Welcome to TaxView with Chris Moss CPA Tax Attorney

Estate Planning is hard to talk about.  Do you really want to talk about death and taxes?  But Estate Planning is also about life-your legacy in this life-and the lives of your children and lives of your grandchildren after you are long gone. Not to mention the tax free estate tax reducing gifts you give to all your children while you are living and enjoying life.  Furthermore, with a custom estate plan, your children and grandchildren can be protected in this life, as you perhaps have been protected if your parents had wisely estate planned in their lifetime. A good estate plan will not only secure and protect your family from harm’s way, but also prevent you all from being taxed to death by excessive estate tax so high your kids might just have to sell the farm to pay your death taxes. So if you are interested in protecting your family-and your assets-for generations to come, stay with us here on TaxView with Chris Moss CPA Tax Attorney and find out how you all can create the perfect Estate Plan for your family.

Let’s start your Estate Plan with gifting.  You can actual gift assets to reduce your estate tax to each child and grandchildren up to $14K or $28K married each year tax free. But what if you gift over the $28K annual exclusion?  Current law in 2015 allows you a one-time exclusion a $5.43 Million dollar limit in your lifetime-$10.86 Million married.  But be warned: this lifetime exclusion is subject to Congressional reform just about at any time during any administration.  If you gift over the lifetime exclusion you are taxed at 40% on the overage as the Cavallaro family found out in Cavallaro v IRS US Tax Court (2014).

Cavallaro started out in 1979 and grew the company with his three sons into Camelot Systems and Knight Tools both operating out of the same building.  In 1994 Ernst &Young (E&Y) was retained to consider an estate plan for Cavallaro.  They suggested a merger of both Knight and Camelot.  Unbeknownst to E&Y, Cavallaro also retained attorneys Hale & Dore of Boston for estate planning.  Mr. Hamel of that firm claimed that much of Camelot was already owned by the three sons based on a one-time transfer made in 1987 to the sons in exchange for $1000 from all three sons.

When E&Y found out about Mr. Hamel’s plan, senior partners in E&Y immediately pointed out that the 1987 transfer was at odds with all the evidence and E&Y would not support this tax strategy. Unfortunately for Cavallaro, the attorneys eventually prevailed and the accountants acquiesced. Gift tax returns were filed after the merger showing no taxable gifts and no gift tax liability.

In 1998 the IRS audited the business returns for 1994 and 1995 eventually claiming that gifts from parents to children as a result of the merger were grossly undervalued in the gift tax returns Form 709 filed in those years of the merger.  The IRS issued third party summonses to E&Y.  The tax attorneys filed petitions to quash the summonses fighting all the way to the Court of Appeals for the First Circuit, but eventually lost on all counts. 

The Court denied Cavallaro’s motion to quash and ordered the summons enforced as per Cavallaro v United States 284 F.3d 236 (1st Cir 2002) affirmed 153 F. Supp. 2d 52 (D. Mass 2001).    As the Court noted there was no attorney client privilege with a CPAs.  Therefore all documents had to be handed over to the Government and the E&Y accountants had to testify in many cases against their client’s best interest in compliance with the Court Order.  Cavallaro appealed in Cavallaro v IRS US Tax Court (2014)  and claimed the gift was at arm’s length. After hearing all the witnesses and reviewing the documents, Judge Gustafson opined that the 1995 merger transaction was notably lacking in arm’s length character, and concluded that the gift was undervalued by Cavallaro.  The Court then ruled that Cavallaro made gifts totally $29.6M in 1995 when the two businesses merged handing Cavallaro a tax bill of $12,889.550.   IRS wins Cavallaro loses.

Another case Estate of Rosen v IRS (2006) brings us to the next key component of gifting: control.  Unless you lose control of the assets you gift, the assets unfortunately still remain in your taxable estate upon your passing.  The facts in the Rosen case are simple.  Her assets were mostly stocks, bonds, and cash.  Her son-in-law formed a family limited partnership in 1996 and the children signed a partnership agreement and a certificate of limited partnership was filed with the State of Florida.  Each of the children were given a .5% interest and the Lillie Investment Trust was formed to own a 99% interest. $2.5 million was transferred from Rosen to the Lillie Investment Trust as consideration for its 99% interest.

