Individual Income Tax Return Mistakes and How to Fix · PDF file6XUJHQW /DQFDVWHU $YHQXH 'HYRQ 3$ 3 ) LQIR#VXUJHQW FRP ZZZ VXUJHQWFSH FRP Individual Income Tax Return Mistakes and

Individual Income Tax

Return Mistakes and

How to Fix Them

INB4/17/01-X6

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This product is intended to serve solely as an aid in continuing professional education. Due to the constantly changing nature of the subject of the materials, this product is not appropriate to serve as the sole resource for any tax and accounting opinion or return position, and must be supplemented for such purposes with other current authoritative materials. The information in this manual has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. In addition, Surgent McCoy CPE, LLC, its authors, and instructors are not engaged in rendering legal, accounting, or other professional services and will not be held liable for any actions or suits based on this manual or comments made during any presentation. If legal advice or other expert assistance is required, seek the services of a competent professional. Revised May 2017 surgentcpe.com / [email protected] Copyright © 2017 Surgent McCoy CPE, LLC – INB4/17/01

Table of Contents

Supplement: The Trump Tax Plan and What You Need to Know in 2017 Top 25 Tax Mistakes Individual Income Tax Return Mistakes and How to Fix Them ..................... 1

NOTES

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Supplement: The Trump Tax Plan and What You Need to Know in 2017

Learning objectives 1 I. All aboard the tax reform train 1

A. Why 2017? 1 1. Similarities with 1986 1 2. Selected proposals to replace the income tax 2

II. The engineers and the build-up (not all inclusive) 5 A. Candidate and President-Elect Donald J. Trump tax proposal 5

1. Individual proposals 5 2. Business proposals 5

B. Speaker of the United States House of Representatives Paul D. Ryan Jr. 5 1. Better way a.k.a. the “Blueprint Plan” 5 2. Individual proposals 6 3. Business proposals 6

C. United States Secretary of the Treasury Steven T. Mnuchin 7 D. Chairman of the Committee on Ways and Means Kevin Patrick Brady 7 E. Majority Leader of the Senate Addison Mitchell "Mitch" McConnell Jr. 7 F. United States Senate Committee on Finance Chairman Orrin G. Hatch 7 G. Director of the National Economic Council Gary D. Cohn 7

III. President Trump’s tax plan as released April 26, 2017 8 A. Goals for tax reform 8

1. Individual proposals 8 2. Business proposals 8 3. Miscellaneous 8

B. Hatch, McConnell, Ryan, Brady statement on administration’s tax plan 9 C. Process 9

IV. Early projections 10 A. Projection #1 10

1. Assumptions 10 B. Projection #2 11

1. Assumptions 11 C. Projection #3 12

1. Assumptions 12 D. Projection #4 13

1. Assumptions 13 E. Projection #5 14

1. Assumptions 14 F. Projection #6 15

1. Assumptions 15 G. Projection #7 16

1. Assumptions 16 V. Closing notes 17

A. What could be on the table? 17 1. In short – Everything! 17 2. Surgent’s Trump-Tracker 17

B. Elements of engagement discussion 17

surgentcpe.com / [email protected] Copyright © 2017 Surgent McCoy CPE, LLC -- SUPP/17/X6 1

Supplement: The Trump Tax Plan and What You Need to Know in 2017

Learning objectives

Upon reviewing these materials, the reader will be able to: • Understand the key components of the Trump tax plan; and

• Identify likely tax outcomes and the practical impacts for CPAs and their clients.

Professionalism Prelude: Where 18th Century Poets Meet 21st Century Professionals

In the late 18th century, while plowing his farm in Scotland, Robert Burns unearthed a mouse’s protective nest. In lamenting the creature’s poor fortune he dedicated a poem -- To a Mouse – which includes a quite famous tagline paraphrased today as: “The best-laid plans of mice and men often go awry.” Many times when discussing accounting, tax and finance policy issues, it can be difficult to divorce the politics from the policy. This manual is dedicated to various policy issues professionals must have detailed knowledge of to fully discuss with their clientele. This dialogue is not intended to be an editorial, opinion, or view of politics. In regard to the 2017 changes discussed by President Trump, professionals must appreciate that the final brew to be ladled from the fiery cauldron of a joint congressional committee will be “awry” of what certain factions deem the “best-laid plans.” There will be winners and losers, singles, doubles, home runs, and grand slams. In the spirit of professionalism, respectfully limit the discussion to policy, not politics, and focus on

doing the very best for our clients.

I. All aboard the tax reform train

A. Why 2017?

1. Similarities with 1986

In October 1986, President Ronald Reagan signed into law the Tax Reform Act of 1986 – landmark

legislation that is recognized as the single largest reform of the U.S. tax code in our nation’s history.

In many ways, the current tax and political environment is remarkably similar to the one that allowed

President Reagan to successfully overhaul the tax code three decades ago:

a. The American people were fed up with the tax code. It was a complicated mess of

multiple brackets, high rates, and special-interest provisions. As President Reagan

described it, the code had become a “haven for special interests and tax manipulators,

but an impossible frustration for everybody else.”

b. Members of Congress had bold proposals for pro-growth tax reform. Americans saw the

total number of income brackets reduced from 15 to two. In addition, the top income-tax

rate for individuals was cut from 50 percent to 28 percent, and the top corporate tax rate

was reduced by 12 percentage points.

c. President Reagan was willing to lead on tax reform. It took three years of sweat and

difficult work in Congress to finally reach enactment in 1986.


A striking number of these same factors are present today:

a. The American people are fed up with the tax code. It again has become a complicated

mess of multiple brackets, high rates, and special-interest provisions. Once again,

Americans are forced to devote their hard-earned dollars and their hard-pressed time to

complying with an overly complicated and complex code. And at the end of the process,

most people believe that everyone else but them got a better deal.

b. Members of Congress now are proposing a variety of serious ideas for pro-growth tax

reform; some are outlined below. Representative Rob Woodall of Georgia is a

champion of the Fair Tax, which would repeal the income tax and other taxes, abolish the

IRS, and enact a national retail sales tax. Representative Mike Burgess of Texas is a

powerful advocate for the Flat Tax, which would give taxpayers the option of having a flat

rate of tax applied to their annual income. Representative Devin Nunes of California has

designed the American Business Competitiveness (ABC) tax, which would transform the

way businesses are taxed in America. Representative Bob Goodlatte of Virginia is

making the case for the Tax Code Termination Act, which would end the current tax code

after 2019 and require Congress to adopt a fair and simple federal tax system to replace

it. More broadly, members of Congress on both sides of the aisle believe that Americans

deserve a better tax system and that Congress must deliver it.

c. Every major primary and general election candidate in the 2016 presidential election

introduced a plan to reform the tax code.

