larry and Cynthia Beeler in Beeler v IRS US Tax Court (1997).  The facts are relatively simple: the Beeler’s lived in Port Richey Florida and owned a mobile home park.  In 1984 in order to expand their operations Beeler paid $766,000 for 76 acres of land next to the trailer park. Beeler also wanted to mine sand if they could obtain a County permit to do so.  Beeler eventually obtained a mining permit in September of 1984 allowing them to extract 600,000 cubic yards of sand. But the application for the permit clearly stated that the primary purpose of the land purchase was to expand the mobile home park not to mine sand.  Beeler claimed mining depletion deductions on their Schedule C on the personal 1040 tax returns from 1984 until the property was sold for $1.2 million in 1991 under Section 1031.  On Beeler’s 1991 tax return the sale was reported on Form 4797 as a nontaxable transfer under Section 1031.  The IRS audited and disallowed the Section 1031 tax free exchange claiming the sand was “property held for sale”.  Beeler appealed to US Tax Court in Beeler v IRS US Tax Court (1997).

Judge Colvin quickly finds that while Beeler did mine the sand, mining was not their primary business as evidenced from the written application filed for the mining permit back in 1984.  The Government countered that sand is inventory, not real estate, that sand on the property was worth $569,000 at the time of the sale and that at least that portion of the $1.2 million sales price should be taxable gain.  But the Court again found again for Beeler in that sand was never mentioned in the sales contract.  Beeler wins, IRS Loses.

So how can you bulletproof your tax return from an IRS Section 1031 HFI audit trap? First, if you are active in Section 1031 tax free exchange of real estate, be warned that to win a HFI IRS audit, you must have “contemporaneous” written evidence that your property was HFI over the entire duration of the Section 1031 exchange period.  Second, if you alternate from year to year from being a landlord to a builder of multifamily rental units, or a developer of land into single family buildable lots, you must have “contemporaneous” evidence from your Board and your tax attorney to prove your 1031 property was HFI and not held for sale..  Finally, make sure each tax return filed during the 1031 exchange period contains written evidence in the return itself as to your HFI intentions. Years later during an IRS Section 1031 HFI audit you will be glad you did.

Thank you for joining us on TaxView with Chris Moss CPA.

See you next time on TaxView.

Kindest regards

Chris Moss CPA