What is interesting is the partnership conducted no business and had no business purpose for its existence other than to save taxes.  When Rosen died the IRS audited sending the Estate over a $1 Million tax bill, claiming all the money in the partnership was includable in Rosen’s estate because Rosen controlled until her death the possession or enjoyment of, or the right to the income from the assets. The Estate of Rosen appealed to US Tax Court  in Estate of Rosen v IRS (2006) claiming that Section 2036(a)(1) does not apply because the assets were transferred in a bona fide sale for full and adequate consideration. Alternatively the Estate argued that Rosen did not in fact retain enjoyment or “control” of the assets while she was alive.

Judge Laro observes that the US Tax Court has recently stated, a transfer of assets to a family limited partnership or family limited liability company may be considered a bona fide sale if the record establishes that: (1) The family limited partnership was formed for a legitimate and significant nontax reason and (2) each transferor received a partnership interest proportionate to the fair market value of the property transferred citing the Estate of Bongard v. Commissioner, Estate of Strangi v. Commissioner, Estate of Thompson v. Commissioner, US Tax Court on remand, and Thompson v. Commissioner on Appeal 382 F.3d 367 (3d Cir. 2004)

The Court concluded that the overwhelming reason for forming the partnership was to avoid Federal estate and gift taxes and that neither Rosen nor her children had any legitimate and significant nontax reason for that formation.  In addition Rosen herself used the partnership to pay for her personal expenses all the way up to her death and therefore never truly “gifted” the assets out of her estate.  IRS wins, Rosen Loses.

So how do you safely start gifting so that your assets are permanently out of your taxable estate in a protected Estate Plan?  First create an Estate Plan that has a legitimate business purpose in mind.  Second, make sure you have sufficient assets to live without the Family LLC having to support you.  Third make sure you have transferred control of these assets to your children with properly filed gift tax returns.  Finally, with the help of your tax attorney make sure all transactions are contemporaneously documented with appraisals inserted into the gift and personal tax returns before you file.  When the IRS comes to examine your Estate Plan your children will be happy you did.

Thank you for joining us on TaxView with Chris Moss CPA Tax Attorney

See you next time on TaxView

Kindest regards

Chris Moss CPA Tax Attorney

Welcome to TaxView with Chris Moss CPA Tax Attorney

There are now four states that have legalized recreational and medicinal use of Marijuana, Colorado and Washington, Oregon and Alaska. The cities of Portland and South Portland in Maine fully legalized marijuana for both medical and recreational use. The District of Columbia has fully legalized recreational and medical marijuana, but recreational commercial sale is currently blocked by Congress.  Nineteen (19) other states have legalized Marijuana for medicinal use only.  If you are one of many thousands of Americans who will be servicing the Marijuana industry either through growing and farming, distribution, wholesale supply to hospitals and pharmacies, or retail sales to the public, the IRS has a special surprise for you when you file your income tax return. Don’t like surprises form the IRS?  Better stay tuned to TaxView with Chris Moss CPA Tax Attorney to find out the latest on the IRS vs Marijuana Court battles, where we are headed, and how best to structure your Marijuana business.

We have previously written about IRS Section 280E in IRS or State Law for Medical Marijuana, which disallows tax deductions for any amount paid in a business dealing in “trafficking of controlled substances” prohibited by Federal law.  As of publication of this Article, the only expense that is currently deductible against Marijuana sales is the Cost of Goods of the Marijuana.  See California Helping to Alleviate Medical Problems v IRS US Tax Court (2007) (CHAMP) and Martin Olive v IRS US Tax Court (2012).  If you are asking why a Marijuana business legally set up under State law is still considered by the IRS as a business dealing in trafficking of a controlled substance you are asking a very good question indeed.