It should be noted, since 2012 President Obama and several Congressional proposals were bandied

about for reduced C corporation tax rates. Under several proposals, the current 34- and 35-percent

brackets would disappear and be replaced by an approximate 25 percent bracket.

2. Selected proposals to replace the income tax

In general a number of alternative tax systems to replace the current income tax system have been

proposed. Many of these proposals alter the tax base so that it is based on consumption, rather than

income.

a. VAT

A VAT is generally a tax imposed and collected on the “value added” at every stage in

the production and distribution process of a good or service. Over 140 countries,

including every member country in the Organisation for Economic Cooperation and

Development (“OECD”) besides the United States, has implemented a VAT, although the

countries have generally done so to supplement, rather than replace, their income tax

system.

(i) While there are several ways to compute the taxable base for a VAT, the amount

of value added can generally be thought of as the difference between the value

of sales (outputs) and purchases (inputs) of a business.

(ii) A VAT is generally thought of as a consumption tax, not because it uses value

added as a base, but because it uses cash-flow accounting principles to measure

value added.

(iii) The amount of value added may be determined in a number of ways under a

VAT.


The credit-invoice method has been the system of choice in nearly all

countries that have adopted a VAT, and determines the tax liability

based on the difference between the aggregate VAT disclosed on sales

and purchase invoices of a taxpayer.

The subtraction method is similar to the credit-invoice method, but

determines the tax liability based on records the taxpayer may maintain

for non-tax purposes.

(iv) Policymakers may exclude goods, services, or classes of taxpayers from a VAT

either by providing a “zero rating” or an exemption. There may be significant

differences between these two alternatives, particularly under the credit-invoice

method.

(v) A VAT based on the destination principle imposes tax on imports and provides

tax rebates on exports. These import charges and export rebates are commonly

referred to as “border adjustments” and are a part of nearly all VAT systems

currently in place.

Under the border adjustments, exported goods are not subject to the

VAT through zero-rating the sale of exported goods (i.e., by applying a

VAT rate of zero to exports, thus allowing the exporter to claim

refundable credits for VAT paid with respect to the purchased inputs).

On the other hand, importers are subject to tax on the full value of

imported goods (because inputs with respect to such products had not

been subject to the VAT).

Similar treatment is provided for imported and exported services.

b. Flat Taxes

In general, a “flat tax” is any tax system with only one marginal tax rate. Many of the flat

tax proposals that have been developed do more than simply apply one rate to the

current and individual income tax base; they redefine the base of the tax as well.

(i) There are two main approaches - A consumption base and an income base. The

difference between the two is in the treatment of savings:

An income-based tax includes the return to savings in the tax base,

A consumption-based tax does not.


Note: Flat Tax Example

An example of a flat tax with a consumption tax base is the Hall-Rabushka (HR) flat tax.1 The HR flat tax has two components: an equal flat tax on business cash flow and on individual compensation. The HR plan was believed to be the basis within Carly Fiorina’s 2016 primary run, in which she indicated her plan would cut the 70,000+ tax code to just 3 pages. Media has estimated the former candidate’s flat tax plan at a 19% tax rate. Under the HR plan businesses of all entity classifications (C-corporations, partnerships, sole proprietorships, etc.) are taxed, at a single rate, on their cash flow, which consists of sales minus purchases from other businesses and the wages they pay, and the pension benefits they provide individuals for their labor services. Employer contributions to Social Security, health insurance, and other non-pension benefits are not deductible by businesses. Individuals are taxed at a single rate on the wages and pension benefits they receive as compensation for their labor services. That single rate does not apply to the first dollar of compensation they receive. The plan provides an exemption that varies by the filing status of individuals and the number of dependents they have. Interest, capital gains, dividends, rents, and royalties are excluded from the tax base. For cross-border transactions, the HR proposal is origin-based, so that tax is imposed on goods

and services produced in the United States, thereby including exports but excluding imports.

c. X-Tax

A proposal similar to the Hall-Rabushka flat tax is the X-tax. An X-tax is a progressive

consumption tax that consists of two primary components: a flat tax on business cash

flow and a graduated-rate tax on individual compensation with a top rate equal to the tax

rate on business cash flow. Financial transactions are excluded from the tax base so that

no tax is paid on capital gains, dividends, and receipt of interest.

d. Retail sales tax

A national retail sales tax is a tax imposed on the retail sales (i.e., sales to final

consumers) of taxable goods and services. A retail sales tax has approximately the same

economic burden as a general VAT. However, a retail sales tax may vary from a VAT in

terms of administrability, compliance burden, and ease of implementation.

(i) The choice of a retail sales tax to implement a consumption tax may be attractive

because the start-up and overall compliance costs of the tax could be small

compared to those for a VAT.

(ii) Part of the reason for these relatively low costs is that a retail sales tax involves

only entities that sell directly to end users of the taxed goods or services. This

means that the number of taxpayers involved in retail sales tax is small

compared to the number of taxpayers involved in a VAT, which makes taxpayers

of all parties involved in the entire production and distribution process.

(iii) Limiting the number of taxpayers limits the aggregate amount of recordkeeping

needed to implement a retail sales tax. In turn, this limits the total cost of the tax

system to both the government and taxpayers.

1 Robert E. Hall and Alvin Rabushka, The Flat Tax, Hoover Institution Press, 1995.


Note: How to evaluate the proposals

Economists and politicians use a number of criteria to assess the effectiveness of any tax system.

Their assumptions and definitions of words such as “fair” do not always agree.

