Welcome to TaxView with Chris Moss CPA

For those taxpayers who might be in the unfortunate position of owing the US Government a large amount of income tax compounding with interest and penalties daily, an IRS approved “Offer-in-Compromise” (OIC), might be just what you are looking for. If you are thinking “that could never happen to me”, think again. Anyone who owns a business, even if you were not involved in the day to day operations, can be nailed by the Government for back payroll tax and the 100% penalty as “the responsible person who had check signing authority”. Or perhaps you have received K1s with amazingly large amounts of phantom income and your distributions are insufficient to pay the tax? How about a legal settlement for damages which net’s you not enough to cover the taxes because your attorney got paid first. Even worse what about a divorce settlement where you have to cover the tax liability of your “ex” and you don’t have the funds to pay the tax. Have I managed to get your attention? Are you at least curious how you would successfully negotiate an OIC with the IRS?

Sec. 301.7122 of the IRS Code authorizes the IRS to compromise the tax you owe. What this means is that if you owe $300,000 in tax to the Government, you can make an offer of $50,000 to settle the whole thing and the IRS can either accept your offer or not. If they accept you are home free. If you are thinking this deal is too good to be true you are only part right. Because like any deal too good to be true, there are always strings attached.

To better understand exactly what strings are attached to this “too good to be true” deal, let’s begin our OIC journey with Murphy vs IRS. Murphy owed over $250,000 in back tax for years 1992-2001. Murphy offered the IRS a $10,000 OIC to settle the case. His OIC was rejected by the IRS. After his OIC was rejected, the IRS proceeded to enforce a levy on Murphy. Murphy appealed to the US Tax Court claiming that the IRS abused its discretion by rejecting his OIC. The Tax Court Opinion sided with the Government. Murphy appealed to the 1st Circuit. Murphy v. Commissioner, 125 T.C. 301, 309 (2005), aff’d, 469 F.3d27 (1st Cir. 2006). The US Court of Appeals agreed that Murphy’s OIC was reasonably rejected by the IRS because Murphy could have made a larger settlement payment in light of his current income and expenses. The Court noted specifically Murphy had a monthly surplus of $1,128. Furthermore after numerous calculations and computations the Court found Murphy’s OIC could have been $80,000, significantly higher than the $10,000 Murphy offered. In fact the Court observed that Murphy never mounted a serious challenge to the IRS calculations other than to say the IRS calculation was “preposterous”. Citing Fargo 447 F.3d at 709-10, the Court of Appeals agreed with the US Tax Court and found that the IRS did not abuse its discretion in denying Murphy an OIC.

You may be interested to know that Fargo also argued that the IRS abused its discretion by rejecting his $7,500 OIC on approximately $100,000 in tax he owed. Fargo claimed his medical expense would soon balloon to $90,000 per year and paying the tax now would cause Fargo to file bankruptcy. The IRS and the Court noted however that Fargo had sufficient assets to pay the tax including income of over $100,000 annually, retirement of over $100,000 and equity in their house of over $300,000. The Circuit Court concluded that the IRS had the right to reject Fargo’s OIC because Fargo’s ability to pay exceeded his OIC.

After the Fargo and Murphy Opinions, you may be asking who then could qualify for an OIC? While in theory the IRS will accept a compromise that is equal to the reasonable collection value of the case-Rev. Proc.2003-71(2)-it is oftentimes hard to convert and transform “collection value” into an acceptable “offer” in dollars. The most often used method to determine reasonable collection value of a case is through both the Government’s and your tax attorney’s analysis of a completed and executed IRS Form 433A. What is Form 433A? Form 433A is a “Collection Information Statement for Wage Earners and Self-Employed Individuals” also known as a complete and absolute total disclosure of all your assets and income sources signed by you “under penalties of perjury”. Because you are signing 433A under criminal penalties of perjury, I personally feel 433A is an amazing trap for the unsuspecting or perhaps trusting taxpayer who feels they can go this route alone without a tax attorney present. Indeed, Section 3 paragraph 11 of Form 433A asks: In the past 10 years, have you transferred any assets for less than their full value? You are then asked to list the assets, the value, and the date transferred and finally “To Whom or Where was the asset Transferred”. That being said, you would be well advised to have your tax attorney present when you complete this form.

Finally, if you decide to go the OIC route, be prepared to make a reasonably large enough offer to the IRS to have your OIC accepted. If the IRS rejects your offer and you believe your offer was reasonable based on your unique financial situation, you can always appeal to the Office of IRS Appeals where perhaps your offer will have a better chance of being accepted. If you lose at the Appeals level you have the right to appeal to US tax Court. Finally if at some point in this journey you are fortunate enough to successfully negotiate an OIC with the IRS you must then abide by the conditions of the OIC or risk a default. Once the OIC is in default, the entire tax you originally owed and all interest and penalties that had accrued becomes due and payable immediately. Robinette v IRS US Tax Court Julu 20 20014 Page 40 . In conclusion, if you owe tax to the the IRS that you can not pay, there is no easy work around. But there is hope with a realistic OIC package submitted to and approved by the IRS. So save yourself and your family the stress of having to deal with IRS liens, levies and attachments flying at you from all directions. Negotiate an OIC. You will be happy you did.

Thanks for joining Chris Moss CPA. See you next time on TaxView.

Submitted by Chris Moss CPA

Welcome to TaxView with Chris Moss CPA

If you own the family business and perhaps your children and grandchildren are working with you as well, I am sure you all once in a while wonder how much your business is worth? Did you know there is someone else who is interested in how much your business is worth. No, it’s not a potential buyer; it’s the IRS! If you read my last article on Family LLC Discounts you know exactly why the IRS is interested in the value of your business. But did you also know that the expert witnesses working for the IRS will compute “personal goodwill” as part of your business valuation? If you are curious as to why personal goodwill is important to the Government then keep reading this article to learn about how personal goodwill will come into play in the likely event of an IRS audit of your estate tax return, perhaps many years after you are long gone.

Goodwill brings us smack into the walls of the US Tax Court where just a few weeks ago Judge Paris decided the case ofT.C. Memo. 2014-155 ADELL vs IRS. Franklin Adell founded STN.Com’s, a cable uplinking company, with his Son Kevin. STN.COM sole business purpose was to broadcast an urban religious program channel named “The Word Network” (The Word). When Adell died in 2006 his estate included the entire ownership of STN.Com and numerous other assets. Adell‘s estate valued STN.Com, with a reported date-of-death value of $9.3 million in the Form 706 Estate Tax return filed in late 2007. Estate tax was owed of approximately $15 Million on STN and all the other assets. The STN.Com stock’s reported value was based on a valuation report prepared by and certified by J Stout Risius Ross, Inc. (Ross).