The answer may be soon playing out in Federal Court. In CHAMP Judge Laro of the US Tax Court said “Section 280E and its legislative history express a congressional intent to disallow deductions attributable to a trade or business of trafficking in controlled substances.   However another non-tax case has been winding its way through the Federal Courts in US v Schweder, Pickard, et al Federal District Court for the Eastern District of California (2011) questions whether or not 30 years after the enactment of Section 280E Marijuana should still be classified in 2015 as a controlled substance.

The facts of the case or very simple.  On October 20, 2011, sixteen individuals were indicted for conspiracy to manufacture at least 1,000 marijuana plants, in violation of 21 U.S.C. §§ 846, 841(a)(1)  Mr. Pickard moved to dismiss the indictment in 2013, arguing that the classification of marijuana as a Schedule I substance under the CSA, 21 U.S.C. § 801, et seq., violates his Fifth Amendment equal protection rights and that the government’s allegedly disparate enforcement of the federal marijuana laws violates the doctrine of equal sovereignty of the states under the Tenth Amendment.  To prove his case Picard filed a motion for an evidentiary hearing which the Court eventually granted.

After the evidentiary hearing was held Judge Mueller on April 17, 2015 denied Picard’s Motion to Dismiss in a 38 page Order concluding that while “At some point in time, in some Court, the record may support granting such a Motion, having carefully considered the facts and the law as relevant to this case, the Court concludes that on the record in this case, this is not the Court and this is not the time.”  Judge Mueller concludes “In sum, the evidence of record shows there are serious, principled differences between and among prominent, well-informed, equivalently credible experts. There are some positive anecdotal reports from persons who have found relief from marijuana used for medical purposes; those reports do not overcome the expert disputes. Consistent with the conclusions other courts have reached, this court finds “[t]he continuing questions about marijuana and its effects make the classification as a controlled substance rational.”

Judge Mueller further opines that after careful consideration, the court joins the chorus of other courts considering the same question, and concludes as have they that – assuming the record created here is reflective of the best information currently available regarding Marijuana - the issues raised by Pickard are policy issues for Congress to revisit if it chooses, citing United States v. Canori, 737 F.3d 181, 183 (2d Cir. 2013) which upheld the constitutionality of Congress’s classification of marijuana as a Schedule I drug.”. Picard then moved for Reconsideration on May 6, 2015 and Judge Mueller Denied the Motion last week on June 1, 2015. Will Picard appeal to the US Court of Appeals for the 9th Circuit?  Good question.  

What does all this mean for anyone planning to run a legal Marijuana business and file a Federal and State income tax return?  First, make sure you retain the services of a good tax attorney who will not only file your tax return but represent you before an almost certain audit of your business by the IRS,  Be prepared to appeal within the Service and eventually to US Tax Court.  Second, be prepared to structure your business to legally maximize your tax deductions through non-Marijuana businesses and to contemporaneously defend this structure to the IRS with sufficient documentation included into the tax return prior to filing.  Finally, be prepared to pay a lot of income tax as an owner of a legal Marijuana business, at least until Congress removes Marijuana as a controlled substance from Federal law.

Thank you for joining us on TaxView, with Chris Moss CPA Tax Attorney,

Kindest regards

Chris Moss CPA Tax Attorney

Welcome to TaxView with Chris Moss CPA

Remember the cash for clunkers program Congress created in 2009 for your old beat up car. You brought in your clunker car to the dealer and got cash to buy a new car to stimulate the economy? It seems that the 100 year old income tax has become an obsolete “clunker tax” and is not working. The income tax needs to be replaced with a new tax better suited for the 21srt century, a National Sales Tax. Stay tuned to TaxView with Chris Moss CPA to find out why.

Historically income tax has always been somewhat of a voluntary tax. History shows most Americans when given the choice, choose not to pay. That is why in 1943 with the introduction of the W2 form in just two years revenue collection increased from $7 billion to $43 billion with 60 million Americans added to the tax rolls almost overnight.   

Congress realized the power of the W2 with revenue collections as a percent of Gross Domestic Product surging from less than 6% to almost 20%.  Unfortunately Americans would fight back against the W2 form.  Slowly an underground economy thwarted forced W2 withholding now estimated to total almost $2 Trillion a year in unreported income.  Congress fought back as well. 

