Welcome to TaxView with Chris Moss CPA

Cost Segregation is a tax savings strategy that in my view defies logic, yet nevertheless is a brilliant absolutely legal way to save taxes. What is Cost Segregation you ask?  In essence, Cost Segregation separates out costs in a building into structural components which can be depreciated at tax advantageous rates. "Structural components" date back to the investment tax credit (ITC) real estate tax shelters in the late 1970s. Accelerated depreciation rules were enacted by Congress back then allowing  “structural components" of a building to qualify for the ITC . More recently the US Tax Court validated "Cost Segregation" of structural components in Hospital Corporation of America vs IRS (1997). How does this help you? It could mean big tax savings for you if you own commercial real estate.  So stay with us here on TaxView with Chris Moss CPA to learn how you can use cost segregation in your commercial or rental real estate for immediate annual income tax savings.

Do any of you remember the late 1970s ITC shelter partnerships?  You would identify the structural components of a building you had just purchased, wrap the deal with a mortgage, add a little of your own money, use the ITC, and presto, you ended up with a large tax loss dramatically reducing your W2 income.  By 1981 wealthy taxpayers were starting to discover real estate tax shelters. Just a few years later the hottest topic at any cocktail party throughout the country was tax shelters.
     
Now fast forward to 1986. The Tax Reform Act was designed to rid the nation of tax shelters and it did just that. The 1986 Reform Act repealed the ITC, prohibited passive losses from offsetting W2 income and dramatically lengthened depreciation of real estate.. All of a sudden commercial property you acquired was now depreciated over 31 year life rather than 19.  (Just so you know, it’s 39 years now).  

As the 1980s came to a close investors began to panic: No ITC and no rapid depreciation and no passive loss offset. Investors looked to their CPAs and their tax lawyers for relief. CPAs and tax lawyers in the early 90s partnering with structural engineers were surprised to find the IRS Code still contained the 1970s "structural component" classifications. Was this a simple Congressional oversight back in 1986 or did Congress intend to leave these provisions in the code for some reason?  At any rate by the mid-90s tax shelter promoters were claiming that the 1970s classifications supported rapid depreciation of "structural components" as long as they were properly classified by competent structural engineers. It didn't take long for the IRS to start fighting back. 

The battle soon moved to US Tax Court in Hospital Corporation of America vs IRS (1997). The facts are simple: Hospital Corporation (HC) was in the business of building and managing hospitals. HC segregated out various components of their many buildings as Section 1245 personal property allowing them to rapidly depreciate these components over a 5 year period. The IRS disallowed all this depreciation sending a $700 Million tax bill to HC for years 1978 to 1988. The Government argued that all the buildings must be depreciated over a much longer period of time as required for Section 1250 property by 1986 Tax Reform Act.  The sole issue? Whether the structural components laws that remained in the Code from the 1970s were nevertheless still valid in 1997,  

Judge Wells in his 116 page Opinion points out that Congress in the 1986 Act did not specifically address the 1970s provisions of the Code that were created to facilitate the ITC back then. The Court noted that the statutory language manifested a Congressional intent to retain the prior law distinction between components that constitute Section 1250 real estate and items that constitute Section 1245 personal property.

With the US Tax Court giving its blessing, and the IRS acquiescing, a billion dollar 
"cost segregation" industry was born to “segregate out” the cost of the tangible Section 1245 portion of a building.  With a good engineering analysis the CPAs were able to confidently and legally rapidly depreciate substantial parts of commercial buildings on annual tax returns knowing they could win an IRS audit.  

What does all this mean to you all? First and most important: Cost Segregation is legal folks but only if your experts are better than the Governments. So if you are purchasing a building, hire the best structural engineering firm you can afford and segregate out those costs into structural components that will qualify for rapid deprecation and immediate tax savings. Second, make sure your tax attorney and structural engineers guarantee their work so when the IRS comes knocking on your door, the same people who did your analysis will be there at no extra charge to act as your expert witnesses at a possible US Tax Court trial. Likewise ask that the same tax attorney who prepared your tax return to guarantee that she will be there for the IRS audit and a trip to US Tax Court if needed.. Finally, don't forget to include your structural engineering cost segregation report summary in the actual tax return you file with the IRS.  When you are audited years later you will be glad you did..  

We hope you enjoyed this weeks TaxView with Chris Moss CPA.