II. The engineers and the build-up (not all inclusive)

A. Candidate and President-Elect Donald J. Trump tax proposal

While candidate and president-elect, current President Trump proposed drastic rate reductions for

individual and business taxpayers, earnings repatriation of foreign profits, aggressive property expensing,

and import protections all with the goal of promoting domestic businesses and job creation. The proposal

was more of an outline as opposed to Candidate Clinton’s detailed proposals.

1. Individual proposals

Reduction in the number of brackets to three, utilizing 12%, 25%, and 33%. The lowest

rate would be for taxable income up to $37,500 for single taxpayers, and $75,000 for

MFJ. The 25% rate would be for incomes up to $112,500 for single taxpayers and

$225,000 for MFJ.

Increase the standard deduction to $15,000 for single individuals and $30,000 for

taxpayers married filing jointly.

Limit itemized deductions at $200,000 for married joint filers and $100,000 for single

filers.

Remove personal and dependent exemptions, yet introduce an above-the-line deduction

for children under 13, which would be capped at state average childcare for age of child,

limited to 4 children per taxpayer.

Eliminate the AMT, the estate tax, the 3.8% NII tax, and head of household filing status.

Retain the existing capital gains rate structure (max rate of 20%).

2. Business proposals

Reduction in the top corporate tax rate to 15 percent.

Cap personal income tax rates on the “active income” of pass-through businesses at

15%.

Allow businesses to immediately and fully write off capital investments.

Commits to retaining the Research and Development Credit; most other corporate tax

expenditures, though none are specifically mentioned, would be eliminated.

B. Speaker of the United States House of Representatives Paul D. Ryan Jr.

1. Better way a.k.a. the “Blueprint Plan”

In mid-2016, Speaker Ryan introduced the GOP’s “A Better Way” Tax Proposal, which also has been

referred to as the Tax Reform Task Force “Blueprint.” The proposal mirrored many of Candidate

Trump’s proposals, however with less drastic rate cuts. The proposal included the following points (not all

inclusive).



Reduction in the number of brackets to three, utilizing 12%, 25%, and 33%. The lowest

rate would be for taxable 2017 income up to approximately $37,950 for single taxpayers,

and $75,900 for MFJ. The 25% rate would be for incomes up to $191,650 for single

taxpayers and $233,350 for MFJ.

Remove most itemized deductions except the mortgage interest, charitable giving and

education expenses, and replace with a larger standard deduction of $12,000 for single

individuals; $18,000 for single individuals with a child; and $24,000 for taxpayers married

filing jointly.

Remove personal and dependent exemptions, yet increase the child tax credit to $1,500

and add a new $500 tax credit for non-child dependents.

Eliminate AMT, the estate tax, and the 3.8% NII tax.

Reduce tax rates on investment income by allowing a 50% deduction for net capital

gains, dividends, and interest income. (In essence investment income would be taxed at

6%, 12.5%, and 16.5% -- one half of the above referenced proposed rates.)

A pledge to allow most individuals to file their taxes on a form the size of a postcard.


Reduction in the top corporate tax rate to 20 percent.

Cap personal income tax rates on the “active income” of pass-through businesses at

25%.

Allow businesses to immediately and fully write off capital investments.

Eliminate some deductions of business interest expense.


C. United States Secretary of the Treasury Steven T. Mnuchin

Steven T. Mnuchin was confirmed by the United States Senate as the 77th United States Secretary of the

Treasury on February 13, 2017, by a vote of 53-47. Secretary Mnuchin is a former banker, hedge fund

manager, politician, and entertainment executive.2

In regard to the Trump Tax Plan, Secretary Mnuchin has been unwelcomely attached to a so-called

“Mnuchin-Rule.” During his confirmation hearings he was asked whether the administration's tax

reductions would mostly favor wealthy taxpayers, to which he inferred the absolute tax cuts for high-

income individuals would be offset by increases in other areas such as reduced deductions.

More recently Secretary Mnuchin did not fully commit to his newly ascribed canon, rather he is quoted as

saying, "Our primary focus is a tax cut on middle income and not the top 1%. We're working toward that

as a goal. Don't hold me to that to the penny. But that's the direction we're going in."

D. Chairman of the Committee on Ways and Means Kevin Patrick Brady

Chairman Brady has indicated in late April 2017 the House Republican “Blueprint” includes vast

simplicity, “What we are proposing is never-before-seen simplicity—that nine of ten Americans will be

able to file their taxes on a postcard-like system.”

E. Majority Leader of the Senate Addison Mitchell "Mitch" McConnell Jr.

Senator McConnell has intimated the Senate will allow the House of Representatives to coordinate with

the White House for the initial stages of 2017 tax reform. In regard to the April Trump Plan, the Senator

has stated approval with many parts, noting “getting tax rates down for American companies, big and

small, will create new jobs and make the United States a more inviting place to do business."

F. United States Senate Committee on Finance Chairman Orrin G. Hatch3

In discussing President Trump’s tax plan, Chairman Hatch notes a variety of provisions will help lay the

groundwork for a comprehensive overhaul that will make the tax code fairer and more effective for the

American people. “The plan is designed to grow the economy. It would reduce rates for both large and

small businesses and job creators, which is also something both Republicans and Democrats have

sought to accomplish in tax reform.”

Senator Hatch also has said “Overall, the President’s tax plan would make our country more competitive

in the international marketplace and reduce the tax burden on millions of middle-class families.”

G. Director of the National Economic Council Gary D. Cohn

Director Cohn is the former president and COO of Goldman Sachs. He is presently within President

Trump’s inner circle as a chief economic advisor. Director Cohn is a registered Democrat and generally

described as being “moderate.”

2 Via RatPac-Dune Entertainment and Relativity Media. These entities are associated with producing many major films in

the years 2014 through 2017, including “The Accountant.” 3 Senator Hatch is also the president pro tempore of the US Senate, the second-highest-ranking official of the United States

Senate.


III. President Trump’s tax plan as released April 26, 2017

On April 26, 2017, an announcement of core principles of President Trump’s tax reform plan were

revealed in a briefing held by the Director of the National Economic Council, Gary Cohn, and Secretary of

the Treasury, Steven Mnuchin. Many details are still being negotiated, and Surgent will update those

details as they are made public. A recap of the April release is as follows.