Just so you know, I thought it interesting that the Estate filed almost back to back amended tax returns in 2008 and 2010 which reduced the estate tax paid from $15 Million to $8 Million. As you see it, if you file a first tax return wrong under penalty of perjury and then file another one wrong and then another, would you think, the IRS might show some interest? At any rate, the tax returns were indeed audited by the IRS. As the end of the audit, the IRS determined that the STN.Com stock was worth not $9 Million as reported on the original Form 706, but more like $92 Million. The increase in valuation resulted in over $60 Million in additional tax liability, penalties and interest to the estate.

During the Tax Court trial, the IRS retained Mr. Burns (Burns) as their expert witness. Adell retained expert witness Ross, who computed the original valuation on the original tax return filed November 2007. Ross argued that STN.Com was worth $4 Million and Burns argued that STN.Com was worth $92 Million. Surprisingly Burns, used the same discounted cash flow analysis of the income approach that Ross used. In addition, Burns substantially relied on the Ross determinations including his projected sales for STN.Com, which were based on the company’s historical performance and on conversations with management. So while Burns and Ross used the same methods their conclusions were dramatically different. How could this be?

The Court found that “Goodwill” was valued very differently by Burns and Ross. Goodwill not from the business or the brand, but Goodwill from Kevin Adell, his personal goodwill. Kevin developed thousands of relationships with The Word and its customers nationwide. Because personal goodwill does not belong to the company, the valuation of STN.Com had to be adjusted downward after Kevin’s personal goodwill was recognized. Both experts recognized that Kevin himself personally created this Goodwill, but Ross valued Kevin’sgoodwill at $12 million while Ross only valued Kevin’s goodwill at $1 million. As a result, Ross valued the company almost $90 Million less than Burns. After a thorough review, the Court sided with Ross but not entirely. Judge Paris gave Adell the 9 Million valuation of STN.Com as per the original tax return filed but not the 4 Million that Adell had asked for on the back to back amended tax returns. Either way, this was a huge victory for Adell, Ross and American taxpayer.

What does this mean for all you small business owners? What can we learn from Adell? First make sure you consult with your tax attorney and tax advisors regarding how they are recording and computing and annually valuing your small business. Have your estate planner teach you, your family and kids the techniques of valuation for estate tax purposes, including the discounted cash flow method of income approach. Second ask your CPA best practice on how to recognize the value of goodwill created by the owners and operational partners and their children. Finally, suggest to your CPA to disclose your business valuations including the personal goodwill to the Government in your annual business tax returns to show contemporaneous and extemporaneous valuations. Better for you to do it now than have the IRS do it later!

Thank you for joining Chris Moss CPA on TaxView. Happy Valuations.

Kindest regards Chris Moss CPA

Welcome to TaxView with Chris Moss CPA.

Has your tax attorney mentioned that Congress could someday sooner than you might think dramatically reduce the $5 Million gift exemption ($10 Million married) to which President Obama gave his blessing in December of 2012. If you are a baby boomer thinking of retiring with substantial assets, and want to take advantage of these historic large gift tax exemptions, you most likely will soon be aggressively gifting your assets to the kids and grandchildren with substantial discounts through a strictly controlled Family Limited Liability Company. But in case you have not yet started the gifting process but are thinking of doing so, or if you are in the process of gifting now, did you know the two basic steps that you need to take to protect your assets from adverse government action if you get audited by the IRS. Moreover, without including such steps in your estate and gifting plan, an IRS audit may dramatically increase you gift and estate tax liability to the Government many years from now, perhaps even many years after you are long gone. So I would recommend that you all continue with TaxView to review the basic two steps in bulletproofing your gift tax returns from harm in the likely event of an IRS audit.

Step one is to gift your children the LLC memberships, not the assets themselves. Let’s take a look why this matters as we review US Tax Court SUZANNE J. PIERRE VS IRS to learn the difference between valuations of underlying assets vs the valuation of LLC member interests and why this is so important. Pierre transferred over $4 Million in publically traded stock to a single member LLC and then days later transferred substantial memberships to trusts for her son and granddaughter. Gift tax returns were filed reflecting over 30% discounted gifts due to lack of marketability and control. The IRS audited the Gift Tax returns and issued a notice of deficiency of over $1 Million. The government argued that the underlying assets, the stocks and securities were the gift, not the LLC and that no discounts could be applied directly to those assets. Pierre argued the opposite view, that IRS rules do not control, that state law controls and more specifically under state law, a membership interest in an LLC is personal property, and a member has no interest in specific property of the LLC. You may want to also review “Cost Basis For Beginners” on the difference between inside and outside basis. Judge Wells sided with Pierre because pursuant to state law Pierre did not have a property interest in the underlying assets of Pierre LLC. Accordingly, the IRS could not create a property right in those assets.

The second and final step in gifting to the kids is a little more complicated. Your discount must be supported by an expert appraiser sometimes many years later in US Tax Court after you are long gone. While Pierre allowed for a 30% discount, other cases have not always been so generous to the taxpayers. For example, in Lappo vs IRS 2003 Lappogifted to children though a family partnership in 1996. In 2001 the IRS audited the 2006 gift tax return increasing the gift from $1,040,000 to $3,137,287, Larro appealed to US Tax Court. Larro’s expert concluded a 35% discount was appropriate. The Government’s expert concluded an 8% discount was appropriate. Judge Thornton’s rather short but very well thought out 27 page Opinion compacted with facts and details only appraisers could appreciate, concludes after an exhaustive examination of expert witnesses for both sides that a 24% discount was appropriate. Just in case you didn’t notice the average between 35% and 8% is 25.5%, and not too bad for Lappo. Unfortunately Tax Court judges do not usually average the discount valuations from the IRS and the Taxpayer and split the difference as clearly evidenced in our next case of True vs IRS.

The True family of Casper, Wyoming didn’t fare so well in US Tax Court case of True vs IRS in 2001. The True clan made their money in Oil and Gas Exploration and Drilling. True believed in the family partnerships and the strength of a unified family in business and America. Dave True gave each of his children general partnership interests in various family business interests. True created numerous operating agreements severely restricted the marketability and control of the family members through the use of buy sell agreements requiring family members to participate in the business or be bought out at predetermined appraised market values forming the basis of the gift tax returns filed in 1993 and 1994 using 30% discounts.