Over the last 30 years there has been an attempt by the Government to “capture” all that underground income by creating the 1099 network of reporting hoping for another W2-like increase in collections as percentage of GDP.  The ultimate 1099 program was enacted in 2010 when Congress tried to capture all income from everyone, but Congress soon realized this was impossible to enforce let alone comply with.  That law was repealed a year later in 2011.  

The fact is that it is impossible in the 21st century to capture all income from 1099s unless the IRS audits everyone. The solution?  An involuntary national sales tax, taxed at the source of each purchase at the same time state sales tax is collected.  Easy, simple and very effective.  But just in case you’re not convinced yet that a voluntary income tax does not work in the 21st century, there’s more:  Identify theft, a 21st century crime is further eroding income tax collections.

The Government is losing at least $6 billion a year to identity theft as organized crime has moved its operations from drug dealing to identity theft.  John Koskinen, the Commissioner of the IRS has recently commented that he has heard from police that “street crime is down because everybody is now filing false IRS returns”.   Add identity theft to the underground economy and the IRS is unable to collect enough money each year to allow America to pay its bills. Further add additional tax revenue being lost to off shore illegal tax shelters and you have the triple crown of tax evasion:  Underground economy, identify theft, and offshore tax shelters.   No wonder our National Debt is dramatically approaching the unthinkable $20 Trillion level.

A National Sales Tax might just wipe out the Underground economy as well as drive organized crime out of the United States Treasury.  As an added benefit, all off shore money would soon return home and many if not all tax shelters would disappear back to the 20th century where they belong.  If Congress were bold enough to embark on a 21st century solution to increase revenue collection, perhaps annual deficits would be wiped out as well.  Could the dramatic rise in collections as a percent of GDP from 1943 be recreated in 2015 with a National Sales Tax?

I don’t know about you all, but I don’t want to see our Government cut services to Americans, including our military, just because Congress does not have the courage to see that the income tax has become a “clunker tax”.  If you all believe that the income tax is now an obsolete clunker, let your elected representatives know how you feel.  Perhaps House Ways and Means and Senate Finance can best serve America by creating a new tax better suited for the 21s century rather than trying to reform a 100 year old clunker.

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

Kindest regards

Chris Moss CPA

Welcome to TaxView with Chris Moss CPA

Do you know someone is defrauding the US Government by filing a false federal tax return? For example suppose you know about a group of perpetrators who are using identity theft to file hundreds of false tax returns and illegally collecting Millions of dollars of bogus refunds.  Are you unconvinced or cynical that this could be happening?  The fact is that Identity theft has grown so lucrative that John Mica, (R Florida) says “Drug dealers are turning to IRS identity theft because it’s less risky and more lucrative”. Perhaps you might discover other tax crimes being committed by neighbors or co-workers hiding assets and taxable income offshore, or better yet not reporting income at all by simply not filing tax returns. Do you become a whistleblower against these folks?  But not so fast your wife says. She asks you to consider the safety and the protection of your family against retaliation before moving ahead with a Whistleblower claim?  Good question right?  So if you are you interested in finding out more about Whistleblowing, IRS style stay tuned to TaxView with Chris Moss CPA to get all the answers on IRS Whistleblowing, whether it is safe to participate for you and your family, and finally, at the end of the day does Whistleblowing really pay.

Just so you know the Government has had a Whistleblower law on the books for over 100 years. The Secretary of the Treasury as early as 1867 was authorized to pay anyone for information leading to conviction of persons guilty of tax fraud. But it was not until 2006, through an enhanced Whistleblower program created in Section 7623 by the Health Care Act of 2006, that the US Tax Court was given jurisdiction to hear disputes between the Whistleblower and the IRS. Furthermore, it was not until about 2012 that taxpayer Whistleblowers started fighting back in US Tax Court to litigate adverse determinations of their awards.  Fast-forward to 2015 and a review IRS Manual Part 25 Special Topics Chapter 2 Whistleblower Awards shows us a massive amount of very good and informative information on the Whistleblower program but no information on currently pending US Tax Court cases. But what about confidentiality and protection of your family?