See you all next time on TaxView
Kindest regards
Chris Moss CPA

Welcome to TaxView with Chris Moss CPA

Have you ever loaned money to someone who didn't pay you back?  Did you know that if you can’t get your money back you could at least write the debt off for taxes?  It’s called a “Nonbusiness Bad Debt” (NBD) and it is deductible as a short term capital loss in the year the debt becomes worthless.  Or perhaps you loaned money to someone only to discover later you were swindled out of your money by a clever scam artist. That loss is called a theft loss (TL) and is deductible as an ordinary loss in the year you were certain you could not recover your money.  Seems easy to take these deductions? Right? Wrong! There are IRS landmines waiting for you in Section 166 and Section 165 of the IRS Code. So if you have a TLs or NBDs and are not sure which year to claim or how much to claim, stay with us here on TaxView with Chris Moss CPA where you will learn how to save taxes by safely deducting a theft or bad debt loss.

So what qualifies as a NBD?  IRS Code Section 166(d)(1) and Regulation 1.166-1(c) says that you have to have a debtor-creditor relationship with the person you gave the money to, that a genuine debt in fact existed and the debt was worthless in the year of deduction. Make sure your tax attorney includes sufficient evidence to prove that there was a genuine debt and include those facts in your tax return before you deduct the bad debt. Herrera vs IRS 2012, and affirmed on appeal to US Court of Appeals (5th Cir. 2013).

Theft loss or TL is covered under IRS Section 165(a)(3)  and Regulations 1.165-1(d)(2)(i), (3), 1.165-8(a)(2).  So if there is TL you can deduct the loss as an ordinary loss. Sometimes a TL could be also an NBD.  This is “kind of” what happened in the US Tax Court case of Bunch vs IRS (August 2014). Mr. and Mrs. Bunch filed a 2006 income tax return claiming a bad debt of over $4 Million from Mortgage Co.  Bunch then amended their tax return a few years later and changed the bad debt to a theft loss for the same amount claiming that the money had been stolen by an employee who worked at Mortgage Co.  The IRS audited Bunch in 2009 disallowing both the bad debt deduction from the original return and the theft loss from the amended return. Bunch appealed to US Tax Court in Bunch vs IRS August 2014.

Judge Wherry says timing is everything when it comes to TL and NBD tax deductions.  Indeed you can only deduct a TL or NBD if you can prove that no reimbursement is possible. The Court further noted that in fact Bunch did receive some recovery of the loss and therefore he could not deduct the loss for the amount and in the year the loss was deducted. Perhaps Bunch could have deducted a smaller loss that he did not recover in some future year, but unfortunately for Bunch that is not the tax strategy his tax preparer used. IRS Wins Bunch Loses.

Jeppsen v. IRS, 128 F.3d 1410 (10th Cir. 1997), affirming Tax Court Jeppsen v IRS (1995) further brings home how important it is to prove that no reimbursement is possible in the year you deduct the loss.  Jeppsen deducted a theft loss of $194,000 on his 1987 tax return claiming a stockbroker misappropriated his money.  However, Jeppsen also sued the broker over the next few years to try to recover the money and eventually won a damage award of $1.5 Million in 1995.  The IRS audited Jeppsen about that time and disallowed Jeppsen’s 1987 loss because it was not certain back in 1987 whether or not Jeppsen would recover his stolen money.  Jeppsen appealed to US Tax Court and lost.  Jeppsen appealed again to the US Court of Appeals and also lost.  IRS Wins Jeppsen Loses.

Halata vs IRS (2012) could happen to anyone who is greedy enough to believe what is too good to be true is true.  Halata a Texas resident befriended Ojeda. Halata was told by Ojeda friend Montgomery that he could repay Halata over $2.5 million in return profits if she loaned him $180,000. Halata did in fact loan $180,000 to Montgomery. The money was never recovered.  Halata never deducted the loss as she most likely did not know she could.  Unfortunately for some other reason her 2007 tax return was audited by the IRS who sent Halata a large tax bill. Halata retained a tax attorney Polk to represent her. Polk claimed his client should be able to deduct the theft loss in 2009 and carry back the resulting net operating loss to 2007 this wiping out any taxes she might owe as a result of the audit.  The IRS disagreed and Halata appealed to US Tax Court.  Halata vs IRS (2012).

.Judge Morrison concluded that under Texas law there was in fact a theft but not until 2009.  Unfortunately for Halata, the Court denied Halata the right to carry back this large loss to 2007 on procedural grounds in that her tax attorney did not raise this issue until after the trial. The Court did however grant Halata the right to take the loss in 2009 and then carry it forward to 2010 and beyond if necessary.  This was a partial victory for Halata and partial victory for IRS.  This case once again underscored the importance of timing when it comes to deducting TL or NBD.