The IRS audited the 1993 1994 gift tax returns and found massive valuation understatements. The True family appealed to US Tax Court. Judge Beghe’s Opinion reviews the work of government expert witnesses, painstakingly detailing the reasoning behind the discounts and then analyzes the use of buy-sell agreements in gift tax valuations. It’s hard to believe but the True family did not retain expert appraisers. Instead, Dave True consulted Mr. Harris, the family’s accountant and longtime financial adviser. Mr. Harris advised True to use a tax book value purchase price formula under the buy-sell agreements for gift tax valuations. However, the Court noted Mr. Harris’s expertise was in accounting not appraisals….and he was the only professional with whom Dave True consulted in selecting the book value formula price” Id at 110. The Court rejected any notion that Mr. Harris was qualified to opine on the reasonableness of using the tax book value formula in the True family buy-sell agreements. The Court further noted that “Mr. Harris was closely associated with the True family; his objectivity was questionable and more importantly, he had no technical training or practical experience in valuing closely held businesses.” Id 111 Without the power of an army of experts to help True, the Government’s experts easily persuaded the Court that only a 10% discount should be allowed, costing the True family millions in dollars of additional taxes, penalties and interest.

How can we learn from True? How can you preserve and keep safe your assets for the next generation? In my view you need to consider gifting strategies in light of ever changing Congressional intent regarding estate and gift tax exemption amounts and tax rates. I personally prefer to save taxes now, as we may never know what “later” will bring. To save taxes now I recommend many of you baby boomers to consult with your tax attorney and estate planners asking them about the two step process in gifting to your kids and grandchildren through a Family Limited Liability Company. Make sure you retain the best and the brightest appraiser prior to filing your gift tax return with the US Government. Your gift tax valuations, your Family LLC Member Discounts, and all the taxes you saved now will be bulletproofed from adverse consequences later during an IRS audit many years from now. Happy Gifting to all from Chris Moss CPA and Thanks for joining me on TaxView.

Submitted by Chris Moss CPA

Submitted by Chris Moss CPA

It is a fact that in your lifetime you likely will be audited by the IRS examination division as long as you are legally required to file tax returns each year. However, there is a remote possibility that an IRS agent during a routine examination of your tax return might refer your case or at least consider referring your case to the IRS Criminal Investigation Division. (CID). This may happen because of something you innocently said to the IRS agent. Or perhaps a disgruntled ex-employee or not so happy ex-wife communicated with the agent? Perhaps you talked too much to the agent and innocently said something misleading that was not quite true? Moreover, for whatever reason, if CID is called in to investigate you and finds insufficient evidence to continue their investigation, CID will refer the case back to IRS agent to conclude the examination. However, as I see it, any IRS audit of your tax return throws your constitutional 5th amendment rights to remain silent in a boxing ring with a powerful legitimate government interest to enforce tax collection for the US Treasury. These clashing interests emerge at the precise moment that the IRS examining agent begins the audit of your income tax return, up to the point that the agent refers your audit to CID. If this referral to CID should happen to you how would you protect yourself and your family from the adverse consequences and publicity that would soon come crashing through your door?

Before we can answer this question we need to review a few interesting facts about the CID. According to the IRS website: “IRS Criminal Investigation Division (CID) is comprised of approximately 3,700 employees worldwide, approximately 2,600 of whom are special agents whose investigative jurisdiction includes tax, money laundering and Bank Secrecy Act laws” The site goes on to say: IRS special agents must follow strict procedures to initiate an investigation and recommend prosecution to the Department of Justice. These procedures include approval by several IRS officials to ensure investigations are based on factual evidence that tax fraud or another financial crime has occurred. While no doubt there are only about a thousand or so taxpayers that actually are indicted and convicted of tax evasion each year, just the threat of a criminal investigation may be enough to turn your life inside out.

In order to better understand the significance of the words we say to the IRS we turn as we often do to case law. The Greve case decided in 2007, US v Greve US Court of Appeals for the 7th Circuit. involved James Greve who was head of Greve Construction his family business. Greve’s 1997 tax return was audited by IRS examination division agent Luke. As the audit progressed Greve seemed disorganized and overwhelmed and in my view should have brought in an attorney sooner than he did. By 2001 examination agent Luke and other revenue agents were considering a referral to CID. As a result, Greve was indicted by a Grand Jury in 2005. Greve was subsequently convicted and found guilty of criminal tax evasion. Greve appealed to Federal District Court and lost. Greve then appealed to the 7th Circuit and filed a motion to suppress and dismiss his statements to the IRS agents based on 5th Amendment violations of his right to remain silent. Greve contends in his motion that Luke affirmatively mislead him by continuing to conduct a civil audit after she had firm indications of fraud. Specifically, Greve maintains that Luke made false promises to him by repeatedly advising him that his cooperation would result solely in a civil tax assessment. This allegedly caused Greve to talk too much in violation of his 5th amendment right to remain silent in a possible criminal proceedings. The Court did not agree. Although the IRS regulations require a civil investigator to cease her investigation when she has developed firm indications of fraud, see Internal Revenue Manual §§ 4565.21(1), 9311.83(1), we have held that “[a] failure to terminate a civil investigation when the revenue agent has obtained firm indications of fraud does not, without more, establish the inadmissibility of evidence obtained by [the agent] in continuing to pursue the investigation.”  United States v. Kontny, 238 F.3d 815, 820 (7th Cir.2001). Based on this interpretation of Kontny, the Court found for the US Government.

Let’s take a look at Kontny. The facts in Kontny are simple: The Kontnys owned an equipment supply business. For over 10 years they defrauded the government of payroll and income taxes by not reporting overtime of their employees to the IRS. The employees knew about this scheme and benefited as well. However, as a result of a labor dispute, one of the disgruntled employees informed CID of the IRS about the scheme. CID assigned civil agent Furnas, who know all about the CID involvement, to investigate Kontny’s tax return. Kontny talked with Furnas before hiring legal counsel. Partly due to his excessive chatter with Furnas, Kontny was convicted of tax fraud and sentenced to jail. Kontnys motion to suppress his statements to Furnas based on the 5th amendment right to remain silent was denied by the District Court and Kontny appealed to the 7th Circuit where his motion was denied.

Judge Posner’s Opinion was that Kontnys talking to Furnas was voluntary and therefore not protected by his 5th amendment right to remain silent. The Court notes that virtually all cases involving coerced confessions involve the questioning of a suspect who is in police custody, an inherently intimidating situation in which people find it difficult to stand up for their rights or even to think straight. The situation is different when a person who does not even know that he is a criminal suspect (that is a premise of the Kontnys’ appeal) is being interviewed in his home, and by a civil rather than a criminal investigator to boot. Furnas was unarmed, un-uniformed, unaccompanied. The Kontnys were at no disadvantage in dealing with him. They were under no pressure to answer his questions. Any answers they gave were voluntary. Trickery, deceit, even impersonation do not render a confession inadmissible, certainly in noncustodial situations and usually in custodial ones as well, unless government agents make threats or promises. Frazier v. Cupp, 394 U.S. 731.

