Florida Tax Attorney Blog

Pursuant to the treasury regulations under I.R.C. § 355, a spin-off must be undertaken for a purpose that is "germane" to the business of either the distributing corporation, the controlled corporation, or the affiliated group of which the distributing corporation and the controlled corporation are a part. In this respect, the IRS has long taken the position that a shareholder purpose is not a valid business purpose. But is this correct? Arguably, no.

Significantly, this issue has not been addressed by a court. That is, this position does not necessarily have any basis in the law (or in logic for that matter). My personal opinion is that a court would, more likely than not, squarely disagree with the IRS on this issue because I believe this general disallowance of shareholder purpose as a valid business purpose to be inconsistent with fundamental principles of corporate governance. The most basic theory of corporate governance is that a corporation exists for its shareholders. E.g., Dodge v. Ford Motor Co., 170 N.W. 668 (N.J. 1919). Indeed, a corporation is organized and carried on primarily for the profit of its shareholders. Id. Thus, any purpose which enhances shareholder value is consistent with the corporation's existence for its shareholders. Why, then, is a shareholder purpose insufficient by itself to support a 355 transaction?

To be clear, I would never recommend supporting a 355 transaction solely with a shareholder purpose. The IRS has clearly stated its position with respect to this issue, and the stakes are simply too high in this type of transaction to challenge the IRS. However, I do think that this is an issue to watch. Eventually, this issue will make its way into the court system, and when it does, I predict that the IRS' position will be invalidated.

The IRS Collection Financial Standards are intended for use in calculating repayment of delinquent taxes. That is, they are used to evaluate a taxpayer's ability to pay delinquent taxes. In essence, the standards estimate a taxpayer's expenses to determine how much of their income is available to allocate towards taxes. In the past, the criteria used by the IRS to evaluate a taxpayer's ability to pay were based on national averages. But of course, costs of living vary from state to state, from county to county, and even from locality to locality. In this respect, the IRS has historically ignored known disparities in costs of living when evaluating ability to pay. For instance, a taxpayer living in New York City would be deemed to have the same living expenses as a taxpayer living in rural Wyoming. In essence, a taxpayer's expenses turned solely on family size with no other variables coming into play. This method for evaluating a taxpayer's ability to pay taxes has troubled me since my first day in the practice of tax law.

When I say that this has troubled me since my first day as a tax practitioner, I mean literally my very first day. The first tax matter that I handled was an innocent spouse petition. The case involved a woman whose former husband failed to report some serious income. Of course, as most married couples do, the couple filed joint tax returns during their marriage. Also, as is the case with many married couples, this woman signed a tax return prepared by her spouse without reviewing or understanding its contents. And no one can blame her for that. After all, marriage is a relationship of reciprocal trust. But as it turned out, her husband failed to adequately disclose income on the tax return. Sounds precisely like the type of situation for which the innocent spouse provisions are designed to provide relief ... unless you're the IRS.

Unfortunately, our innocent spouse petitions weren't well-received by the IRS. The IRS imputed knowledge of the unreported income to this woman by virtue of her signature on the couple's joint income tax return and was unwilling to deviate from this position notwithstanding the circumstances. That led to plan B: offer in compromise. Part of the offer in compromise process involves completing IRS Form 433-A. On this form, the taxpayer provides information regarding his or her income and expenses so that the IRS can evaluate the ability to pay tax. This is where the Collection Financial Standards come in.

Of course, one of the things South Florida is known for is a high cost of living. As a result of the IRS' national standards, however, the maximum expenses that the woman was allowed to report were substantially below her actual expenses. How is this an accurate reflection of a taxpayer's ability to pay delinquent taxes?

The good news is that the IRS recently issued new Collection Financial Standards. Significantly, these new standards take geographic disparities in costs of living into account, at least in part. For instance, under the new standards, the maximum allowable car or lease payment for a taxpayer living in Miami is $346. In this respect, Broward County (e.g., Fort Lauderdale) is included in the Miami region. The remaining counties in the state, however, fall into the broader "South Region" for which the maximum allowable car ownership expense is capped at $244. The propriety of drawing this $102 line at the Broward-Palm Beach County line is questionable, but the line has to be drawn somewhere, and any type of line-drawing will necessarily be arbitrary to some degree. Still, the perceived benefits of a bright-line standard like this typically outweigh any arbitrariness. In any event, these local standards are a significant improvement from the previous one-size fits all national standards. From this perspective, although the $244 maximum allowable car ownership expense for the South Region is $102 less than the $346 allowed for taxpayers in Broward and Miami-Dade Counties, it is, nevertheless, $52 more than that allowed for taxpayers in Seattle, $32 more than that allowed for taxpayers in the Midwest Region, and $28 more than that allowed for taxpayers in the Minneapolis-St. Paul area. Thus, while the new local standards may not be completely accurate in all circumstances, it does reflect disparities in costs of living.

In addition, the newly issued standards include comprehensive local standards for costs of housing and utilities. In this respect, the maximum allowable expense is computed on a county-by-county basis. The maximum allowable expense for housing and utilities for one person in Broward County is $1,719. The maximum allowed in Miami-Dade County is $1,676, and the maximum allowed in Palm Beach County is $1,710.