In conclusion, if you all have a material TL or NBD, it is perhaps critical that you retain a tax attorney to prepare your tax return so that your strategy as to the timing of the loss can be properly documented and articulated to the Government in the tax return itself before filing.  Do not file that tax return with a loss unless you can show that there is reasonable certainty that you could not obtain reimbursement for your loss in that specific year. Finally remember when it comes to TL and NBD, timing is everything, making the year of deduction more important than the deduction itself.  Bullet proof your tax return TL and NBD strategy before you file.   Your tax position will be safe and secure from IRS challenge for many years to come. Thank you for joining Chris Moss CPA on TaxView.

See you next time,

Kindest regards

Chris Moss CPA 

Welcome to TaxView with Chris Moss CPA

Are you an entrepreneur with family business? Have you thought about your children and grandchildren being more involved in your business? Perhaps a Family Limited Liability Company (Family LLC) is just what you need. Properly structured for your unique situation, the Family LLC is a 21st century way to hand down the family business for generations to come in a safe, protected and orderly business structure. But if you set up your Family LLC be aware you face dangerous IRS tax mines hidden in IRS Code Section 2036(a) that could explode your tax plan into an IRS audit focusing on when a gift is not a gift (GINAG) and when a transfer is not a transfer (TINAT). Indeed, you may experience unexpected increases in estate tax so high the children might have to sell the farm just to pay the tax. So if you don’t want GINAG or TINAT, or just want to learn more about them, stay with us here on TaxView with Chris Moss CPA to fully understand how to avoid GINAG, TINAT, and Section 2036(a) so you can save and preserve your assets for your children for many generations to come.

Section 2036(a) prohibits you transferring property out of your estate that are “testamentary “in nature. The US Supreme Court in Grace V US, 395 US 316 (1969) has defined “testamentary” as those transfers which leave you in significant control over the property transferred. For example you still control the business you just transferred to your children.Section 2036(a) does not apply to transfers that are bona-fide sales for adequate and full consideration. Furthermore, the bona fide sale exception is satisfied where the record establishes you had a legitimate and significant nontax reason for creating your Family LLC, and your children received membership interests proportionate to the value of the property transferred. Turner v IRS 2011 at page 33. Therefore, all transfers and gifts to adult or minor children in a Family Limited Liability Company must be perfectly executed to comply with Section 2036(a). See Bigelow v IRS, 503 F.3d 955 (2007)Affirming Bigelow v IRS T.C. Memo. 2005-65; also see Rector v IRS 2007.

Our first US Tax Court case is True v IRS 2001. Dave and Jean True made direct gifts in their family business to some or all of their children every year form 1955-1993 at the maximum annual exclusion each year. True did not use a Family LLC. Instead of using an LLC Operating Agreement, True created restrictive buy-sell agreements for all of the family. This Agreements gave Dave True total control over all family business. Dave True died on June 4, 1994 with many various trusts in place with True still maintaining control over all businesses. An Estate Tax return was filed on March 3, 1995 with the Estate valued less the value of all the gifts given to all the children over all the years. The estate was audited by the IRS in 1998. Do you all see the GINAG and TINAT coming?

Sure enough the IRS determined that the whole purposes of the gifts to the True children and related buy-sell agreements was to avoid estate tax. The Government sent the True family a bill for over $75 Million plus $30 Million in penalties adding back all those gifts as a violation of Section 2036(a). This is major GINAG. Why? True was giving everything away without a business structure to back up his estate plan making the primary motive to avoid estate tax. As the Court notes on page 108 of this over 300 page Opinion, Dave True had “control” over the whole operation which made for good GINAG in that he had a “life estate” in the business operations. In my view if True had set up a Family Limited Liability Company with normal restrictions placed in a family Operating Agreement allowing the family under unanimous consent provisions to control the assets, GINAG and TINAT would have been avoided, and assets would have been preserved and protected from Section 2036(a). Unfortunately for the True children, IRS wins True loses.

Our next case is Hurford v IRS 2008. Thelma Hurford was a very wealth widow. On advice of legal counsel she formed a Family Limited Partnership which allowed her to transfer assets, including farms and ranches into a single entity. Hurford gave a 25% interest to each of her children. But Hurford still maintained control over everything. GINAG is written all over this. Hurford even remained the sole signatory on many of the accounts. Hurford died on February 19, 2001. The estate tax return was filed on September 26, 2001. The IRS audited the return on November 18, 2004 claiming Hurford owed over $20 Million for estate and gift tax. Hurford appealed to US Tax Court in Hurford v IRS 2008.