Frazier was convicted in an Oregon state court of second-degree murder in connection with the September 22, 1964, slaying of one Russell Anton Marleau. After the Supreme Court of Oregon had affirmed his conviction, 245 Or. 4, 418 P.2d 841 (1966), Frazier filed a petition for a writ of habeas corpus in the United States District Court for the District of Oregon. The District Court granted the writ, but the Court of Appeals for the Ninth Circuit reversed, 388 F.2d 777 (1968). The US Supreme Court granted certiorari to consider three contentions of error raised by Frazier. Justice Thurgood Marshall’s Opinion finds none of these allegations sufficient to warrant reversal. Here are the facts: When Frazier was brought in by police for questioning he was still was reluctant to talk, but after the officer sympathetically suggested that the victim had started a fight by making homosexual advances, petitioner began to spill out his story. Shortly after he began he again showed signs of reluctance and said, “I think I had better get a lawyer before I talk any more. I am going to get into trouble more than I am in now.” The officer replied, “You can’t be in any more trouble than you are in now,” and the questioning session proceeded. A full confession was obtained and, after further warnings, a written version was signed. Since Frazier was tried after this Court’s decision in Escobedo v. Illinois, 378 U.S. 478 (1964), but before the decision in Miranda v. Arizona, 384 U.S. 436 (1966), only the rule of the former case is directly applicable. Johnson v. New Jersey, 384 U.S. 719 (1966). Petitioner argues that his statement about getting a lawyer was sufficient to bring Escobedo into play and that the police should immediately have stopped the questioning and obtained counsel for him. The Court concludes it was not. The Confession was valid because Frazier predated Miranda.

Miranda notwithstanding, as far as I can tell, if you say something in your polite conversation to an IRS agent during a routine audit that possible incriminates you later during a criminal investigation, you cannot then suppress what you said even if the government knew that a criminal investigation was underway, and sadly even if the IRS questioning of you violates its own internal rules during the civil examination. What does this mean for all of you who file tax returns each year? As Frazier makes clear, if you get audited by the IRS, and if you voluntarily talk to the IRS agent during your audit, you have no constitutional 5th amendment rights to suppress those statements in later criminal proceedings. In conclusion, it appears to me that If you get audited best practice would be to have your tax attorney do the talking. We should never forget that Americans have a 5th amendment right to remain silent and to have an attorney represent us to keep us safe and protected.

Thank you for joining Chris Moss CPA on TaxView

See you next time.

Kindest regards
Chris Moss CPA

Submitted by Chris Moss CPA

All business owners and entrepreneurs are at one time or another having to deal with a “basis” computation analysis when they sell their interests in the company they started. Likewise real estate developers and builders use basis to compute their gains and losses when they sell their property. Moreover, all taxpayers who sell real estate have to know their basis to compute a gain. Even if you sell your primary home you have to know your basis if the gain is over the $250,000 exemption ($500,000 married joint). But in the unlikely event of an IRS audit are you prepared to prove to the government your “basis computation” both inside and out? How can you bulletproof your annual tax return each year when it may not be for another ten or twelve years that you sell the property or membership interest? Is basis just your cost or does a valid indebtedness like a promissory note or mortgage increase your basis? Is you current tax advisor keeping annual track of your inside and outside basis and are you being informed of what your basis is each year?

To answer these questions, let’s head on down to the US Tax Court on Capitol Hill in Washington DC and take a look at some “basis” cases. First a few basics: Your individual “outside” basis is your cost to you of the real estate or membership or shares you purchased. The “inside” basis on that purchase is how the LLC or partnership values the real estate, membership or shares on their books on the balance sheet. As per the IRS partnership audit guide, “A partner’s basis in his/her partnership interest is referred to as “outside basis.” Upon formation of the partnership, a partner’s initial outside basis will generally equal the amount of money and the adjusted basis of property contributed. If the partner purchases his/her partnership interest, the outside basis will equal the purchase price.” The inside basis is how the partnership carries that partnership interest on the balance sheet of the books and records.

In Barnes vs IRS decided in March of 2012, Washington, D.C. based entrepreneurs Barnes were engaged in several different lines of business, including restaurants, nightclubs, and event promotion. The IRS audited the 2003 tax return for Barnes almost 5 years later and by June 3, 2008, the IRS issued the Barnes a statutory notice of deficiency, determining a deficiency in tax of $54,486, a section 6662(a) accuracy-related penalty of $10,897, and a section 6651(a)(1) late-filing addition to tax of $5,691 with respect to their 2003 return. Judge Morrison’s 44 page Opinion meticulously, methodically, and almost painstakingly precisely, goes through year by year from 1995 to 2003 to conclude that the Barnes tax advisors had computed his cost basis incorrectly over the years thereby ultimately giving the Government victory in Court.

Note the government does not fool around during a basis computation audit either in a small simple case like Barnes or a bigger more complex 2005 case like Santa Monica Pictures and Corona Film vs IRS. This 332 page opinion by Judge Thornton involves complicated transactions that occurred in the wake of the 1996 sale of the “legendary motion picture company Metro-Goldwyn-Mayer (MGM) by the French banking giant Credit Lyonnais.” Peter Ackerman, his business partner Perry Lerner, and their related entities (Ackerman) had helped organize a consortium which made a bid to purchase MGM from Credit Lyonnais. Although Ackerman lost out to Kirk Kerkorian’s winning bid, Ackerman nevertheless set out to acquire MGM’s parent company, Santa Monica Holdings Corp. (SMHC) which Credit Lyonnais still owned. Ackerman set up a controlled partnership Santa Monica Pictures (SMP) which successfully bid to purchase SMHC. A short time later SMP then sold the assets of SMHC at a loss to various other entities allowing SMP to deduct over $400 million in losses. The IRS audited the basis computations and disallowed all losses claiming the losses were based on invalid basis computations by Ackerman because the whole series of transactions lacked a primary business purpose. Judge Thornton in finding for the Government sends a strong message that “cost basis” computations are valid only for parties doing legitimate business together with tax savings playing a secondary role. “The transaction between the banks and Ackerman carried the seeds of its own undoing: it depended upon the banks’ withdrawing from the very partnership they purported to join. The banks’ “contributions” to the partnership were not intended to have any economic significance apart from transferring built-in tax losses.” Id at 226.

Finally, in Moore vs IRS Moore reported on his 2005 Schedule D, Capital Gains and Losses, a capital loss of $1,502,519 from Mr. Moore’s sale of the ATS stock. In calculating the capital loss, his CPA Catherine Fox from BDP Seidman reported a basis of $4,502,519 in the ATS shares. The IRS audited Moore’s basis computation for 2005 and recomputed the 2005 tax return to show a $1 Million basis. Moore appealed to US Tax Court. The facts in the case are relatively simple: In turns out ATS loaned Moore $5 Million to buy ATS stock from Baker in 2000. In 2002 however Moore sued ATS claiming he was misled to the value of ATS. Moore eventually won a judgment allowing Moore to reduce his debt to ATS to $1 Million the actual market value of the stock that Moore purchased. As a result on December 31, 2002 ATS decreased Moore’s loan by over $5 Million and then increased on the same date the loan to $1 Million. In 2005 Moore sold all his ATS shares for $3 Million. Judge Thornton easily concludes that Moore’s original debt to ATS was not absolute and that the actual debt was only $1 Million. Therefore the Court concluded Moore had a gain of $2 Million- sales price of $3 Million less cost basis of $1 Million.