Note, however, that inaccurate national standards continue to govern the maximum allowable expenses for food, clothing, personal care products (e.g., cosmetics, toothpaste, etc.), and health insurance costs. In this respect, an individual is allowed a maximum of $300/month for food, $86/month for clothing, and $32/month for personal care products. To illustrate the inadequacy of these national standards, consider that a taxpayer living in Broward or Miami-Dade County is allowed to allocate more monthly income to a car lease payment than to food. But hey, no one has ever accused the IRS of being a picture of logic. To be sure, the new local standards represent with respect to transportation and housing expenses represent a significant improvement. But there's still a long way to go.

This week, the First Circuit convicted a couple who received erroneous tax advice from a dentist of tax evasion. United States v. Allen, 1st Cir., No. 10-2160 (Jan. 6, 2012).

Facts:

The taxpayers in this case worked in the health and wellness industry. Specifically, they worked in the field of nutrition and vitamin supplement sales. On the advice of their dentist (which they claim to have confirmed through their own tax research), the taxpayers concluded that the Internal Revenue Code did not require them to pay taxes. They attached an explanation to this effect to their federal tax returns filed during the 1990s.

Beginning in 1998, the taxpayers claimed exemptions from withholding for federal income taxes. As a result, their employer discontinued withholding income taxes from their paychecks. Subsequently, the taxpayers classified themselves as independent contractors (as opposed to employees) such that their employer also discontinued withholding for FICA (i.e. Social Security and Medicare).

In 2000, the taxpayers stopped filing tax returns altogether. This is true notwithstanding their income of at least $100,000 during those years. Moreover, the taxpayers closed out all bank accounts, had their checks made payable either to cash or directly to creditors, and transferred the title to their home to a trust. From this point on, the taxpayers paid all expenses with cash or money orders.

In 2009, the taxpayers were charged with one count of conspiracy to defraud the United States, one count of attempted tax evasion, and four counts of willful failure to file income taxes (i.e. tax evasion). In April 2010, the taxpayers were tried in a joint trial in which they defended against the charges by asserting good faith reliance on their dentist's prior tax advice and good faith misinterpretation of the tax law. Not surprisingly, their argument was to no avail.

To be clear, the established law is that a taxpayer lacks the willfulness necessary for tax evasion if it is honestly believed, based on a misreading of the tax laws, that no taxes are owed. Cheek v. United States, 498 U.S. 192 (1991).

Holding:
Unfortunately for the Allens, however, the jury did not buy their argument. To the contrary, the jury convicted on all counts, and the Court sentenced each of them to three years in prison.

Bottom Line:
Ignorance or misinterpretation of the tax law is not a defense. Nor is reliance on tax advice received from a non-tax professional. So here's the bottom line: Don't give tax advice if you're not a tax professional, and don't rely on a tax position that sounds too good to be true (because it probably is).

In a recent case, the United States Tax Court addressed an increasingly hot topic: the deductibility of business expenses. More specifically, the Tax Court addressed the substantiation requirement (i.e. the extent of support that a taxpayer must provide to support a business expense deduction).

Summary of Facts:

Taxpayer was employed as a mortgage banker by a company called Quick Loan Funding and Homefield Financial Inc. He was paid wages reported on Forms W-2, Wage and Tax Statement, of $ 127,319.47 and $ 79,052.24, respec-tively.

Taxpayer included three Schedules C with his individual tax return for three separate businesses in 2007. First, tax-payer reported gross receipts of $ 2,309 and claimed deductions for car and truck expenses of $ 10,242 in connection with his business as a mortgage banker. Respondent disallowed this expense. Second, taxpayer reported no gross re-ceipts or sales but claimed total expenses of $ 69,893 ($11,922 of which was for car and truck expenses) in connection with an advertising business. Respondent disallowed all of the ZE Advertising Co. claimed expenses. Finally, taxpayer reported gross receipts of $ 43,218, claimed costs of goods sold of $ 22,587, and claimed miscellaneous advertising expenses of $ 25,560 in connection with a search engine optimization business. The IRS disallowed all deductions.

Holding:

The Tax Court upheld the IRS' disallowance of taxpayer's claimed business expenses. Consequently, taxpayer was liable for taxes on the claimed deductions. Furthermore, taxpayer was liable for accuracy-related penalties for improperly claiming unsubstantiated business expense deductions.

Discussion:

Deductibility of Business Expenses

I.R.C. § 162(a) allows a deduction for "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." In this respect, a business expense is "ordinary" if it is normal, usual, or customary within the taxpayer's particular trade, business, or industry. Commissioner v. Heininger, 320 U.S. 467, 471 (1943); Deputy v. du Pont, 308 U.S. 488, 495 (1940). Similarly, a business expense is "necessary" if it is appropriate and helpful for the development of the business. Id.

When is an Expense a "Business Expense"?

In Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987), the United States Supreme Court held that to be considered to be carrying on a trade or business within the meaning of section 162, "the taxpayer must be involved in the activity with continuity and regularity and . . . the taxpayer's primary purpose for engaging in the activity must be for income or profit." In determining whether a taxpayer's involvement with the alleged business was sufficiently continuous and regular, it is not controlling that the taxpayer intended to operate a business, because a business may not exist or yet have commenced without a single customer. There is no business in active operation where there are no customers and no evidence of any sales efforts that could lead to customers. Goodwin v. Commissioner, 75 T.C. 424, 433 (1980), affd. 691 F.2d 490 (3d Cir. 1982); Wolfgram v. Commissioner, T.C. Memo. 2010-69.