Section 25.2.2.11 "Confidentiality of the Whistleblower"indeed claims that the Government will protect the identity of the Whistleblower as a “confidential informant” to the “fullest extent permitted by law”. But the Treasury Department in its own 2013 report to Congress has doubts that there is sufficient protection. Specifically Treasury reports “…Unlike other laws that encourage Whistleblowers to report information to the Government, section 7623 does not prohibit retaliation against the IRS Whistleblower…” Furthermore, if you decide to become a Whistleblower and you are an essential witness in a judicial proceeding it may not be possible to pursue the investigation or examination without revealing your identity. 

Does the Whistleblower have any recourse if their claim is unreasonably rejected? If the Government will not move forward and pay you unless your reveal your identity, you can always petition the US Tax Court for a “Protective Order” to seal the record or in the alternative proceed anonymously while you dispute the Government’s position.  In Whistleblower 14106 vs IRS, US Tax Court (2011), the Court sided with the Government on the dismissal of the claim, but Judge Thornton said that “Petitioner’s request to seal the record or proceed anonymously presents novel issues of balancing the public’s interest in open court proceedings against Petitioner’s privacy interests as a confidential informant. The Court noted that Section 7623 does not expressly address privacy interests of tax whistleblowers.  But the US Tax Court has observed in US Tax Court 130 T.C. 586 that in appropriate cases the Court “might” permit a petitioner to proceed anonymously and might seal the record as well. The Court in Whistleblower 14106 did in fact under Section 7461(b)(1) and Rule 103(a) grant the Petitioner the right to proceed anonymously as a Whistleblower but denied the Petitioner the right to seal the record in order to preserve the case for the public’s ability to follow the proceeding, including I might add, my ability to insert the facts of the case into this article. Judge Thornton then ordered the parties to redact from the record all names and any identifying formation regarding the Petitioner. Taxpayer wins on anonymously proceeding and IRS Wins on dismissal.

Now that we know you can proceed anonymously if the IRS does not pay you, we now ask what it takes to win as a Whistleblower in US Tax Court.  In other words at the end of the day if the IRS denies you compensation, what are your odds of getting paid by appealing to US Tax Court?  

First some statistics:  According to the Tax Executives Institute  in 2012 there were 8,634 Whistleblower cases filed, 128 awards granted totaling over $125M leading to taxes collected of over $592M---a 21% return for the lucky whistleblowers whose claims were accepted by the Government on the funds they all brought in to the US Treasury. But there were also 8,506 Whistleblower cases in 2012 which are either still pending, or were dismissed. At the same time, there has been a materially significant increase of US Tax Court Whistleblower cases that are being litigated.  So let’s take a look at what is going on in US Tax Court on some of these pending cases.

In Kenneth William Kasper v IRS US Tax Court (2011), the IRS denied Kasper’s Whistleblower claim determining that the information Kasper provided did not meet the criteria for an award.  Kasper appealed to US Tax Court in Kasper vs IRS US Tax Court (2011). The IRS moved for motion to dismiss for lack of jurisdiction claiming that Kasper did not appeal within the 30 day statute. Judge Haines sides with Pro Se Whistleblower Kasper holding that the 30-day period of Section 7623(b)(4) begins on the date of mailing or personal delivery of the adverse determination sent to his last known address. The IRS could not prove that such a mailing had been delivered so IRS loses, Kasper wins round one.  The case is now hopefully proceeding to trial to eventually be decided on its merits.

So what does all this say about your chances of winning a Whistleblower award?  While there has been a large group of recent Whistleblower cases winning preliminary jurisdictional issues, including the right of Whistleblowers to remain anonymous, it remains to be seen whether or not these same Whistleblowers will eventually win in US Tax Court on the merits of their claims.  Stay tuned to TaxView in 2016 with Chris Moss CPA when we will revisit the Whistleblower claims that are winding their way through US Tax Court to ultimately answer whether or not it pays to be an IRS Whistleblower.   See you all next time on TaxView.