What does all this mean for us? In my view the IRS aggressively is auditing taxpayer basis computations, usually finding that the taxpayer basis was incorrectly computed, and is winning regularly in US Tax Court. What can you do to help protect your tax return from adverse audit consequences? Next time you meet your tax advisors make sure they discuss with you how they are keeping track of your basis each year to year and whether or not they are prepared to defend your basis in the event of an IRS basis adjustment audit. Each taxpayer has unique basis issues and so there is no “cookie cutter” basis computation for all taxpayers. Best practice requires your tax advisor to go over with you in person all your real estate purchases and sales including purchases, sales, acquisitions and mergers of closely held partnership, LLCs and corporations. Finally when you sell anything that has a basis have your tax professionals fully disclose your basis calculations in your tax return prior to filing that tax return. You can then relax knowing your tax returns are bulletproofed, safe and secure against IRS audit. How cool is that?

Thank you for us on TaxView with Chris Moss CPA

See you next time, Kindest regards
Chris Moss CPA

Submitted by Chris Moss CPA

The US Income Tax Return form 1040 is probably one of the few annual forms that just about all Americans sign, either manually or electronically, under penalty of perjury. The exact phrase you certify in a quasi-oath like setting is: “Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, are true, correct, and complete.” I don’t know about you all, but how many of us really understand everything on our tax return as we give the tax preparer the go ahead to file our returns each year.

So I would not be surprised if most of you did not welcome the thought of an IRS audit commencing up to three years from the date you filed your tax return as per IRS Code 6501. But did you know there are three “statute extenders” that the IRS has at its disposal to audit us even after 3 years? The first extender is the 25% or more understatement of income. The second extender is unreported foreign financial asset income of more than $5000 and the third extender is fraud or criminal attempt to evade tax. The 25% extender is straightforward: You report $100,000 of taxable income from earnings but omit another $30,000 of dividends and interest. Equally clear-cut is the $5000 extender; you report $100,000 of taxable income from earnings but omit $5000 of foreign dividends from that secret Swiss bank account. In each of these extenders your statute of limitations is 6 years. The Fraud or Criminal evasion extender, or what I call the “Ultimate Forever Extender, (UFE) has no statute of limitations, imposes very large penalties, and for about 2000 taxpayers a year, carries criminal prosecution and prison. Will any of these powerful extenders come into play with your tax returns? Will an audit of your tax return head south to fraud and criminal investigation? You say no way! I say perhaps someday if you don’t know the way. Keep reading to find out how to stay free of UFE.

Let’s take a look at what’s happening in US Tax Court. We start off with a Judge Halpern opinion Scott v IRS, US Tax Court decided in March of 2012. Scott was a dentist whose 1994 tax return was selected for audit by the IRS in 1996. For reasons that defy logic Scott did not cooperate with the examining agent Thomas Demeo. By 1997 Agent Demeo expanded the audit to 1995. Without the cooperation of Scott, Demeo was forced to go directly to the bank with official summons to review the original bank records. With the audit still going strong in 1998 the statute of limitations of 3 years was fast approaching. Most likely due to Scott’s lack of cooperation, the case was referred to Criminal Investigation Division (CID). But CID apparently did not find a criminal case so CID sent Scott back to civil examination sometime after 1999. By 2000 Scott had outlasted Demeo and a new agent was assigned to the case Agent Barbati. Eventually Barbati assessed a tax for 1994 95 and 96 many years after the statute had run and the notice of deficiency and 90 day letter was issued to Scott alleging he owed almost $300,000 in tax and $200,000 in penalties. Scott appealed to US Tax Court arguing the three year statute of limitations had run. The government claimed a UFE, the “Ultimate Forever Extender” and set about to prove that Scott was guilty of tax fraud thus unleashing the dreaded UFE.

The key question presented then for Judge Halpern was whether there was intentional wrongdoing of fraud with the specific purpose of avoiding a tax that Scott knew was owed to the government. If this question was answered affirmatively the IRS would be empowered to activate their UFE allowing the government an easy win. If not, the case would be dismissed due the 3 year statute of limiations having run out allowing the Scott to win. After a careful review of all the facts, Judge Halpern finds for the government, relying on his own 2011 Opinion Browning v IRS . Citing Browning, Judge Halpern applies the 11 factors or “badges of fraud” to the Scott case. The eleven badges of fraud are: 1, Understatement of income, 2, inadequate records, 3. Failing to file tax returns, 4. Implausible explanations of behavior, 5. Concealment of income 6. Failing to cooperate 7 engaging in illegal activity, 8 intent to mislead 9. Lack of credibility of testimony 10 filing false documents and 11 the last one, dealing in cash.

While the Court found many of the 11 badges of fraud in Browning applicable to Scott, in my view, the facts in Browning are very different than the facts in Scott. Browning owned a Vermont based manufacturing corporation. On advice of his tax advisor Browning allegedly illegally moved funds offshore. From these offshore accounts Browning used credit cards to purchase goods and services for personal use with funds that had not been taxed. In addition Browning allegedly tried to mislead the IRS during the audit about this scheme. As I see it Browning’s deception to the government was worse than the offshore scheme itself.  The Court saw it that way too..  Judge Halpern handed over to the IRS the power of the UFE years after Browning’s three year statute had run its course.

While Scott did not mislead or deceive the IRS during the audit as Browning did, it was Scott's failure to cooperate with authorities, his lack of organized books and records, and his implausible testimony on the witness stand that eventually did him in with a Court approved UFE.  Scott eventually paid all his tax he owed plus a 75% fraud penalty and surely massive amounts of interest. Just so you know, if Scott had cooperated with the IRS examination division in the first place, my guess is that he could have avoided the 75% fraud penalty and perhaps just got hit with a much lower substantial understatement penalty instead. However, on a positive note, Scott was fortunate (as was Browning) to avoid a criminal prosecution and possible jail time.