Judge Holmes and the Government proposed GINAG for the whole estate plan calling it nothing more than a transparently thin substitute for a will. The Court agreed with the Government finding that Hurford retained an impermissible interest in the assets she had tried to transfer to her children in total violation of Section 2036(a). Further the Court noted that Thelma commingled her own funds with the partnerships until shortly before she died, and that there was no meaningful economic activity where the partnership furthers family investment goals or where the partners work together to jointly manage family investments. You guessed it IRS wins Hurford loses.

Our last case: Stone vs IRS 2003. Mr. and Mrs. Stone founded multiple business ventures. They were also beneficiaries of various trusts. Perhaps due to or because of all this wealth, the family and 4 children Eugene, Rivers, Rosalie and Mary and other parties sued each other in the early 1990s over these trusts. After settlement of all the litigation, Stone formed 5 family limited partnerships in 1996 for his wife and 4 adult children. The partnership agreements provided unanimous consent of all partners to sell, transfer or encumber property and the children worked in the businesses owned by the partnerships. Mr. Stone died as a South Carolina resident on June 5, 1997 at age 89. Mrs. Stone died on October 16, 1998 at age 86. An estate tax return was filed for both Mr. and Mrs. Stone and the IRS eventually audited. The Government sent Mr. Stone a bill for $8 Million and Mrs. Stone a bill for $1.5 Million claiming the transfers to the partnerships violated Section 2036(a). Stones appealed to US Tax Court Stone v IRS 2003.

Judge Chiechi notes that the Stones retained enough assets in their estate to maintain their life style. The Court found that transfers were motivated primarily by investment and business concerns relating to the management of certain of the respective assets of Mr. and Mrs. Stone during their lives and thereafter. The Court concludes that the partnerships had economic substance and operated as joint enterprises for profit through which the children actively participated in the management and development of the assets and therefore the transfers were bona fide sales for adequate and full consideration in money or money’s worth under section 2036(a). Stone wins IRS Loses. Also see Mirowski v IRS US Tax Court 2008

So what does this all mean for us? If you have a business or perhaps multiple businesses and your tax attorney has suggested a Family Limited Liability Company which will own all of these businesses make sure the operating agreements protect you from Section 2036(a) and GINAG and TINAT. Based on the US Tax Court case law, retain some assets for yourself to maintain your lifestyle and perhaps transfer everything else to the LLC. Regarding adult children who are willing to participate in the family business see to it that they are signatures on the bank accounts and make sure there are unanimous consent requirements for all important decisions. Any gifts to minor children through the annual tax free gift exclusion require an absolute legitimate bullet proof non tax purpose in forming the LLC. Finally consult a tax attorney to create your unique business plan. Avoid GINAG and TINA. Most importantly avoid violation of Section 2036(a). You will be ready for any IRS audit coming your way and your assets will be part of your family legacy to your children and your children’s children for many years to come.

Thanks for joining me on TaxView with Chris Moss CPA.

Kindest regards
Chris Moss CPA

Welcome to TaxView, with Chris Moss CPA

Death tax is a fact of life, or death, as the case may be, and  Governments have been taxing us for thousands of years with death taxes when we die. Euphemistically referred to as “estate tax”, the tax is assessed when assets are transferred to your beneficiaries on that special day of your departure over the tax free IRS allowed exemption. Despite the fact that Congress likes to adjust this exemption from time to time, if your tax attorney “guessed” right as to what the tax free exemption will be when you die, your estate pays no tax, if she guessed wrong….well your kids just might have to sell the farm to pay the estate tax. Best practice is to gift to your Family Limited Liability Company (LLC) up to the IRS annual 2014 exclusion of $14,000 per person ($28,000 if married) which reduces by the same the amount of the value of your estate. Sounds easy, but beware of the IRS tax traps waiting for the unwary beginner. So you had better stay with us on TaxView with Chris Moss CPA for an exciting journey to the beginner’s world of estate and gift tax planning so you can keep your assets legally safe from taxation for many generations to come.