A. Goals for tax reform

Grow the economy and create millions of jobs.

Simplify our burdensome tax code.

Provide tax relief to American families—especially middle-income families.

Lower the business tax rate from one of the highest in the world to one of the lowest.


The seven current individual income tax rates would be reduced to three: 10%, 25%, and

35%. The income levels applicable to these proposed rates have not been determined.

The standard deduction would be doubled so that fewer taxpayers would itemize.4

Although no specifics were provided, there would be some sort of deduction for child and

dependent care expenses.

The Alternative Minimum Tax would be repealed.

The 3.8% Net Investment Income Tax would be repealed.

The estate tax would be repealed.

Most Schedule A deductions would be repealed except for home ownership and

charitable gifts. Secretary Mnuchin specifically stated that the mortgage interest

deduction would be retained.


The business tax rate would decrease from 35% to 15% for corporations. The top rate for

pass-through businesses (partnerships, most LLCs, sole proprietorships) would be

reduced from 39.6% to 15%.

There would be a one-time repatriation tax on offshore earnings. A 10% tax is being

contemplated.

There would be a change from the worldwide system of taxation where a U.S. taxpayer is

taxed on income regardless of where earned to a territorial system where income is taxed

in the country earned.

3. Miscellaneous

No plan was included for a Border Adjustment Tax.

No mention was made of capital gains rates.

The plan did not include proposals for raising additional revenue lost by the tax cuts.

4 Although Director Cohn indicated the standard deduction would double, he also used the figure $12,000 for single

taxpayers, and $24,000 for Married Filing Jointly (MFJ). The 2017 standard deduction is presently set at $6,350 single and $12,700 MFJ. A true doubling would be slightly higher than their discussion.


B. Hatch, McConnell, Ryan, Brady statement on administration’s tax plan

Following the April 26, 2017 tax reform announcement by the Trump Administration, Senate Finance

Committee Chairman Orrin Hatch, Senate Majority Leader Mitch McConnell, House Speaker Paul Ryan

and House Ways & Means Committee Chairman Kevin Brady issued the following joint statement:

“The principles outlined by the Trump Administration today will serve as critical guideposts for

Congress and the Administration as we work together to overhaul the American tax system and

ensure middle-class families and job creators are better positioned for the 21st century economy.

Lower rates for individuals and families will allow them to keep more of their hard-earned money

and empower them to invest more in their future. Getting tax rates down for American companies,

big and small, will create new jobs and make the United States a more inviting place to do

business. With an eye toward fairness and simplicity, we’re confident we can rebuild our tax code

in a way that will grow our economy, better promote savings and investment, provide our job

creators with a competitive advantage, and bring prosperity to all Americans.”

C. Process

Throughout the month of May and into the summer, it is anticipated the Trump Administration will hold

listening sessions with stakeholders to receive their input and will continue working with the House and

Senate to develop the details of a plan that provides massive tax relief, creates jobs, and makes America

more competitive—and can pass both chambers.

Note: Broad-brush overview

For an example of the current discussions taking place, in the April 26 release and briefing Director Cohn was asked – “On the 10, 25, and 35 percent rates, do you have income brackets established that you're going to propose? His answer - Again, we are in constant dialogue with the House and the Senate. As the Secretary said, we're holding a bunch of listening groups right now. We have outlines; we have a broad-brush view of where they’re going to be. We're running an enormous amount of data on the proposals right now. We will be back to you with very firm details. We're very confident to where they’re going to be, we just wanted to get out and give you a broad-brush overview where

we are.


IV. Early projections

Projections: Format of charts and notes

For the following projections: ● The first column represents 2017 tax calculated utilizing current tax applications. ● The second column represents 2016 Candidate and President-Elect Trump’s early Tax

Plan. ● The third column represents 2016 House Ways and Means Better Way or “Blueprint” Tax

Plan. ● The fourth column represents the April 26, 2017 President Trump proposed Tax Plan. Projections -- Note 1: in regard to column 4, as noted above Director Cohn mentioned a doubling of the standard deduction to $12,000/$24,000. A true doubling would be slightly higher. However, for the following projections Surgent Professional Education (Surgent) has utilized Director Cohn’s figures as verbalized. Projections -- Note 2: also in regard to column 4, also as noted above, the tax rate brackets were not originally announced with release of the plan. For this analysis, Surgent has estimated the 10% bracket will apply to the first $33,000 of taxable income for single filers and $66,000 for MFJ. The 25% bracket has been estimated by Surgent to apply to taxable incomes from above $33,000 to $125,000 for single taxpayers, and above $66,000 to $250,000 for MFJ. The projections are limited in scope and include assumptions and estimates. These are for

discussion purposes only, and practitioners should not utilize for advanced planning.

A. Projection #1

1. Assumptions

Single taxpayer, $50,000 in ordinary income, standard deduction, no children.

1 2 3 4 5

Current Candidate Better President Future

System Trump Way Trump Plan

Plan Plan Plan Notes

AGI $50,000 $50,000 $50,000 $50,000 $50,000

Standard -$6,350 -$15,000 -$12,000 -$12,000 - $

Exempt -$4,050 $0 $0 $0 - $

Taxable $39,600 $35,000 $38,000 $38,000 $

Tax $5,639 $4,200 $4,567 $4,550 $

$1,439 $1,072 $1,089 $

25.52% 19.01% 19.31% %Reduction - %

Single - 2017

Reduction - $


B. Projection #2

1. Assumptions

Single taxpayer, $100,000 in ordinary income, standard deduction, no children.

Note: Percentage reductions

In comparing Projection #1 and #2, the percentage of tax reduction for a single taxpayer of moderate income, in this case $50,000, is nearly triple the percentage reduction for a higher income taxpayer with income of $100,000. The projections are limited in scope and include assumptions and estimates. These are for discussion purposes only, and practitioners should not utilize for advanced planning.