What does this mean for all of us? The IRS has three years to review your unique situation and decide whether or not to audit your tax return. Make sure you don’t empower the IRS with UFE. Fully disclose each year what is going to your tax professionals. Have your tax professionals insert into your tax returns anything unique in the tax strategy you are using each year. For example, if there is some question as to how much you received from a customer, or whether the amounts received were fully taxable, disclose in a footnote in the tax return before you file why you didn’t report all this income. Moreover, if you own a business as did Browning or Scott or have a somewhat complex financial situation you would be well advised to retain the appropriate tax counsel who could both prepare and file your returns and also be there for you years later to represent you in the event of an IRS audit, all a long maintaining that very important attorney-client privilege with you. If you are audited three, four or five years later, pull those books and records with confidence down from the Cloud to make sure your records are 100% complete. In conclusion, good records, open and honest disclosure in the actual tax return prior to filing, and cooperation with the IRS examination division will go a long way in avoiding the Ultimate Forever Extender. May you live long, prosper and avoid the UFE.

Thank you for joining Chris Moss CPA on TaxView.

See you next time,
Kindest regards
Chris Moss CPA

Submitted by Chris Moss CPA with TaxView

In reading a recent 143 page 2012 US Tax Court Opinion F.Lee Bailey vs IRS I ask why a famous attorney would not have his accounting records in the Cloud. In the Bailey case Judge Gustafson says “there is no provision that excuses taxpayers from retaining their records…taxpayers are required to retain their books and records as long as they become material….” Similarly Judge Gustafson presiding over a 2013 US Tax Court Opinion Graffia v IRS notes “For many of the disputed points in these cases, Graffia lacks records entirely”. While records created by Bailey and Graffia were lost, destroyed, or misplaced, there was no question that Bailey and Graffia owned those records..  But when your accounting records are in the Cloud, all 20th century rules of ownership become airborne.  You might think you own your records after you scan raw data into the Cloud to your bookkeeper for processing.  But it is not so apparent as to who owns the processed financial data or "accounting records" that are created from all those scanned documents.   

In order to see how critical it is that you have control and ownership of your own accounting records in the Cloud think about these possible very realistic scenarios occurring to you and your business: Have you all thought of what might happen if the IRS subpoenaed your ex-bookkeeper who did not leave your company on the best of terms, to testify before a Grand Jury? Or perhaps your ex-wife has sued you for increased alimony and she subpoenas your bookkeeper to a family court hearing? Or even more realistically disgruntled ex-employees have a court issue discovery requests for documents sent directly to the outside bookkeeper and to the company that maintains the bookkeeper’s server, and this bookkeeper no longer works for you? How would you handle that? What if your outside bookkeeping company goes out of business or changes ownership? You call to get your records only to find out that the provider who had your records on their server no longer does business with your former outside accountant who has left the state, or worse the country. How do you get control over your business records?

Let's think "out of the box" by comparing processed accounting records on the Cloud to your Domain name on the Internet.:  Who owns your domain name? You own your domain name if you are the “Registrant” AND you are the “Administrator” on ‘WHOIS”. What or Who is WHOIS? “WHOIS” is the entire Internet domain data base. Before we get to WHOIS we need to rewind back to President Eisenhower who created the Advanced Research Projects Agency (ARPA) in 1958. ARPA eventually evolved into two agencies, the Advanced Research Projects Agency Network (ARPANET) and the Defense Advanced Research Projects Agency (DARPA), both US Government Dept. of Defense agencies. DARPA and ARPANET created a protocol called WHOIS to keep track of ownership of domain names. Eventually the Government granted a few private businesses including Network Solutions in 1993 the authority to assign Internet domains and the rest is history.

Fast-forward to 2014 and WHOIS. Google WHOIS until you get in the WHOIS data base. Type in your domain name and see who owns your domain name. Don’t be surprised or concerned if you see your IT person as the Technical or Billing contact. But you the business owner should be “Registrant” and the “Administrator”. If you are not, you are not legally the owner. There is one exception and that is private registration. Yes, you may have a “private” registration which allows you to keep your identity secret from the public. But the sad fact is that under a “private” registration you have almost no way to prove to a Court that you are the legal owner if your IT people decide to quit the company and take the domain name with them and worse case shut your web site down.

Perhaps you see where I am going now. As goes domain ownership, so goes bookkeeping records ownership. When you scan your accounting records to the Cloud the work product like the check register produced from all those original documents will be owned by the “Administrator” who is on your cloud provider’s data base. Your Cloud Provider is giving your company server space somewhere in the world. Most likely the Cloud Provider was retained by your outsourced Bookkeeper and more than likely I would guess your Bookkeeper is the “Administrator”. You may also or may not be the “password Administrator”. However, the password “Administrator” for the password may or may not be the legal “Administrator” with the Cloud Provider. As with the Domain IT person, the renegade Bookkeeper could shut your accounting Department down in seconds and you may have little recourse if you are not the Administrator.

Are you confused? Sorry there is no easy answer here but there are some steps you can take right now to better protect and keep safe your cloud accounting records. Consult your attorney and make sure your legal department confirms that you are the administrator of the account with your outside bookkeeper or accounting service. Further work with your legal department to make certain the outside Bookkeeping Service has a lower security password than you so if in an emergency you could prevent the Bookkeeper from having access to the system. Make sure the Cloud provider the bookkeeper contracted with has a separate space on their server in your name and reserved for you. If you are not using the outside bookkeeper’s server, but using a QuickBooks Cloud type provider you may not have a separate legal ownership on the space they provide for you on their server. If all else fails, I recommend you call your legal counsel or legal department to create a bullet proof contract between you and your outsider bookkeeping service to better protect you. Finally, make sure to ask your attorney, “Who Owns Your Accounting Records”, and get the answer in writing. Good luck and thanks for joining me here on TAXVIEW with Chris Moss CPA.

Kindest regards and see you next time,
Chris Moss CPA

Submitted by Chris Moss CPA

Are you planning to gift a conservation easement on your land or home in accordance with Section 170 of the IRS Code? Or have you gifted a conservation easement a few years ago and are benefiting from the carryforward year after year?  Listen up conservation easement advocates:  The IRS may be watching you.  The government could be planning on auditing your charitable deductions and unleashing a value diminution trap (VDT).  What you ask is a VDT and how can a VDT be used against you in US Tax Court? Please continuing reading to learn how to protect your charitable deduction carryforwards as we observe the VDT in action in a recent US Tax Court case decided May 2014, :Chandler v IRS 142 T.C. No. 16. Avoid the mistakes the Chandlers made when they deducted their conservation easement and learn how to bullet proof your tax return so that your deductions and carryforwards are safe and protected in the event of an IRS audit and ultimate appeal to US Tax Court.

The Chandlers had gifted facade easements on two of their homes. The Chandlers then retained professional appraisers.    According to the appraisers, the properties lost $562,650 of their combined value. because of all the restrictions placed on the homes by the facade easements.  The Chandler’s CPA then deducted a large charitable deduction in 2004 which carried forward to subsequent years 2005 and 2006 and beyond. The IRS audited Chandlers for tax years 2004, 2005 and 2006.  The IRS disallowed all the charitable deduction and carryforwards claiming that the easement deduction was overstated and the appraisals were worthless. How did this happen? 