In Baacel Roumi v. Commissioner, the taxpayer failed to establish that his claimed advertising business was in fact an ongoing business for profit as required by Section 162(a). Taxpayer presented no evidence that the business was in operation in 2007. Indeed, taxpayer testified at trial that his advertising business was "in development" in 2007. Moreover, the advertising company's taxpayer identification number was not established until January 2008. Furthermore, taxpayer did not present evidence that the business had ever generated revenue or that he had claimed expense deductions relating to it in prior tax years. On this basis, the Tax Court held that the taxpayer failed to persuasively explain why an active business generated no gross receipts or sales yet managed to generate $ 69,893 in expenses.

Continue reading "MAKE SURE YOU CAN SUBSTANTIATE BUSINESS EXPENSE DEDUCTIONS" »

The new year is upon us, and so is tax season. And as tax season quickly approaches, it is important for Florida business owners to be aware of their tax obligations. Here's the 411 on when and how to file and pay:

FEDERAL:

Income Tax

Corporations

Due: March 15 if the corporation operates on a calendar year. Otherwise due on the 15th day of 3rd month following the end of tax year.

• C-corporations - Form 1120

• LLC Taxed as a Corporation - Form 1120

• S-corporation - Form 1120S (Note: an S-corp itself is generally not liable for any tax

Partnerships

Due: April 15 if the partnership operates on a calendar year. Otherwise due on the 15th day of 4th month following the end of tax year.

• Partnership - Form 1065

• LLC Taxed as a Partnership - Form 1065

LLCs

• Most LLCs with more than one member file a partnership return (Form 1065).

Due: April 15 if the LLC operates on a calendar year. Otherwise due on the 15th day of the 4th month following the end of the LLC's tax year.

• To be taxed as a corporation, a Form 8832 must be filed. LLCs taxed as corporations file a corporate return (Form 1120).

Due:March 15 if the LLC operates on a calendar year. Otherwise due on the 15th day of the 3rd month following the end of the LLC's tax year..

Single-Member LLCs

• Sole Member = Individual - Form 1040.

If you would prefer to have the LLC file as a corporation, you must file Form 8832. LLCs taxed as corporations file a corporate return (Form 1120).

• Sole Member = Corporation - Form 1120 (for C-corps) or Form 1120S (for S-corps)

Employment Tax
Businesses with employees must withhold federal income, Medicare and Social Security taxes from wages. When and how these taxes are paid to the government depends on a business's aggregate annual employment tax liability.

• Small Businesses With Annual Employment Tax Liability of Less Than $1,000: Payments may be made annually on January 31 by filing Form 944, Employer's Annual Federal Tax Return.

• Businesses With Annual Employment Tax Liability in Excess of $1,000: Payments are generally made on a monthly or semi-weekly basis. For businesses with total annual deposits in excess of $200,000, the Electronic Federal Tax Payment System is required. Businesses with total annual deposits of less than $200,000 may use Form 8109-B to make these payments. The tax should be reported on Form 941, Employer's Quarterly Federal Tax Return

Unemployment Tax

Due: Jan. 31, April 30, July 31, Oct. 31

• Must be paid for employees who were paid $1,500 in wages within a calendar quarter or who were employed for any portion of a day in 20 different weeks during the year.

• Due at the end of the month that follows the last day of each quarter.

• Electronic Payment or Form 8109-B.

• Paid on a quarterly basis, but reported on an annual basis (Form 940).

FLORIDA:

Florida Corporate Income Tax

Due: April 1 if the corporation operates on a calendar year. Otherwise due on the 1st day of 4th month following the end of tax year.

• Corporations that do business in Florida are subject to a 5.5% state corporate income tax.

• C-corporations generally pay tax on Form F-1120. However corporations with a tax liability that is less than $2,500 may file a short form, F-1120A.

Estimated Tax Payments: Corporations that owe more than $2,500 in Florida corporate income tax for the year must make estimated tax payments on Form F-1120ES on or before the last day of the fourth, sixth and ninth months of the taxable year and on the last day of the tax year.

Limited Liability Companies:

• LLCs which are classified as corporations for federal tax purposes are required to file a Florida corporate income tax return.

• LLCs which are classified as partnerships for federal tax purposes are required to file a Florida Partnership Information Return (Form F-1065) if they are doing business in Florida and one or more of their owners are corporations.

• A corporate owner of an LLC that is classified as a partnership for Florida and federal income tax purposes must file a Florida corporate income tax return.

S-Corporations: An S-corporation is not required to file a Florida corporate income tax return (except in cases where the S-corp has federal taxable income).Florida Unemployment Tax

Due:Jan. 31, April 30, July 31, Oct. 31:

A Florida business is required to report wages and pay taxes to the Unemployment Compensation program if:

• It paid $1,500 in wages within a calendar quarter;

• Employed one person for any portion of a day in 20 different weeks during the calendar year; or

• is liable for federal unemployment tax.