Kindest regards,

Chris Moss CPA

Welcome to TaxView with Chris Moss CPA

Many of you small business owners out there will at some point or another will be audited by the IRS.  If your audit concludes with what you believe to be an incorrect application of the law to the facts in your specific case you should have the professional who prepared your tax return file a “protest” with the IRS Appeals Division. What is the IRS Appeals Division you ask?  First and foremost IRS Appeals is not in the business of examining your tax return and reviewing for example the cancelled checks to support your expense deductions. The IRS Appeals Division rather is an elite group of experts, who ultimately report directly to the Commissioner.  Appeals will very effectively and efficiently look at the results of your field examination audit and based on the “protest” prepared by your tax professional will make a determination as to whether or not the law was properly applied to the facts in your unique case . So if you have IRS examination tax liability stay with us here on TaxView with Chris Moss CPA to learn how to defend your business by skillfully applying the law to your unique facts before the IRS Appeals Division.  

IRS promulgated Treasury regulation Section 601.106 provides and sets forth the entire framework for Appellate IRS practice.  The IRS says all taxpayers have the “guaranteed right” to appeal as does the Taxpayer Bill of Rights but there is not an IRS Code Section that I can find that guarantees an absolute right to appeal. In fact, as underscored in the Estate of Weiss v IRS 90 Tax Court 566 (2005), while 26 U.S. Code § 7123 Appeals dispute resolution requires the Secretary to prescribe procedures by which any taxpayer may request early referral to the Office of Appeals, Federal law does not guarantee the taxpayer's right to appeal as it does so with the taxpayer's right to appeal to the US Tax Court. See Nina Olson testimony before the House Ways and Means and Joint Committee on Taxation May 19, 2005.

So if the Appeals process is not a guaranteed right, what exactly is Appeals?  In my experience, appellate procedure within the IRS can be a positive cordial experience that ultimately saves both the Government and the taxpayer time and money. While the appeals process initially follows a somewhat structured path, there is invariably very informal discussions between your tax attorney, the examination division and ultimately the appeals officer.   

You also now have the choice of a Fast Track Settlement by filing Form 14017 along with your written statement to your IRS appeals office detailing your position in writing on disputed issues.  You may want to consider Fast Track for a quick easy compromised resolution if your facts are not contemporaneous and your intent years earlier was not easily established by the facts at that time.

Why are contemporaneous facts so valuable in establishing intent to the Courts? Contemporaneous facts, not self-serving testimony given years later, are important in establishing your intent, opines Chief Judge Phillips, in Philhall Corp. v. United States, 546 F.2d 210, 215 (6th Cir. 1976).  If whoever prepared your tax return did not include contemporaneous facts in the tax return itself then at least your tax professional who prepared your tax return has a chance to compromise your tax liability through Fast Track. 

For those of you who have the contemporaneously established facts that can be applied to Federal law, then you might be better off if your Tax Attorney files a more formal Protest either prepared on Form 12203 or prepared in a US Tax Court Petition type format. For example let’s take a look at a typical audit examination where the IRS agent is focusing on your rather larger than normal “office expense” deductions.   

During the examination phase taking place in 2015 of your 2011 Form 1065 partnership return the IRS agent disallowed all your office expense claiming that he found substantial capital assets in office expenses that should have been capitalized.  Specifically he found you purchased 20 ink jet printers at $200 each for a total of $4,000. You told the agent you decided to expense all capital purchases under $500 and record them in office expense, but both the agent his group manager declined to concede to you the deduction. All parties agreed the case was ripe for Appeal.

On Appeal your tax attorney argued that Federal law enacted in 2011 allowed for uniform expensing of capital assets for amounts that are less than $500. The Appeals Officer asked if you could establish this fact contemporaneously from 2011 records and did the law in effect at that time support your tax position taken on your tax return?  As it turns out you were advised by your tax attorney in 2011 to contemporaneously include in your tax return an explanation of your $500 policy.  Your tax attorney said to the Appeals Officer that such a $500 policy was created as a legal and reasonable tax strategy in accordance with Temporary Regulation 1.263(a)-2T(g). In fact, the Appeals Officer acknowledged that you had included this information in the Protest he received from you and that indeed you had a written policy in place as per disclosure in your 2011 tax return that all capital expenses less than $500 would be expensed as office expense. The Appeals Officer then noted that the temporary regulation in effect in 2011 were eventually made permanent by the IRS as fully detailed in Internal Revenue Bulletin 2013-43 issued October 21, 2013.  The Appeals Officer looked one more time at your extemporaneous facts as applied to the law in your Protest and agreed that your tax position was justified, legal and reasonable.  He recommended to the Commissioner that the Government concede this issue and that the examination agent's report be adjusted with no tax due. You win, IRS losses.