Let’s look specifically at the facts: Both Chandler homes were in Boston’s South End, which the Federal Government has included in the National Register of Historic Places and designated a National Historic Landmark District. Chandler’s donated a “facade easement” to the National Architectural Trust (NAT) which severely restricted what the Chandler’s could do to the property without the permission of NAT. The Chandler’s were told by their professional appraisers the easement under NAT would reduce the value of the homes by $562,650. Unfortunately for the Chandlers this tax strategy had them walk directly into an IRS trap, the VDT trap. After the trap was sprung on the Chandlers during the government audit, the IRS argued that the easements under local government, South End Landmark District Commission (SELDC), were equally restrictive as those of NAT, thereby making the easements under NAT worthless. The Chandlers appealed to US Tax Court.

US Tax Court Judge Goeke gave much weight to the value diminution traps that had been spread all over the country by the IRS.  Judge Goeke also relied heavily on Kaufman T.C. Memo. 2014-52, finally decided in March of 2014, just a few months before Chandler. 
Judge Halpern handed a major victory to the IRS and this victory appears final..  I say appears final because Kaufman lost (Kaufman 1),. had resubmitted the case for reconsideration (Kaufman 2) and then after Kaufman lost again, appealed to the 1st Circuit (Appeal).  The 1st Circuit reversed Judge Halpern and remanded the case back to Tax Court (Kaufman 3).  Kaufman v. Commissioner, T.C. Memo. 2014-52. Kaufman 2 and Kaufman 3, on remand from the U.S. Court of Appeals for the First Circuit, Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012).   Let’s take a closer look at Kaufman 3. where as I mentioned appears final now.

On review of Kaufman 3 Judge Halpern relies heavily on the IRS star expert witness appraiser John C. Bowman III. Mr. Bowman has been certified by the Commonwealth of Massachusetts as a State-certified general real estate appraiser. He has received a Certificate of Completion for the Valuation of Conservation Easements program offered by the American Society of Appraisers (and other organizations) and is endorsed by the Land Trust Alliance. His appraisal work includes a particular emphasis on conservation and preservation restrictions. He has served on the Boston Landmarks Commission for 10 years, serving as chairman of the commission for 6 years. He has extensive experience appraising partial interests in real property, including conservation easements.

Mr. Bowman believed that no value was lost after Kaufman received a facade easement on his property thus no charitable contribution deduction was available.  Kaufman's experts and original appraiser, Hanlon did not seem credible to Judge Halpern who had little confidence in Hanlon's opinions. The Court concluded both “Kaufman and Hanlon failed to persuade us on account of the preservation agreement, lack of control and lack of marketability that the easement reduced the value of the property. To the contrary, Mr. Bowman’s expert testimony has convinced us that the restrictive components of the preservation agreement are basically duplicative of, and not materially different from, the South End Standards and Criteria, and we so find.”

By the way, just so you know, guess who the IRS used as their expert witness in Chandler? You guessed it, Bowman. I am not sure if Bowman is still testifying for the IRS, but just in case he is, you probably want to retain the services of a really good and probably very expensive army of qualified appraisers who are equally as good as Bowman before you file a tax return with a conservation easement charitable deduction.. 

How critical is the expertise of your appraiser? I found a very informative piece underscoring the importance of performing a good appraisal to bullet proof your tax return in a Journal of Accountancy article written in 2011 by C Andrew Lafond CPA and Jeffrey J Schrader CPA. The article emphasizes the importance of obtaining at least two appraisals with the following caveat: “Given the significance of the appraisal as to the value of the donation and the ability of the donation to withstand an IRS audit, donors should engage an appraiser who has experience in valuation of conservation easements and whose appraisals have successfully withstood IRS examination during audit and appeal to US Tax Court. If the dollar value of the donation is significant, it may be wise to obtain two appraisals.”

In conclusion, as I see it, your charitable tax deduction is simply in many cases based solely on an educated guess by appraisers some of whom are better than others. What this means for any of you contemplating gifting a conservation easement is that much of whether you win or lose in US Tax Court is going to depend primarily on how good your expert witness appraiser does on the witness stand and how much time the appraisers used to assess and back up their numbers and conclusions. Indeed, in my view, if you want to bullet proof your tax return from IRS attack and subsequent US Tax Court appeal, you had better get the best two appraisers out there to avoid an IRS VDT. On second thought, get three if you think Bowman has set a VDT in your neighborhood..

Thanks for joining Chris Moss CPA on TaxView.

Kindest regards from Chris Moss CPA

Submitted by Chris Moss CPA

If you read my last article on the Completed Contract Method of Income Tax Deferral we concluded that Shea v IRS was a big win for the developers. Unfortunately the IRS has come back with a vengeance in June of 2014 with a big win in Howard Hughes v IRS. (Hughes) Why did the government win big against Hughes and lose against Shea? What can you all do differently to avoid this adverse Hughes ruling in the event of an IRS audit against your development company? How can you align yourself with Shea so that you win if your case after IRS audit should proceed to US Tax Court? To answer these questions I suggest anyone out there who is a real estate developer currently developing residential communities to keep reading if you want to protect your income tax deferrals against adverse IRS audit consequences on your 2014 income tax return.

Let’s take a look at the facts in the Hughes case: Hughes was a large land developer of Summerlin, approximately 22,500 acres on the western rim of the Las Vegas Valley about nine miles west of downtown Las Vegas. Hughes created and paid for the massive master planned community as approved by Las Vegas and Clark County, and signed 30-year agreements enabling Hughes to develop the land without the necessity of separate village by village agreements. Hughes profits and sole source of revenue from Summerlin derived primarily from 4 categories, pad sales, finished lot sales, custom lot sales and bulk sales. These sales were made to builders and consumers with the intent the builders and customers would build homes on the land that Hughes sold. Hughes deferred tax on much of their residential related revenue based on the completed contract method asserting that Hughes was in the home construction business. In accordance with IRS regulations, taxable income was recognized when 95% of the estimated costs allocable to each lot were incurred.

The IRS audited Hughes for 2007 and 2008 and disallowed Hughes from using the completed contract to defer what would have been taxable income in various villages throughout Summerlin. As a result the IRS adjusted Hughes income upwards hundreds of millions of dollars resulting in a tax deficiency of over $120 Million. Hughes appealed to US Tax Court. The question presented to US Tax Court Judge Wherry: Whether the long term construction contracts being used by Hughes were “home construction contracts” as defined by 460(e)(1)(A)(B). If Hughes could prove to the Court that their contracts were “home construction contracts” then Hughes wins, if they can not, then the Government wins. Seems to me a pretty black or white case or perhaps not?