Generally paid on a quarterly basis by submitting Form UCT-6 to the Florida Department of Revenue.

Florida Sales and Use Tax

Due: First day of the month

• Businesses with taxable transactions must register with the Florida Department of Revenue by filing Form DR-1 or e-filing via the Florida Department of Revenue's website.

• Businesses that collect more than $20,000 annually in sales and use tax must pay through electronically.

• Businesses that collect less than $20,000 annually may use Form DR-15.

• Returns and payments are generally due on the first day of the month following the month in which the tax was collected. However, businesses that do not collect substantial amounts of sales and use taxes may file and pay on a less frequent basis. Specifically, businesses that collect less than $1,000 per year may file on a quarterly basis; businesses that collect $500 or less per year may file on a semiannual basis; and businesses that collect $100 or less per year may file on an annual basis.

Florida Discretionary Surtax

Due: First day of the month

• Some counties impose an additional surtax on transactions that are subject to the state sales and use tax.

• In such counties, this surtax is reported on Form DR-15 with sales and use tax.

Use Tax on Out-of-State Purchases

Due:First day of the month following the quarter in which purchase was made

• When out-of-state sellers fail to collect Florida sales tax, buyers must make the payment on their own.

• Applies to merchandise purchased from the Internet, shopping networks, mail order catalogs, etc.

• Applies to merchandise purchased while traveling out of state and shipped to Florida.

• Paid on Form DR-15MO

Florida Tangible Personal Property Tax

Due: April 1

• Florida businesses that own tangible personal property (e.g., computers, furniture, equipment) must this tax annually.

• Inventory is not subject to tax.

• Paid to county property appraiser on Form DR-405.

In Healthpoint, Ltd. v. Commissioner, T.C. Memo 2011-24, the U.S. Tax Court addressed the frequently considered question of whether amounts received in settlement of litigation should be taxed as capital gain or ordinary income. The conclusion: it depends. This is because the character of the income for tax purposes is determined by the nature of the settlement award itself. Stated more simply, tax character depends on what the recipient of the award is being compensated for. For instance, punitive damages would be taxed as ordinary income. On the other hand, reputation damages would be taxed as capital gain. In the past, this has generally meant that settlement agreements determined tax consequences. That is, the parties to the settlement would include an allocation of the settlement award among various types of damages within the settlement agreement itself, and that allocation would determine the income tax consequences to the recipient. Significantly, however, the IRS successfully challenged the parties' allocation in Healthpoint.

Facts. Healthpoint Ltd. ("Healthpoint"), a specialty pharmaceutical company, owned the exclusive rights to a popular prescription cream used in the treatment of wounds. Ethex Corporation ("Ethex"), another pharmaceutical company, developed a competing cream which it marketed as comparable to Healthpoint's popular ointment. In reality, Ethex's cream was not comparable to Healthpoint's cream at all. To the contrary, it was formulated with different ingredients, and many users experienced side effects and otherwise adverse results.

Because Ethex marketed its cream as comparable to Healthpoint's cream, doctors and other healthcare practitioners stopped prescribing both creams as a result of the negative patient experiences with the Ethex cream. As a result, Healthpoint experienced lower-than-projected sales and brought suit against Ethex for its lost profits. Specifically, the lawsuit alleged false advertising, unfair competition, misappropriation, and trademark dilution. In the meantime, Ethex formulated an improved version of its cream and brought it to market while Healthpoint's lawsuit against it was pending. Healthpoint responded with a second lawsuit, raising the same allegations as in the first suit, plus trademark theft.

The first lawsuit ultimately awarded Healthpoint $16.5 million in damages, allocated as follows:

Actual Damges: $5 million

Lost Profits: $1.64 million

Punitive Damages: $3.2 million

Trademark Dilution: $6.3 million

Ethex appealed, and the parties entered into settlement negotiations while the appeal was pending. Ultimately, the parties agreed to settle both lawsuits for $15.8 million, allocated as follows:

Lawsuit #1:

Damage to Goodwill and Reputation: $10.45 million

Lost Profits: $1.35 million

Lawsuit #2:

Damage to Goodwill and Reputation: $4.05 million

Lost Profits: $450,000

As a result, Healthpoint reported $1.8 million of ordinary income and $14.5 million of capital gain. This character differential could have been inconsequential if Healthpoint were a corporation without substantial capital losses (because corporations are not entitled to the preferential capital gains rates). However, because Healthpoint was structured as a partnership, all tax attributes passed through to the individual partner level. Thus, there were substantial tax savings to be had here by characterizing the bulk of the settlement award as capital gain. Not surprisingly, the IRS challenged Healthpoint's characterization, and the issue was litigated before the Tax Court.

Holding. In the end, the Tax Court reallocated the settlement award in a way that reflected what it perceived to be the economic realities of the underlying claims. This included a partial allocation for punitive damages, which are taxable as ordinary income, despite explicit language in the settlement agreement stating that no portion of the settlement amount constituted a punitive damage award.

Practical Implications. Settlement agreements will be afforded less weight in determining tax consequences going forward. As a result, taxpayers must be able to substantiate any allocation of the settlement proceeds that the settlement agreement purports to make. In other words, it is no longer sufficient to simply set forth an allocation of damages in the settlement agreement.