1 2 3 4 5




AGI $100,000 $100,000 $100,000 $100,000 $100,000

Standard -$6,350 -$15,000 -$12,000 -$12,000 - $

Exempt -$4,050 $0 $0 $0 - $

Taxable $89,600 $85,000 $88,000 $88,000 $

Tax $18,139 $16,375 $17,067 $17,050 $

$1,764 $1,072 $1,089 $

9.72% 5.91% 6.00% %

Single - 2017

Reduction - $

Reduction - %


C. Projection #3

1. Assumptions

Married Filing Jointly, $100,000 in ordinary income, standard deduction, no children

1 2 3 4 5




AGI $100,000 $100,000 $100,000 $100,000 $100,000

Standard -$12,700 -$30,000 -$24,000 -$24,000 - $

Exempt -$8,100 $0 $0 $0 - $

Taxable $79,200 $70,000 $76,000 $76,000 $

Tax $11,278 $8,400 $9,120 $9,100 $

$2,878 $2,158 $2,178 $

25.52% 19.13% 19.31% %

MFJ - 2017

Reduction - $

Reduction - %


D. Projection #4

1. Assumptions

Married Filing Jointly, $100,000 in ordinary income, itemizes deductions for - Taxes ($8,000), Mortgage

Interest ($7,000) and Contributions ($2,500). No children

Note: Effect of increased standard deduction

In comparing Projection #3 and #4, the effect of the standard deduction increase can be seen. Taxpayers with moderate itemized deductions have been receiving an annual tax benefit for the amount of deduction in excess of the standard deduction. In these examples the benefit is $1,050 ($11,278 - $10,228). However the proposed changes to the standard deduction and elimination of the personal exemption will result in more use of the standard deduction, and therefore a loss of the added benefit of moderate itemized deductions. In these cases, as seen in columns 2, 3 and 4, the non-itemizer and moderate itemizer generate the same tax. The projections are limited in scope and include assumptions and estimates. These are for discussion purposes only, and practitioners should not utilize for advanced planning.

1 2 3 4 5




AGI $100,000 $100,000 $100,000 $100,000 $100,000

Deduct -$17,500 -$30,000 -$24,000 -$24,000 - $

Exempt -$8,100 $0 $0 $0 - $

Taxable $74,400 $70,000 $76,000 $76,000 $

Tax $10,228 $8,400 $9,120 $9,100 $

$1,828 $1,108 $1,128 $

17.87% 10.83% 11.03% %

Reduction - $

Reduction - %

MFJ - 2017


E. Projection #5

1. Assumptions



Note: Percentage reductions

In comparing Projection #4 and #5, the percentage of tax reduction for married taxpayers of moderate to high income, in this case $100,000, is more than double the percentage reduction for a higher income taxpayer with income of $200,000. The projections are limited in scope and include assumptions and estimates. These are for discussion purposes only, and practitioners should not utilize for advanced planning.

1 2 3 4 5




AGI $200,000 $200,000 $200,000 $200,000 $200,000

Deduct -$17,500 -$30,000 -$24,000 -$24,000 - $

Exempt -$8,100 $0 $0 $0 - $

Taxable $174,400 $170,000 $176,000 $176,000 $

Tax $35,717 $32,750 $34,133 $34,100 $

$2,967 $1,584 $1,617 $

8.31% 4.43% 4.53% %

MFJ - 2017

Reduction - $

Reduction - %


F. Projection #6

1. Assumptions



Note: Tax increase

In comparing Projection #5 and #6, the increased standard deduction appears to benefit middle income taxpayers with average itemized deductions. However, it appears higher income taxpayers with moderately larger itemized deductions may lose. President Trump has stated that any tax increases will be corrected when final legislation is approved so that no American will face a rate increase. Also note that this projection reveals higher income taxpayers will still not itemize deductions due to combination of the higher standard deduction and loss of many itemized deductions. The projections are limited in scope and include assumptions and estimates. These are for discussion purposes only, and practitioners should not utilize for advanced planning.

1 2 3 4 5




AGI $200,000 $200,000 $200,000 $200,000 $200,000

Deduct -$30,000 -$30,000 -$24,000 -$24,000 - $

Exempt -$8,100 $0 $0 $0 - $

Taxable $161,900 $170,000 $176,000 $176,000 $

Tax $32,217 $32,750 $34,205 $34,100 $

($533) ($1,988) ($1,883) $

-1.65% -6.17% -5.84% %

MFJ - 2017

Reduction (Increase) - $

Percentage Change


G. Projection #7

1. Assumptions



Note: The Mnuchin-Rule

Early pundits have indicated that with the advent of the so-called “Mnuchin-Rule,” discussed earlier in this module, that the capital gain rates would not be lowered, as they tend to favor higher income taxpayers. However, in keeping President Trump’s direction that no American will face a rate increase, the above analysis indicates a lowering of the capital gain rates may be in play. The projections are limited in scope and include assumptions and estimates. These are

for discussion purposes only, and practitioners should not utilize for advanced planning.

1 2 3 4 5




AGI $500,000 $500,000 $500,000 $500,000 $500,000

Deduct -$74,414 -$74,414 * -$40,000 -$40,000 - $

Exempt $0 $0 $0 $0 - $

Taxable $425,586 $500,000 $460,000 $460,000 $

Tax $115,838 $110,688 $121,071 $119,800 $

$5,150 ($5,233) ($3,962) $

4.45% -4.52% -3.42% %

* Assumed

MFJ - 2017

Reduction (Increase) - $

Percentage Change


V. Closing notes

A. What could be on the table?

1. In short – Everything!

President Trump has stated that no American will face a rate increase. Officials Ryan, Mnuchin, Brady,

McConnell, Hatch, Cohn and many others have indicated a desire for a monumental change in the

landscape of tax in the United States. In order to meet this goal, practitioners must wait to see which

buttons are pushed, which passages are placed within the final bill, and which are removed.

It took 3 years of horse-trading before the Tax Reform Act of 1986 was signed by President Reagan.

Practitioners in 1984 and 1985 would have bet the mortgage against certain tax changes, such as the

steep reduction in tax rates, the passive activity rules of §469, the loss of investment tax credits, and even

the requirement to report the Social Security number of dependents. Yet these changes all made the

final version of the tax bill.

