Florida Tax Attorney Blog

Brokerage Firms Use Advance Commission Loans as Part of Compensation

Brokerage firms often use advance commissions incentives to stockbrokers, financial advisors, and other financial professionals as an employee recruitment tool. The intent of this type of industry-standard compensation package is generally three-fold. First, and most significantly, the advance on future commissions functions as a financial subsidy for the broker during the transition from the former employer to the new employer. Because of the regulated nature of the securities industry, it often takes months for a broker's license to clear and transfer to a new firm. Similarly, it takes time for the broker's clients' account paperwork to be completed and returned to the new firm. Even once these documents are received by the new firm, the transferred accounts are subject to the firm's internal account approval process. It is only after completion of this internal approval process that the asset transfer process between financial institutions can be completed. And only after the transfer of the clients' assets from the old firm to the new firm can the revenue streams associated with the client accounts commence with the new employer.

The second purpose of these compensation arrangements is to acknowledge and compensate for the reality that brokers often lose clients when transitioning from one firm to another. For instance, some clients may decide to remain with the broker's former firm. This might happen for a variety of reasons. In many cases, the extended re-licensing process allows another professional at the former firm to establish a relationship with the client during the lengthy license-transfer process. In other cases, the client may have a pre-existing relationship with the new firm or may have previously had a bad experience with the new firm that left a sour taste.

The third and final purpose of these types of compensation arrangements is to provide proceeds which the broker may use for business development. For instance, a portion of the proceeds are typically used to pay for additional sales help (e.g., assistant), to purchase leads for potential clients, and to pay other costs of marketing and general business expenses. More importantly, however, the proceeds can be used to fund a platform of investments which the broker can then showcase to existing and potential clients as evidence of the broker's investment and money management skills. In this way, the broker is able to create a performance track record which conveys the broker's competence and qualification to existing and prospective clients.

Forgiveness of Debt In Connection With Termination of Employment

These arrangements are generally evidenced by a promissory note to be repaid over a period of several years through paycheck deductions. If the broker leaves the employ of the firm prior to full repayment, the notes are often due and payable on demand. In the vast majority of cases, however, the outstanding principal amount will be forgiven in part or full.

Subject to some exceptions, cancellation of debt generally constitutes taxable income insofar as the debtor receives an economic benefit as a result of the debt forgiveness. The effect of a debt cancellation is to reduce the debtor's liabilities and, thereby, increase the debtor's overall net worth. Thus, the amount of debt forgiven is generally treated as taxable income received. Generally, brokerage firms and financial institutions report this income to the IRS as non-employee compensation on Form 1099-MISC. As a result, brokers who leave the employ of a firm prior to repayment of the employment-related loan end up not only with income tax liability, but also self-employment tax liability (about 14% for Social Security, Medicare, FICA, etc). However, since most brokers and financial professionals are W-2 employees, use of a 1099-MISC is often an improper method of reporting the income.

Cancelled Debt as W-2 Wages

The use of a 1099-MISC to report the cancellation of debt as non-employee compensation is, in essence, an explicit statement by the brokerage house that the recipient employee is not an employee. So then why would the employer report this employment-related income as non-employee compensation rather than as W-2 wages?

Maybe to avoid the employer-portion of payroll tax (e.g., FICA, Social Security, Medicare). Maybe due to other non-tax commercial considerations. Whatever the case may be, both the Internal Revenue Service and the United States Tax Court have found stockbrokers and financial advisors to be employees for federal tax purposes. E.g., Gierek v. Commissioner, T.C. Memo 1993-642; Rev. Rul. 76-138, 1976-1 C.B. 315. Most brokers and financial advisors are provided with an office, equipment, and other benefits. In addition, commissions are usually reported on a Form W-2. Finally, and most significantly, stockbrokers and financial advisors are subject to the firm's control with respect to trading and other business activities. Moreover, the promissory notes are issued in connection with the employment. In these respects, the loan proceeds are in the nature of employee compensation. Consequently, the forgiveness of debt is properly reportable on Form W-2 rather than on a 1099-MISC. See Chief Counsel Advice 200130038. In this respect, it should be of no moment whether the cancellation occurs prior to or subsequent to the broker's resignation or termination from the firm. Under relevant United States Supreme Court jurisprudence, an amount constitutes W-2 wages if it arises in connection with the employment relationship. This is true even where the employment relationship no longer exists at the time taxable income is realized to the former employee as a result of the debt forgiveness.