How to avoid the Healthpoint result. In recharacterizing the allocation of the settlement award, the Tax Court emphasized that Healthpoint failed to provide any documentation to support or otherwise justify its allocations. Additionally, the Court pointed out that Healthpoint was cognizant of the tax consequences of its allocation. With that being said, I would urge taxpayers in settlement negotiations to do two things: (1) create a paper trail to support the allocation of the settlement award; and (2) deemphasize any tax motivation for certain allocations during settlement negotiations.

There are two certainties in life: death and taxes. This is especially true in the viatical settlement context. A viatical settlement involves the sale of a life insurance policy by the insured during his or her lifetime. In effect, the investor will finance the insured's life insurance policy in exchange for being named beneficiary of the policy. In this way, the insured is able to extract value from the policy during his or her lifetime. When the insured dies, the investor is entitled to receive death benefits under the policy.

Although I.R.C. § 101(a) generally excludes life insurance proceeds from gross income, life insurance proceeds are includible in gross income in cases where, as in the viatical settlement context, the underlying policy was "transferred for valuable consideration." I.R.C. § 101(a)(2). In that case, the transferee of the policy must recognize income to the extent the death benefits exceed its basis in the policy. Therefore, a viatical settlement investor has income to the extent of his or her basis, which in most cases will be the cost of the investment. See generally, I.R.C. § 1001.

But when must this income be recognized for tax purposes? When the insured dies and the investor becomes entitled to the life insurance proceeds? Or when the investor actually receives payment from the insurance company? In many cases, the insured dies and the investor receives payment in the same year. But what about the case where the insured dies in one year and the investor does not receive payment from the insurance company until the following year?

Under I.R.C. § 451(a), income is included in a taxpayer's gross income in the taxable year in which it is received, unless properly accounted for in a different period. This means that cash basis investors may defer recognition of income until the year of receipt. However, under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income, and the amount thereof can be determined with reasonable accuracy. Treas. Reg. § 1.451-1(a).

Fixed Right to Income. Where a right to receive income is subject to one or more conditions precedent or other contingencies, courts have generally held that accrual of income is not required. E.g., Ringmaster, Inc. v. Commissioner, T.C. Memo. 1962-167 (accrual not required prior to purchaser's acceptance of sale conditions); Webb Press Co. Ltd. v. Commissioner, 3 B.T.A. 247 (1925) (accrual not required until acceptance after testing product). In these types of cases, the complexity of the tax laws and the potential for different interpretations of relevant statutes justifies non-accrual.

However, a "ministerial" contingency will not delay establishment of the fact of liability. Dally v. Commissioner, 227 F.2d 724 (9th Cir. 1955). In this regard, requirements of invoice certification, claim submission, and claim processing have been held to be ministerial acts which do not cause the right to income to be unfixed. Dally v. Commissioner, 227 F.2d 794 (9th Cir. 1955) (invoice certification); Rev. Rul. 98-39, 1998-2 C.B. 198 (claim submission); U.S. v. General Dynamics Corp., 481 U.S. 239 (1987) (claim processing). Therefore, the viatical settlement investor's right to receive income becomes fixed on the date of the insured's death. At that point, all conditions precedent to the investor's right to income have been satisfied. (Of course, this assumes that the insurer does not contest its obligation or otherwise have discretion to deny the claim).

Determinable with Reasonable Accuracy. Under the all events test, income must be reported in the tax year in which its collectability is assured, not in the year in which it is actually received. Clifton Manufacturing Co. v. Commissioner, 137 F.2d 290 (U.S. Tax Court 1943). However, if a taxpayer has "good reason" to believe that income cannot be collected, accrual is not required. American Fork & Hoe Co.v. Enterprise Manufacturing Co., 64 F.2d 1008 (1933).

The U.S. Tax Court has found "good reason" where there is "serious doubt as to ultimate collection." Corn Exchange Bank v. U.S., 37 F.2d 34 (U.S. Tax Court 1930). As for what constitutes "serious doubt," the law is unclear. But the law is relatively clear as to what does not constitute "serious doubt." Indeed, the Tax Court has explicitly stated that, "the fact that a lapse of time is contemplated before collection . . . does not constitute doubtful collectability." Harmont Plaza, Inc. v. Commissioner, 64 TC 632 (U.S. Tax Court 1977). Consequently, the fact that an accrual-basis investor may not receive payment of the death benefits in the year of death does not justify non-accrual. The income must be reported in the year of death, notwithstanding whether income is actually received in that year.

Buyer and Seller enter into a purchase and sale contract pursuant to which buyer places a deposit. Buyer breaches contract. Seller retains deposit. It happens more than you would think. And an interesting tax question is presented when it does: does the retained deposit constitute taxable income to the seller? And if so, is that income taxed as ordinary income rates? Or can the seller take advantage of the preferential capital gains rates?

As an initial matter, it should be noted that a "sale or other disposition of property" is a necessary precondition to a capital gain. See I.R.C. 1001(a). Obviously, there is no sale where a seller retains a deposit as a consequence of a contractual breach on the buyer's part. But is there a "disposition" within the meaning of I.R.C. 1001?

At the outset, the answer would appear to be an obvious no insofar as the seller continues to hold title to the property. After all, isn't disposal of the asset an essential component of an asset disposition?