As director Cohn said in the April 26 briefing, “…we're holding a bunch of listening groups right now. We

have outlines; we have a broad-brush view of where they’re going to be. We're running an enormous

amount of data on the proposals right now. We will be back to you with very firm details.”

Just where will the tax rates, brackets, capital gains, itemized deductions, etc. land will be settled by time.

Practitioners may determine who the winners and losers are when preparing tax returns after tax reform

becomes a reality.

2. Surgent’s Trump-Tracker

In an effort to track the status of all changes proposed by President Trump that could affect CPAs and

their clients, Surgent has introduced the “Trump-Tracker” found at:

https://www.surgentcpe.com/trump-tracker

Links to “Trump-Tracker” may also be found on Surgent’s Facebook, LinkedIn, and Twitter pages.

B. Elements of engagement discussion

Participants may discuss a common thread of certain items within this module, such as:

A goal of tax reform is the simplification of the tax code.

The Blueprint Plan included a pledge to allow most individuals to file their taxes on a form

the size of a postcard.

Chairman Brady indicated that nine of ten Americans will be able to file their taxes on a

postcard-like system.

Projection #6 reveals higher income taxpayers may not itemize deductions.

Obviously there are many unanswered questions regarding child credits, education credits, adjustments,

allowed vs. disallowed itemized deductions, capital gain rates and so on.

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Top 25 Tax Mistakes

1. Failure to report income witnessed by 20 million people ........................................................................ 1

2. When “gifts” can be taxable .................................................................................................................... 5

3. Are IRA distributions directly to a charity only for the wealthy? .............................................................. 8

4. Not all forgiven principal residence debt is excludable ......................................................................... 10

5. How much trouble do you get in for not filing FinCEN Form 114 (FBAR)? .......................................... 14

6. Hazy tax situation -- Gain on property, ordinary or capital?.................................................................. 25

7. Hazy corollary -- Loss on property, ordinary or capital? ....................................................................... 27

8. Is basis increased by phantom income, or reduced by losses not deducted? ..................................... 30

9. Failing to find hidden gains in Schedules K-1 ....................................................................................... 33

10. When a “rollover” is not a rollover -- The Claim of Right Doctrine ...................................................... 37

11. When a “rollover” is not a rollover -- No written plan on receiving end ............................................... 39

12. Understanding the risks in non-traditional IRA investments ............................................................... 40

13. Reporting negative “other income” -- Why are manhole covers round? ............................................. 47

14. Failing alimony’s same household requirement .................................................................................. 49

15. Getting the “last word” on divorce agreement sinks a deduction ........................................................ 51

16. Would $37,000 unsubstantiated non-cash charitable contributions be noticed? ............................... 54

17. Do not let your children grow up to be lying, drug dealing, tax cheats ............................................... 57

18. Getting caught watching the paint dry -- Failing to look at Emerging Issues ...................................... 61

19. Private tax debt collection ................................................................................................................... 65

20. Identity Theft Affidavit for seasoned preparers (and taxpayers) ......................................................... 68

21. Failing in advance to protecting taxpayers from increased 1099 penalties ........................................ 73

22. Social Security 2017 and forward ....................................................................................................... 76

23. A self-directed IRA miscue eliminates bankruptcy exemption ............................................................ 83

24. RS levy on pension account -- Excepted v. exempt property ............................................................. 85

25. Missed the 60 day rollover, can we find someone to blame? ............................................................. 87

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Individual Income Tax Return Mistakes and How to Fix Them

Learning objectives 1 I. Gross income reporting 1

A. Failure to report income witnessed by 20 million people (#1) 1 1. 39 days, 16 people, ONE survivor! 1 2. The blooper 1 3. The law is the solution 2

B. When “gifts” can be taxable (#2) 5 1. First case -- Gifts resulting in taxable income 5 2. The “Revenge” 1099 5 3. Is the State court determined “gift” taxable? 6 4. Regarding the amount to be repaid -- Can the income qualify for rescission? 6 5. Second case -- Gifts resulting in gift tax -- A $10 million tip -- It could happen to you 7 6. Where is the mistake? Do not forget about gift taxes! 7

C. Are IRA distributions directly to a charity only for the wealthy? (#3) 8 1. Background 8 2. Truth, like light, blinds. Falsehood, on the contrary, is a beautiful twilight that enhances

every object 9 3. Tax-free charitable distributions from an IRA are not just for the original IRA owner 10 4. Tax-free charitable distributions from an IRA are not just for electronic transfers 10

D. Not all forgiven principal residence debt is excludable (#4) 10 1. “Qualified” principal residence indebtedness 10 2. The blunder 11 3. The law – what exactly is qualified principal residence debt? 11 4. Conclusion and solution 11

E. How much trouble do you get in for not filing FinCEN Form 114 (FBAR)? (#5) 14 1. More on income being income 14 2. The blooper 14 3. The law 14 4. The conclusion, solution, and Form 8938 15 5. Question and Answer examples provided by IRS 16

II. Capital gains and losses 25 A. Hazy tax situation -- Gain on property, ordinary or capital? (#6) 25

1. Income from real estate sale 25 2. Property held primarily for sale to customers 25 3. Dissecting the factors 26 4. Heads they win 26

B. Hazy corollary -- Loss on property, ordinary or capital? (#7) 27 1. Theft loss, or some other kind of deductible loss 27 2. And the Form 1040 reports a loss! 28 3. Property held primarily for sale to customers 28 4. Dissecting the factors 28 5. Tails, taxpayer loses 30 6. For practitioners to avoid errors 30

III. Income from rents and pass-through entities 30 A. Is basis increased by phantom income, or reduced by losses not deducted? (#8) 30

1. “The hardest thing in the world to understand is the income tax” or perhaps calculating basis 30

2. Error in calculating basis 31 3. The law - Specific order for adjustments to basis after 1996 31 4. Conclusion and unsuccessful last ditch attempt 32 5. Inconsistent treatment of Schedule K-1 items 33

B. Failing to find hidden gains in Schedules K-1 (#9) 33 1. Hidden partnership or LLC gains 33 2. The error practitioners make – review of liabilities 34

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3. Solution – proper completion of basis worksheet 34 4. Worksheet for basis in a partnership/LLC 35 5. Worksheet for basis in an S Corporation 35