Takeaway

If you or someone you know has incurred a tax liability in connection with the cancellation or forgiveness of an employment-related loan, you might be paying too much in tax.

Pursuant to I.R.C. § 861(a)(3), "[c]ompensation for labor or services performed in the United States shall not be deemed to be income from sources within the United States if the labor or services are performed by a nonresident alien individual in connection with the individual's temporary presence in the United States as a regular member of the crew of a foreign vessel engaged in transportation between the United States and a foreign country or a possession of the United States."

Consequently, nonresident crew members working onboard a foreign flagged yacht may not be subject to the withholding requirements found in I.R.C. §§ 3402 or 1441, so long as that yacht is engaged in transportation between the U.S. and a foreign country or U.S. possession. In this regard, it should be noted that U.S. territories (e.g., Puerto Rico, U.S. Virgin Islands) and their territorial waters are not considered to be part of the U.S. for purposes of I.R.C. § 861.

If you're going to walk away from your upside down mortgage, do it in 2012.

Under current law, homeowners may engage in a short sale or foreclosure transaction without tax consequences so long as the lender officially releases the debt. This is the result of the Mortgage Debt Relief Act of 2007 which allows taxpayers to exclude income from the discharge of debt on their principal residence.

But be aware of a planned change in the law. Effective January 1, 2013, debt forgiven in connection with a short sale or foreclosure of a primary residence will be taxable for federal purposes. This is a big deal.

For example, this means that a short sale of a home for $25,000 less than the outstanding mortgage amount would subject the seller to taxes on $25,000 of income. Homeowners in the 35 percent tax bracket would owe $8,750; homeowners in the 33 percent tax bracket would owe $8,250; homeowners in the 25 percent tax bracket would owe Homeowners in the 28 percent tax bracket would owe $7,000; homeowners in the 25 percent tax bracket would owe $6,250; homeowners in the 15 percent tax bracket would owe $3,750; and homeowners in the 10 percent tax bracket would owe $2,500.

Short sales can take a long time, so homeowners who want to short sell their homes during 2012 before the law change takes effect would be well-advised to begin the process now.

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" »

401(k). As a general rule, a taxpayer can contribute up to $16,500 tax-free to a 401(k) plan. In addition, taxpayers who are older than 50 years old may contribute an additional $5,500 for a maximum tax-free contribution of $22,000. Significantly, the amount contributed lowers taxable income.

IRA. Taxpayers who do not have a 401(k) may make a deductible contribution to a traditional IRA. However, the contribution limits are lower. For taxpayers 50 years or younger, the contribution limit for 2011 is $5,000. For taxpayers older than 50 years old, the contribution limit for 2011 is $6,000. out of your taxable income. Nonetheless, taxpayers are generally well-advised to contribute pre-tax income into a retirement account where it can grow tax-free rather than paying taxes on that money.

Gifts. The gift-tax exemption is currently at an all-time high of $5 million ($10 million for married taxpayers). Consequently, high-wealth individuals may be well-advised to consider making gifts this year before the gift-tax exemption reverts to $1 million after 2012.

Charitable Giving. Consider donating appreciated stock or other assets to charitable organizations that accept such donations. Such a donation will result in a charitable deduction equal to the fair market value of the donated asset. This means that taxpayers can deduct the full value of the donated property without incurring a tax liability on the appreciation.

Charitable Contributions Directly from IRA. This is the last year in which taxpayers aged 70½ and older will be permitted to make charitable contributions straight out of their IRAs. This method of charitable giving could be advantageous for taxpayers with IRAs that have appreciated substantially over time or for taxpayers who do not need the required minimum distributions for living expenses for three reasons. One: tax is avoided on appreciation. Two: the taxpayer is entitled to a charitable deduction. Three: the required minimum distribution is not included in the taxpayer's income for the year.

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.

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.

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