One would think so. However, the U.S. Tax Court has analogized earnest money deposits to option payments. See e.g., Ahadpour v. Commissioner, TC Memo 1999-9. This is significant because there is language in the Internal Revenue Code which treats gain realized on the lapse of an option as capital gain.

Specifically, I.R.C. 1234(b)(1) provides:

In the case of the grantor of the option . . . gain on lapse of an option in property shall be treated as a gain . . . from the sale or exchange of a capital asset held not more than one year."

To be sure, "property" is narrowly defined for purposes of Section 1234 to include only stock, securities, commodities, and commodity futures. IRC § 1234(b)(2)(B). However, the Taxpayer Relief Act of 1997 extended sale or exchange treatment to "any property . . . [that] is a capital asset in the hands of the taxpayer." I.R.C. 1234A (emphasis added). In this regard, the legislative history of I.R.C. 1234A explicitly lists forfeiture of a down payment under a contract as an example of the type of property to which Section 1234A applies. See Staff of the Joint Comm. on Tax'n, General Explanation of Tax Legislation Enacted in 1997, 105th Cong., 1st Sess. 189.

But Section 1234(b)(1) treats a gain on lapse of an option as a short-term capital gain, and the preferential capital gains tax rates are only available for long-term capital gains. See I.R.C. 1234(b)(1) ("[G]ain on lapse of an option in property shall be treated as a gain . . . from the sale or exchange of a capital asset held not more than one year") (emphasis added); see generally I.R.C. 1(h).

Significantly, however, Section 1234A provides for treatment as "gain or loss from the sale of a capital asset." This is in contrast to Section 1234(b), which provides for treatment as "gain . . . from the sale or exchange of a capital asset held not more than one year." (emphasis added). Presumably, if Congress had intended to provide for short-term capital loss treatment in Section 1234A, it could have easily done so by including language similar to that which is found in 1234(b).

With that being said, the plain language of I.R.C. 1234A arguably supports long-term capital gain treatment of the retained deposit. (Of course, the counter-argument would be that I.R.C. 1234A was intended to extend I.R.C. 1234(b)'s sale or exchange treatment to a broader class of property, and as such, it should be construed consistently with that provision).

In any event, it should be emphasized that in Ahadpour (cited above for treatment of earnest money deposit as option to purchase), the Tax Court treated the forfeited deposit as ordinary income. Although this decision was issued in 1999, after the 1976 addition of 1234(b) and the 1997 addition of 1234A, the Court relied on pre-1234A case law in reaching that result. Thus, it is questionable whether this case was correctly reasoned.

The American Opportunity Tax Credit provides up to $ 2,500 per eligible student for qualified educational expenses (e.g., tuition, books, supplies) at the undergraduate level. Up to forty percent of the credit - or $1,000 - is refundable.

According to a recent Treasury report, the government has erroneously granted and taxpayers have wrongly received nearly $3.2 billion in American Opportunity Tax Credits. The report attributes this $3.2 billion error to ineffective IRS procedures for the review of education credits. To this end, the Treasury has forecasted that an additional $12.8 billion in wrongfully claimed education credits will be granted over the next four years under the current system of review.

In the wake of this report, the IRS has announced that it will closely scrutinize all tax returns that claim education tax credits going forward.

The good news is that the Treasury will save $12.8 billion over the next four years that it would have otherwise erroneously paid out in the form of wrongly claimed education credits. The bad news is that taxpayers claiming education credits will have their returns more closely scrutinized. In this regard, it is important not only to ensure that any education credits claimed are bona fide, but also that the tax return is accurate in all other respects since the return will be isolated for closer review.

Not only will the IRS more closely scrutinize tax returns that claim education credits, but it will also require taxpayers to provide more documentary support than in the past for any education credits claimed. The IRS is currently revising Form 8863, which is used to claim the Opportunity credit, and beginning in 2012, taxpayers claiming this credit must identify their educational institution on the Form 8863.

In addition, the IRS is considering a joint effort with the Department of Education whereby the Department would provide educational information to the IRS that could be used to verify taxpayers' eligibility for the credit.

Under current tax law, receipt of an insubstantial benefit in connection with a charitable contribution will not adversely affect or otherwise limit the deductibility of the contribution for tax purposes.

However, an interesting tax question is raised where a donor receives naming rights to a building or other capital facility in exchange for a contribution. Indeed, the fact that this type of charitable giving may be motivated by (or even conditioned on) receiving naming rights raises serious tax questions about the nature of the "gift."

Deductibility. In order to be deductible as a charitable gift, a contribution must be made without expectancy of any sort of return benefit. To this end, the U.S. Tax Court has stated, "[i]f a payment proceeds primarily from the incentive of anticipated benefit to the payor beyond the satisfaction which flows from the performance of a generous act, it is not a gift. DeJong v. Commissioner, 36 T.C. 896, 899 (1961). In this spirit, the IRS has limited deductibility where the donor receives a substantial benefit in connection with a contribution. E.g., Rev. Rul. 86-63 (emphasis added); see also I.R.C. 170(c). Thus, in situations where a donor makes a contribution with an expectation of receiving naming rights, the question becomes one of substantiality.