First, if you don’t yet have a Family LLC I recommend you first read my article on the Family LLC as well as read my article on Family LLC Discounts. You can make up to $28,000(married) in 2014 tax free gifts a year to each of your children. If you are married and have two children age 10 by the time they are both 20 each will have $280,000 worth of membership in your family LLC. In addition to the annual gift exclusion of $28,000, you can also make lifetime gifts of $5M ($10M married) but these gifts require the filing of a gift tax return with the IRS. Any gifts over the $10 Million are taxable, either as gifts if you are alive or as estate tax if you are dead. Because Congress frequently changes these exemptions and exclusions, best practice requires annual review of your estate plan by your tax attorney to make sure your unique plan complies with current law. Sounds simple but not really. In addition to ever changing exclusion and exemptions amounts, there are many death traps awaiting you as you create the family LLC.

The first trap we are going to cover today is released with a trap question: When is a gift not a gift? To answer this question we head on over to US Tax Court to listen in on a 2013 Tax Court case Estate of Sommers v IRS. Sommers was a successful physician who owned a valuable collection of art. Sommers retained the services of a B&T Tax Attorney who advised Sommers in 2001 to get the art appraised, create an LLC as owner of the art and gift LLC units to his three nieces, Wendy Julie and Mary up to the maximum allowed exemption ($675K at that time) to avoid Sommers of having to pay gift tax. However, after the appraisal came in over the exemption and gift tax was owed, the nieces paid the gift tax themselves to avoid any breach of the agreement and more importantly to reflect that the parties carried out the original intent of the agreement that Sommers pay no gift tax.

Fast forward a few years and Sommers (or perhaps other relatives of Sommers) changed their minds about gifting the art to Wendy, July and Mary, but the nieces refused to give the art back to Sommers. After Sommers died, his executor sued the nieces for the art in various State court actions claiming that the gift agreement was illegally altered when the appraisal came in over the allowed exemption. Even though the estate eventually lost in state court, it’s legal executor nevertheless included the value of the art as part of the estate tax return on Form 706. The IRS rejected this return noting that Form 709 a US Gift tax return had been filed years earlier in 2001 for these same works of art. Sommers estate appealed to US Tax Court. Estate of Sommers vs IRS. Judge Halpern sided with the IRS noting that Sommers did not retain the power to “alter, amend, revoke or terminate those gifts within the meaning of IRS Section 2038 and therefore, the gifts were valid and had to be removed from Summers estate. IRS (and nieces) win, Estate of Sommers and other relatives lose.

The second trap we are going to look at today is found in the Operating Agreement of the LLC as highlighted in the US Tax case of Hackl v IRS. Hackl was a successful executive with Herff Jones Inc. in Georgia. Upon his retirement in 1995 he started a tree farming business with his wife in both Georgia and Florida. Treeco LLC was created with both Mr and Mrs Hackl owning 50% each. The LLC operating agreement designated Hackl as the initial manager to serve for life and had very restrictive buy sell provisions. One such restrictive provision required each new member to get Hackl’s permission before they could sell their membership, even if the sale was between brothers and sisters. Shortly thereafter, Hackl gifted various membership interests in Treeco to each of his eight (8) children and spouses and timely filed gift tax returns to the IRS claiming the gifts qualified for the annual exclusion under IRS Code 2053(b). The IRS audited the 1996 gift tax return in 2000 and disallowed the exclusions claiming the gifts were future interest gifts and had no present value. Hackl appealed to US Tax Court in 2002 Hackl v IRS claiming the gifts were in fact gifts and had real substantial present value. Judge Nims points out that for Hackl to win his children must have an unrestricted right to the immediate use possession or enjoyment of the property or the income from property within the meaning of IRS Section 2503(b). The Court agreed with the IRS that due to the severe operating agreement restrictions the children never received a “present” interest in the LLC memberships they received. IRS wins, Hackl Loses.

What does that mean for all of us? If you are planning to gift the current $28,000 (married) annual exclusion to your children through your Family LLC make sure you and your tax attorney create an operating agreement for the children that can withstand Government scrutiny regarding “present interest” in the event of an IRS audit. Second, if you are gifting large gifts over the $28,000 annual exclusion either less than or in excess of the current $10M exemption (married) make sure you file all gift tax returns and pay any gift tax you owe to make sure the gift cannot be revoked or amended by other not so happy relatives after your death. Finally, develop a long range estate and gift tax plan with your tax attorney so that when your final day comes you can keep your assets legally safe from estate taxation to assist your children and preserve your wealth for many generations to come.  Thank you for joining us on TaxView with tax attorney Chris Moss CPA.

Kindest regards and see you next time,
Chris Moss CPA