So what does all this mean for you?  First, always include extemporaneous evidence or “facts” to support your tax positions in your tax return prior to filing.   Second, make sure your tax return preparer stands by her work and agrees in writing to represent you before the IRS all the way up at least the Appeals level to fight and defend the positions she took on your tax return.  Finally, if and when there is ever an IRS audit coming your way, make sure your professional tax team has credentials and expertise to battle back and defend against the IRS adverse examination adjustments by either filing for Fast Track or submitting a formal Protest to Appeals.  Remember, if you have the facts and law on your side an IRS Appeal may be just what your Tax Attorney ordered for safety and tax free living for many years to come.

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

If you all are entering or coming out of a 1031 tax free exchange this year, you may want to consider selling your relinquished investment property or purchasing your replacement investment property from a trusted member of your family. Sounds good right? But not so fast. There are two very dangerous IRS traps out there for your Related Party 1031 Tax Free Exchange.  So stay with us on TaxView with Chris Moss CPA to make sure your Related Party 1031 Tax Free Exchange is fully protected and your tax return is bullet proof from adverse IRS audit action which could save you big tax bills many years later after the return is filed.

Before we get to IRS traps ahead, let’s review how the Government defines a related party as it would relate to your planned 1031 tax free exchange.  IRS Code Section 1031(f) via IRS Section 267(b) or 707(b)(1) defines related party as your spouse, child, grandchild, parent, grandparent, brother, sister, or a related business, trust, or estate. A business related party could be an individual who owns 50% or more of a business, or two corporations which are members of the same controlled group.  There are many more specific business related parties in Section 267(b) and also partnership related parties in Section 707(b)(1).

Once you determine you have a related party as part of your 1031 tax free exchange here is an easy IRS trap to watch out for and avoid:  If the related party sells or disposes your relinquished property within 2 years or if you sell or dispose of the replacement property within 2 years then the whole gain is immediately taxable on the date of sale or disposition.  

Setting off the 2 year 1031 related party trap results in very harsh penalties and interest on the back taxes you would owe.  But if the sale or disposition, either for you, or your related party, had a principal purpose other than tax avoidance, the trap opens wide and you are free to leave.  But imagine climbing out in victory of this trap only to get wacked with another hideous IRS trap.  Indeed, as Ocmulgee Fields vs IRS US Tax Court (2009) found out, there is Section 1031 (f)(4), a catch all trap for anyone and everyone even those folks who escape the first IRS 2 year trap.  So keep tuned to TaxView with Chris Moss CPA as we explore the Section 1031(f)(4) trap and see how to best avoid it.

Ocmulgee Fields, developed owned and managed real estate in Georgia since 1973.  Owners were Charles Jones, his sons Dwight and Jefferson, and Jones Family Partnership, which was owned 1/3 each by Charles, Dwight, and Jeff. In 2003 Ocmulgee sold the Wesleyan Station property, for $7,250,000.  A CPA named Pippin with McNair McLemore Middlebrooks out of Macon suggested a 1031 tax free exchange.  After considering at least 6 possible replacement properties Ocmulgee purchased a replacement property called the Barnes and Noble Corner, a recently developed shopping center, which Ocmulgee sold years earlier as raw land in 1996 to a “related company” owned by Dwight and Charles called Treaty Fields for $6,740,000.