Are naming rights a substantial benefit? A 1986 Revenue Ruling issued by the IRS relating to contributions to collegiate athletic programs may provide some guidance in this area. See Rev. Rul. 86-63, 1986-1 C.B. 88. In this ruling, the IRS held that a charitable deduction is disallowed to the extent of any benefit received. However, a charitable deduction is still allowed to the extent that the contribution exceeds the value of the received benefit. Thus, if a taxpayer donates $500 to a college athletic program and receives football tickets valued at $300, a charitable deduction of $200 will be allowed. See Rev. Rul. 86-63. At the same time, the U.S. Supreme Court has clearly indicated that insubstantial benefits received in connection with a contribution are not necessarily considered. Specifically, the Supreme Court has stated that, "[w]here the size of the payment is clearly out of proportion to the benefit received, it would not serve the purposes of section 170 to deny a deduction." See U.S. v. American Bar Endowment, 477 U.S. 105, 117 (1986).

In the context of naming rights, then, the essential question is one of valuation. But how is the opportunity to name a building or other capital facility valued? The valuation issue is further complicated by the fact that different taxpayers may value naming rights differently. For instance, naming rights would likely be more valuable to a corporation than to an individual philanthropist due to the advertisement and exposure value that comes with it.

Minimum Donation Requirements.Where church members deducted a fixed amount paid to the Church of Scientology in exchange for some type of religious training, the U.S. Supreme Court held that there was no gift at all because the taxpayers received services with a measurable value. See Hernandez v. Commissioner, 490 U.S. 680, 691 (1989). As the Court explained, the value of the services was measurable because it was fixed by the church. Id. In this spirit, the Supreme Court disallowed the charitable deduction and held that only bona fide gifts are deductible. In this regard, the Court stated that a gift is not bona fide to the extent that the donor expects to receive a benefit in return.

Often, a university or other organization will fix a minimum donation as a prerequisite to receiving naming rights. It seems that the IRS could disallow a deduction to the extent of the dollar amount fixed by the organization based on the current law. The question is whether it should. And more importantly, whether it would.

A bond swap is a tax and investment strategy whereby an investor sells a bond that has declined in value and simultaneously purchases a substantially similar bond with the proceeds from the sale.

Why?

If an investor plans to use the proceeds of the bond sale to purchase a substantially similar bond, why not just hold the existing bond? The reason is purely strategic. By engaging in this type of transaction, the investor generates a tax loss. This artificially generated tax loss can be used to offset capital gains and ordinary income without altering the general composition of the taxpayer's investment portfolio.

Here's How It Works:

Step 1: investor sells a bond that has declined in value.

Step 2: investor simultaneously purchases a bond with substantially similar attributes in terms of principal amount, yield, and recovery period.

Following this transaction, the investor continues to own a bond with substantially similar investment characteristics and also holds a tax loss that can be used to reduce his or her income tax liability. The tax loss realized on this transaction can be used to offset capital gains realized on other investments. In addition, to the extent the loss exceeds capital gains, it can be used to offset up to $3,000 of ordinary income. SeeInternal Revenue Code §1211(b). Any loss beyond that can be carried forward and used to offset capital gains and ordinary income in future tax years. SeeInternal Revenue Code §1212(b).

IRS May Challenge Bond Swap Transactions Under 2010 Legislation.

Investors have been engaging in bond swap transactions for years in order to trigger tax losses without altering their overall economic positions, and this practice has generally been accepted by the IRS. Moreover, the United States Supreme Court has seemingly endorsed this tactic. See Cottage Savings Association v. Commissioner (upholding mortgage loan swaps by banks to realize tax losses). But recent additions to the Internal Revenue Code have raised questions about the continued propriety of this tax and investment strategy.

In 2010, Congress codified the common law economic substance doctrine in Section 7701(o) of the Internal Revenue Code. Under the economic substance doctrine, tax benefits are denied if the transactions giving rise to the benefits lack economic substance apart from tax considerations. Pursuant to Section 7701(o)(1), in cases where the economic substance doctrine is relevant, a transaction shall be treated as having "economic substance" only if: (1) the transaction meaningfully changes the taxpayer's non-tax economic position; and (2) the taxpayer has a substantial non-tax purpose for entering into the transaction.

Because the bonds swapped are substantially similar and because the sole purpose of a bond swap is to create tax losses without changing the investor's overall financial position, this type of transaction is subject to challenge under this new legislation.

Bond Swaps Probably Remain Acceptable Despite 2010 Legislation.

Notwithstanding the 2010 codification of the economic substance doctrine, bond swaps probably remain safe tax and investment strategies.

First, in order for the IRS to invoke Section 7701(o) to challenge a bond swap transaction, the statute requires that the economic substance doctrine be "relevant" to the challenged transaction. Based on the pertinent case law, the economic substance doctrine is arguably irrelevant to a bond swap transaction. Indeed, in Cottage Savings, the Internal Revenue Service raised the economic substance doctrine in opposition to a bank's mortgage swap transaction, but the Supreme Court declined to apply the doctrine. Moreover, the Supreme Court seemingly rejected the relevance of the economic substance doctrine in swap transactions when it stated that, "a much less demanding and less complex test" is required.