The “gray” in this case starts with the basic provision of the IRS Tax Code that allows for this very lucrative tax deferral by defining “home construction.” “Home construction” is defined as 80% or more of the contracts costs are for the construction of dwelling units and improvements to real property directly related to such dwelling units. The IRS argued that Hughes did not build homes on the land they sold and therefore their expenses were not for “home construction”. Hughes argued that the IRS statute “contemplates a broader definition of home construction costs.” Hughes further argued that as long as a cost in some way benefits the dwelling unit those costs should count towards meeting the 80% test. Under this view all their development costs were attributable to dwelling units and real property improvements.

Unfortunately for Hughes, Judge Wherry gave little weight to Hughes argument because Hughes did not offer even one case to support its tax position. Judge Wherry instead attempted to look to the legislative history as to how Congress felt about “home construction”. The Court noted that “While the conference report is ultimately silent as to why the exception was added in its final form, it is clear that the intended beneficiaries of this relief measure were taxpayers involved in the building construction reconstruction or rehabilitation of a home and not land developers who do not build homes, even if essential development work paves the way for and thus facilitates home construction.”

Continuing in his analysis, Judge Wherry distinguishes Hughes from Shea by noting that “…at no point in Shea did we say a home construction contact could consist solely of common improvement costs. The starting point in Shea was that the taxpayer’s contracts were for construction of qualifying dwelling units…Shea developed land and built homes…so we permitted Shea to add the cost of the dwelling units they constructed to their common improvement costs.” Judge Wherry concludes that “our Opinion today draws a bright line. Developers can qualify their home construction contracts for income tax deferral only if the developer builds integral components to dwelling units or real property improvements directly related to the site of each unit. If we allow developers the completed contract method to defer tax who have construction costs that merely benefit a home that may or may not be built then there is no telling how long deferral would last.”

In conclusion, the Court in Hughes has made it very clear to all developers who are counting on a tax deferral based on a completed contact method to make certain that their contracts include residential home building. And yes as I am sure you noticed by now, perhaps by an ironic coincidence, but certainly making the cases interesting, US Tax Court Judge Wherry presided over both Shea and Hughes Finally after the government victory against Hughes I believe that the IRS will be aggressively moving against the completed contract method being used by small and large developers alike. So if you are a developer in residential construction I would advise especially after Hughes for you all to carefully review your contracts with your contract attorney and tax attorney prior to filing your 2014 income tax return to make certain that Shea facts are controlling rather than Hughes in the event of an IRS audit. Thank you for joining us and look forward to seeing you all next time on TaxView with Chris Moss CPA.

Kindest regards
Chris Moss CPA

Submitted by Chris Moss CPA

Many real estate developers use the Completed Contract Method (CCM) of income recognition as they develop large tracts of land into buildable lots and ultimately residential housing around the nation.  This special method of revenue recognition is allowed for small developers earning less than $10 million who anticipate a 2 year date of completion on their project. Also qualifying are general residential construction developers regardless of size or cost as long as their project qualifies under IRC section 460(e)(1)(A) as “home construction” If you use this method of income tax deferral be aware that the IRS has in recent years become very suspect of the use of CCM. A 2009 IRS Memorandum asserts that the abuse of CCM is a growing trend within the residential construction industry. 

The IRS further asserts that “Taxpayers are improperly treating residential land sales contracts and long-term construction contracts (including contracts for subcontract work for common improvements) as home construction contracts eligible for CCM. The IRS also says that taxpayers are postponing recognition that a contract is considered complete to improperly defer income (and expenses) under CCM. However a 2014 US Tax Court case appears to grant wider latitude to real estate developers on how long taxes can be deferred. This is great news for the hardworking real estate developer community. So listen up all real estate developers in America: We are headed to US Tax Court to learn about a case that may change your life: Shea Homes v IRS 142 Tax Court 3 (2014)

The Shea family developed real estate through various family entities (Shea) for more than 40 years. Their business involved the analysis and acquisition of land for development and the construction and marketing of homes and the design and/or construction of developments and homes on the land they acquired. Shea entered into standard sales contracts with prospective homebuyers requiring earnest money deposits. Contracts could not close until all improvements were made or bond was posted. Shea used CCM for all its qualifying developments. Shea was audited by the IRS for year 2004 2005 and 2006 and ultimately appealed to US Tax Court on the key issue of when income tax deferral should have ended. The Government said the contracts were completed sooner than Shea reported and claimed that Shea should recognize income when the actual contracts closed and the buyer moved into the house. Shea argued that closing the contracts did not complete them as per the clear language of the contracts even if the buyer moved into the house. Shea further argued specifically that the contract language encompassed the entire development and therefore was not yet complete at closing. Shea concluded that final completion and acceptance triggering the end of the tax deferral did not occur until the final road was paved and the final bond was released. After an in depth analysis of the various contracts Judge Wherry brilliantly observes the “buyers of their homes understood and believed that the parties had contracted for the entire lifestyle of the development and its amenities, more than just the purchase of the home itself.”

Judge Wherry continued: “Thus, at the very minimum, the 95% completion test, as applied here, looks to costs beyond just those associated with the house, the lot, and improvements to the lot….The final completion and acceptance test also indicates that the subject matter of the contract in these cases is more than just the house, the lot, and improvements to the lot. Ultimately, this outcome is supported by our conclusion that Shea’s contracts consist of more than the purchase and sale agreement alone. When the contract documents are read together, the subject matter of the contract is quite clearly more than just the house, the lot, and improvements to the lot.” Id at 71.

This is great news for developers but I advise caution: Judge Wherry in his final footnote on page 82 warns: We are cognizant that our Opinion today could lead taxpayers to believe that large developments may qualify for extremely long, almost unlimited deferral periods. We would caution those taxpayers that a determination of the subject matter of the contract is based on all the facts and circumstances. Further, sec. 1.460-1(c)(3)(iv)(A), Income Tax Regs., may prohibit taxpayers from inserting language in their contracts that would unreasonably delay completion until such a super development is completed.

In conclusion, if you are a real estate developer who qualifies to use the completed contract method for income tax deferral, I advise you to work carefully with your contract attorney and your tax attorney in the same room at the same time to make absolutely certain prior to filing your 2014 tax return that your contracts have the appropriate language to defer income tax under Shea case law. Once the contracts are finalized, I would recommend you consult with your tax advisor and CPA to include at minimum in the tax return prior to filing that return the necessary contract summery explanation specifically focusing on Shea requirements to bullet proof the tax return against IRS attack in anticipation of a government audit. A bullet proof tax return with the necessary contract documentation is absolutely critical if you expect to win in US Tax Court as Shea did. Thank you all for visiting Taxview with Chris Moss CPA.

See you next time. Kindest regards from Chris Moss CPA