Treaty Fields filed its Form 1065 partnership tax return for 2003 with a gain of $4,185,999.  Ocmulgee filed its 2004 corporate return form 1120 prepared by CPA Pippin with no gain claiming a deferral of $6,122,736 gain disclosing under part II of Form 8824 that Treaty Fields was a related party.  The IRS audited Ocmulgee for 2004 and sent them a bill for $2M and penalty for $400K claiming they failed to qualify for a tax free exchange under Section 1031 (f)(4) which says: This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection. Ocmulgee appealed to US Tax Court in Ocmulgee Fields v IRS US Tax Court (2009).

Ocmulgee argued that they had a legitimate business reason for working with a related party in that the purchase “reunited its ownership” with the larger shopping center that the land had become since 1996. Ocmulgee also claimed they listened to the advice of CPA Pippin. The IRS countered that this case was like Teruya vs IRS US Tax Court (2005) where the Court found the taxpayer failed to show that tax avoidance was not one of the principal purposes of the transaction. 

Judge Halpern agreeing with the Government, citing Teruya v IRS, US Tax Court (2005), opined that Ocmulgee anticipated the sale of its low basis property and was tempted to exchange the low basis property for a high basis property to a related person, with the related person then selling the property at a reduced gain—or possibly a loss—because of the shift to the property of his high basis in the property relinquished. 

Applying this law to the facts, the Court notes that if Treaty Fields had received Wesleyan Station from petitioner in exchange for the Barnes & Noble Corner, Treaty Fields’s adjusted basis of $2,554,901 in the Barnes & Noble Corner would have shifted to Wesleyan Station (which, in petitioner’s hands, had a basis of only around $716,164). Because of that step-up in basis, Treaty Fields would have realized a gain on the sale of Wesleyan Station approximately $1.8 million less than Ocmulgee would have realized had it forgone an exchange with Treaty Fields and sold Wesleyan Station itself.

The US Congressional report refers to this as “basis shifting”.  In effect, because of basis shifting, related persons are able to “cash out” of their investments in property having an inherent gain at relatively little or no tax cost. Also, in some cases, basis shifting allowed related persons to accelerate a loss on property that they ultimately retained. Congress concluded that “if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, ‘cashed out’ of the investment, and the original exchange should not be accorded nonrecognition treatment.  This policy is reflected in section 1031(f), as enacted in the Omnibus Budget Reconciliation Act of 1989, Pub. L. 101-239, sec. 7601(a), 103 Stat. 2370.

Based on the facts in Ocmulgee, Judge Halperin concluded that “basis shifting” allows the Court in this case to infer that tax avoidance was the principal purpose of the 1031 exchange.    While the Court conceded that it is not prepared as a matter of law to find that “basis shifting” precludes the absence of a principal purpose of tax avoidance in all cases,  it in fact does show tax avoidance in the unique set of facts in Ocmulgee’s case; namely the immediate tax consequences resulting from the 1031 exchange with Treaty Fields included an approximate $1.8 million reduction in taxable gain.  The tax savings are plain and Ocmulgee’s counter arguments were unconvincing or speculative.  Therefore Ocmulgee has failed to convince the Court that tax avoidance was not a principal purpose of the 1031 tax free exchange.  IRS wins. Ocmulgee loses.

What does this mean for you?  If you are planning to Section 1031 tax free exchange with a related party, make certain the property that you sell does not sell again within the 2 year period.  Likewise you cannot sell the property you purchase for 2 or more years.   Even if you avoid the 2 year trap, make sure your tax attorney records the evidence of a non-tax avoidance purpose and inserts that evidence into the tax return being filed that is deferring the gain to avoid Section 1031(f)(4).  If you can gather than facts contemporaneously and record them in your tax return you will be bullet proof from IRS attack. Finally, make sure there is no negative evidence of “basis shifting”.  Remember you can be presumed to be avoiding tax if there is evidence of basis shifting regardless of the 2 year rule, so make certain the facts are in your favor, and fully recorded by your tax attorney in your tax return as you file.  You will most likely be glad you did when the IRS comes knocking on your door.  Thanks for joining Chris Moss CPA on Tax View.

See you next time on TaxView with Chris Moss CPA.

Kindest regards,

Chris Moss CPA  

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