IV. Other income issues 37 A. When a “rollover” is not a rollover -- The Claim of Right Doctrine (#10) 37

1. Trusted friends 37 2. In practice, without all the facts, errors can be made 38 3. IRA distributions, the law, and “Claim of Right” 38 4. This is a distribution, not a rollover 38 5. Solution found in different case, yet the same day 39

B. When a “rollover” is not a rollover -- No written plan on receiving end (#11) 39 1. Business owners retirement savings account? 39 2. Steps to create a ROBS 40 3. If IRA funds are used, is it still an IRA? 40 4. Without an established plan, how could there be a rollover? 40

C. Understanding the risks in non-traditional IRA investments (#12) 40 1. Background 40 2. Types of investments 41 3. Risk No. 1 -- Loss of tax-favored status 42 4. Risk No. 2 -- Unforeseen federal tax liability 43 5. Risk No. 3 -- Difficulty obtaining fair market value heightens the risk of noncompliance 44 6. Risk No. 4 -- Difficulty in distributing retirement income 46

D. Reporting negative “other income” -- Why are manhole covers round? (#13) 47 1. Litigation is a battle that bruises both sides, at an hourly or fixed fee 47 2. How to avoid reporting a large questionable expense 47 3. A novel concept 47 4. Why are manhole covers round? 48

V. Adjustments to income 49 A. Failing alimony’s same household requirement (#14) 49

1. Practitioner error in noting addresses of taxpayers 49 2. The law 50 3. Could this error occur at your office? 50 4. Solution -- Know your client 51

B. Getting the “last word” on divorce agreement sinks a deduction (#15) 51 1. Income, deductions, and dollar amounts are important to taxpayers 51 2. Words are important to lawyers and judges 52 3. Eager carelessness 53

VI. Itemized deductions 54 A. Would $37,000 unsubstantiated non-cash charitable contributions be noticed? (#16) 54

1. Not too much of a stretch here, the IRS disallowed all non-cash donations 54 2. The law for donations 55 3. Are door-hanger receipts satisfactory? 56 4. Are written acknowledgements necessary if the donated items are less than $250? 57

VII. Other selected planning issues 57 A. Do not let your children grow up to be lying, drug dealing, tax cheats (#17) 57

1. Let them be doctors and lawyers and tax professionals and such… 57 2. Qualifying children and tiebreaker 58 3. Busted! Caught in a Code section specific trap 59 4. A compassionate yet incapable court 60

VIII. Getting caught watching the paint dry -- Failing to look at Emerging Issues (#18) 61 A. Future State Initiative 61

1. Think ahead or fall behind. Time will slip by, don’t wait until it’s too late 61 2. The taxpayer component -- Virtual Taxpayer Assistance 61 3. Other components of the “Future State” Initiative 64

B. Private tax debt collection (#19) 65 1. Fiction is the truth inside the lie 65 2. Authorized collection agencies 66 3. Operating ground-rules 66 4. More phone scams may be expected 67

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5. Payment plans 67 C. Identity Theft Affidavit for seasoned preparers (and taxpayers) (#20) 68

1. The Identity Protection PIN (IP PIN) 68 2. A sensible part of ID theft defense 69

D. Failing in advance to protecting taxpayers from increased 1099 penalties (#21) 73 1. Trade Preferences Extension Act of 2015 73 2. 2016 Updated Publication 1586, Reasonable Cause Regulations 73 3. Front-end advisory required to meet the Reasonable Cause Regulations 74

IX. Social Security and Retirement 75 A. Social Security 2017 and forward (#22) 76

1. File and suspend 76 B. Determining when it is best to claim your Social Security 77

1. Reduced retirement benefits commencing at age 62 77 2. Delayed retirement 78 3. When to retire? 78 4. 2017 Earnings limits 78

C. Current discussions to buttress Social Security 79 1. The time frame keeps shortening 79 2. CBO, 11 Options for Social Security over the next 10 years 79

D. A self-directed IRA miscue eliminates bankruptcy exemption (#23) 83 1. Can I borrow from my IRA? 83 2. Taxpayers always have two reasons for doing anything: a good reason and the real reason 83 3. The Law 84 4. Conclusion and solution – Bankruptcy Court, District Court, and Court of Appeals all agree 84

E. IRS levy on pension account -- Excepted v. exempt property (#24) 85 1. An abundance of caution 85 2. Was the pension excluded from, or included and exempted in bankruptcy estate 85 3. The law 86 4. Phraseology does not change the unfortunate result 86

F. Missed the 60 day rollover, can we find someone to blame? (#25) 87 1. The best-laid plans of mice and men 87 2. Often go awry 87 3. The law 87 4. Conclusion and solution 88 5. Self-certification procedure for a waiver of the 60-day rollover limit 89 6. Conditions for self-certification 90 7. Effect of self-certification 90 8. Sample self-certification letter 91

This product is intended to serve solely as an aid in continuing professional education. Due to the constantly changing nature of the subject of the materials, this product is not appropriate to serve as the sole resource for any tax and accounting opinion or return position, and must be supplemented for such purposes with other current authoritative materials. The information in this manual has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. In addition, Surgent McCoy CPE, LLC, its authors, and instructors are not engaged in rendering legal, accounting, or other professional services and will not be held liable for any actions or suits based on this manual or comments made during any presentation. If legal advice or other expert assistance is required, seek the services of a competent professional. Revised May 2017

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Individual Income Tax Return Mistakes and How to Fix Them

Learning objectives Upon reviewing this manual, the reader will be able to: • Identify how practitioners have worked with clients who desire to “stretch” the law to the

last possible point without crossing the line into fraud or tax evasion, beginning with ordinary income issues in which taxpayers must realize income is income. From Schedule A, C, and E issues arise that practitioners must face, including finding “hidden” gains.

• Identify the common requirements associated with a plan “rollover,” errors in certain itemized deductions, retirement asset protection issues, and proposals to buttress Social Security.

Overview: The topics appear in a somewhat representative order of a tax return. Many topics begin with some background or history of a situation. The mistake or error is discussed and also the underlying law at issue.