Additionally, even if the economic substance doctrine is relevant to bond swap transactions, this type of transaction arguably possesses economic substance and business purpose apart from tax considerations in the sense that, although similar, the two debt instruments differ in the sense that they represent different debt obligations and have different issuers. Moreover, swap transactions have substance beyond the tax considerations in the sense that the swap itself is a mere component of a larger transaction of deriving a desired rate of return on the overall investment portfolio.

Continue reading "BOND SWAPS MAY BE SUBJECT TO CHALLENGE UNDER NEW TAX LAW" »

This past Labor Day weekend, I married my college sweetheart (go Canes!) in Vero Beach, Florida!

My husband's parents kicked off the weekend with an exquisite rehearsal dinner at the Vero Beach Hotel & Spa. On Saturday afternoon, we married at Holy Cross Catholic Church, a charming Florida church situated within an enclave of aged oak trees. Following the mass, my parents hosted an enchanting soiree at the Orchid Island Beach Club.

But like all good things, our fairytale wedding weekend eventually came to an end. Now, it's time to take care of some business items so that the IRS doesn't disturb our matrimonial bliss this tax season.

1. SOCIAL SECURITY NUMBER. The name on your tax return must match the name registered to your social security number. Use Form SS-5 to change your name with the Social Security Administration.

   This form must be supported by evidence of: (1) your age; (2) your identity; (3) your citizenship; and (4) your legal name change. An original or certified copy of your birth certificate can be used to prove your age and your U.S. citizenship; a passport may be accepted as an alternative. (Non-citizens must provide evidence of their immigration status). A driver's license or a passport can be used to prove your identity. Your marriage license can be used to prove your legal name change.

   Take or mail the completed Form SS-5, together with the supporting documentation to your local Social Security office. This form must be filled out using blue or black ink.

   All honeymoon reservations should be made using your maiden name. It typically takes several weeks for the marriage license to arrive in the mail, so you will not be able to obtain a new passport or driver's license in time for the honeymoon.
   

2. DRIVER'S LICENSE. Because your driver's license is your primary form of identification, you must also change your name on your driver's license. Most DMVs will issue a new driver's license upon presentation of the marriage certificate (i.e. from the church), but some will require a certified copy of the marriage license (i.e. from the State). Check with your local DMV before you go for its requirements. You will also need to bring your current driver's license.
3. CHANGE OF ADDRESS. Notify the U.S. Postal Service of any address change so that it may forward any mail from the IRS (e.g., refund checks, letters) by completing the Postal Service's official change of address form. The Postal Service will usually notify the IRS of your new address, but it is a good idea to notify the IRS directly of any address change by completing a Form 8822.
4. INFORM YOUR EMPLOYER OF NAME AND ADDRESS CHANGES. It is important to inform your employer of any name and address changes so that the information on your W-2s correspond with the name registered to your social security number and used on your tax return and so that you timely receive your W-2.
5. ENSURE CORRECT WITHHOLDING. Your newly combined incomes and marital status may subject you and your spouse to a higher or lower tax bracket. Ensure that your employers are making correct withholdings for federal taxes so that you do not end up overpaying or owing significant tax in excess of withholding. Check out the IRS Withholding Calculator to determine the correct amount of withholding.
   

SOURCES:

• IRS Summer Tax Tip: Advice to Newlyweds
• Social Security Administration FAQ: How to Change a Name on a Social Security Card

Police departments across the Nation are advising citizens of a disturbing trend in phishing email scams whereby identity thieves impersonate the Internal Revenue Service (IRS) in efforts to obtain personal financial information from taxpayers.

Over the past several years, various forms of this deceptive email scheme have been circulated on the Internet, but this identity theft tactic is becoming alarmingly popular. The most common IRS email scam claims to be from the IRS and notifies the taxpayer that he or she qualifies for a tax refund and instructs the taxpayer to open an attachment or click on a link to access a refund form.

The latest variation of this IRS email hoax claims to be from the IRS and informs the recipient that the IRS has rejected his or her electronic tax payment. The email instructs the taxpayer to open an attachment or click on a link to access a form to rectify the problem.

By opening the attachments or clicking on the links contained in these phishing emails, the taxpayer unknowingly downloads a virus which enables identity thieves to collect confidential information about the taxpayer (e.g., credit card numbers, online banking login information, social security numbers, birth dates). This fraudulently obtained information is then used by the identity thieves to access the victim's bank accounts and obtain credit cards, loans, and other benefits in the victim's name and at the victim's expense.

If you receive an email from the IRS requesting personal information, do not become a victim of identity theft. Do not click on any links contained within the email. Do not open any attachments. Do not send an email reply to the sender.

These emails look official (see sample email here), but the IRS never contacts taxpayers by e-mail. If the IRS must contact you regarding a tax matter, it will always do so by way of traditional mail.

SOURCES:

• IRS Resources, What To Do If You Receive a Suspicious IRS-related Communication
• IRS Newswire, IRS Warns of Email Scam About Tax Refunds
• IRS Resources, Suspicious Emails and Identity Theft
• Anthony Holloway (Columbus Dispatch), IRS Warns of Email Scams That Seek Info
• Chris Cifatte (WINK News), New Email Hoax Hitting Southwest Florida Claims To Be From IRS