I. Gross income reporting

A. Failure to report income witnessed by 20 million people (#1)

1. 39 days, 16 people, ONE survivor! a. Picture this: You are on a secluded island off the coast of Borneo, stranded with little more

than the clothes on your back. You and 15 others are divided into two teams that compete against each other, with the losing team forced to vote a member off. Eventually the teams merge and it's everyone for him- or herself. The lone survivor takes home $1 million dollars.

b. Issue: Are winnings from a reality game show earned in Borneo and witnessed by millions of television viewers included in taxable income?

2. The blooper a. Income is income.

The first CPAs hired by Mr. Richard Hatch, the premier season winner of “Survivor” properly included the winnings in his return. Unfortunately, Hatch did not file that return and disengaged from the preparer. Sometime later he delinquently filed a return (not signed by any preparer) which did not include his winnings.

b. On January 19, 2005, the United States Attorney's Office reported that Hatch failed to report $1,000,000 prize winnings from the Survivor show on his federal income tax returns. In addition, he failed to report in excess of $300,000 he received for other appearance fees. Hatch was charged with filing a false tax return. An agreement was arranged whereby Hatch was offered a lenient sentence in exchange for a guilty plea; however, Hatch did not accept the arrangement. A ten-count indictment included additional charges that he failed to report rental income from properties he owned, failed to declare an automobile he won on Survivor, used money as personal income that was paid to a charity organization he had set up.

c. The use of money as personal income, which was earmarked for charity arises from another television show in which Hatch appeared, “The Weakest Link.” Hatch was awarded $10,000

http://en.wikipedia.org/wiki/January_19

http://en.wikipedia.org/wiki/2005


for his appearance, payable to the charity of his choice. In the criminal indictment, Hatch was accused of establishing a bank account and ultimately having the “Weakest Link” proceeds deposited therewith. Subsequently, the account was disbursed for personal use, and none of the funds were utilized for a charitable purpose.

d. In January, 2006 a jury found Hatch guilty and he was sentenced to 51 months in prison. e. In December, 2006 Hatch filed an appeal of his conviction claiming that the trial judge

prevented him from arguing that he had made a deal with CBS to pay his taxes. Without a jury present, Hatch claims to have caught show employees providing other contestants food. Hatch claims to have then made a deal with the show’s producers: he wouldn’t tell, and in return they would pay his taxes if he ultimately won. In front of the jury, Hatch did not mention such a deal and CBS has said the claim is false. In February 2008, Hatch's conviction was upheld by the United States Court of Appeals for the First Circuit. The Court stated that Hatch was given several opportunities to testify about the alleged deal, but he never took the opportunity, and noted "The failure of Hatch to present any evidence of such conversations when invited by the court strongly suggested that no actual promises were made, and no such 'deal' actually existed. It was not the court's right, much less duty, to put words in Hatch's mouth."

f. Notable Quote included in a Department of Justice press release1 - "Our nation's federal tax system is not a reality show to be outwitted, it is a reality, period.”

3. The law is the solution a. Income is defined by the Code in what has been referred to as the “Santa Clause” in §61. b. I.R.C. §61 - Definition of Gross Income

1) Section 61(a) defines gross income as follows: a) “Except as otherwise provided in this subtitle, gross income means all income from

whatever source derived, including, (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits, and similar

items; (2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest; (5) Rents; (6) Royalties; (7) Dividends; (8) Alimony and separate maintenance payments; (9) Annuities;

(10) Income from life insurance and endowment contracts; (11) Pensions; (12) Income from discharge of indebtedness; (13) Distributive share of partnership [and S Corporation] gross income; (14) Income in respect of a decedent; and (15) Income from an interest in an estate or trust.”

c. The vast majority of professionals do not have problems interpreting this section.

1 Attributed to prosecutor Eileen O'Connor.

http://en.wikipedia.org/wiki/January_25


Practice note: Privilege of confidentiality

The case touches on the privilege of confidentiality, an often misunderstood concept for CPAs. The law does not accord the accountant a greater privilege than that enjoyed by attorneys. §7525 provides that information transmitted for the purpose of preparing a tax return, even if transmitted to an attorney, is not considered privileged information. For professionals who give a client both tax advice and tax-return preparation, the IRS will contend that whatever tax advice given, and whenever it was given, falls under the category of “tax-return preparation” that does not qualify as legal advice for purposes of confidentiality privilege under §7525. If the preparer has knowledge of unreported income or less than valid deductions, they will be compelled to testify against the taxpayer. That is, the preparer may be the star prosecution witness against their ex-client.

d. Failure to report income sequel - Wesley Snipes - who was charged in October 2007 with

fraudulently amending returns for 1996 and 1997 to claim zero income thereby receiving refunds totaling nearly $12 million. He was also charged with failure to file returns from 1999 through 2004.

e. Snipes was acquitted on charges of tax fraud and conspiracy as jurors accepted his argument that he was innocently duped by errant tax advisers. However, he was convicted on misdemeanor charges. Before sentencing, the actor asked the court to show mercy and offered three checks totaling $5 million, which the prosecutors and treasury accepted. Mr. Snipes was sentenced to three years in prison on the misdemeanor counts of failing to file tax returns, which he appealed. In November 2010, a federal judge ordered Snipes to surrender to authorities and he began serving a three-year prison sentence, from which he was released on April 2, 2013.

Practice note: The “Starr” witness

As noted above preparers may be the star prosecution witness against their ex-client. Review the address on the 1997 Form 1040-X prepared for Snipes. In court, Ken I. Starr (not the same Ken W. Starr known for his investigation of figures during the Clinton administration) testified as a prosecution witness. Subsequent to the Snipes trial, Ken I. Starr was arrested and charged for allegedly running a $59 million Ponzi scheme with the money of a number of celebrities as his clients including Snipes, Sylvester Stallone, and Carly Simon. On September 10, 2010, Starr plead guilty.2

2 http://en.wikipedia.org/wiki/Kenneth_I._Starr.

http://en.wikipedia.org/wiki/Ponzi_scheme

http://en.wikipedia.org/wiki/Celebrities

http://en.wikipedia.org/wiki/Sylvester_Stallone

http://en.wikipedia.org/wiki/Carly_Simon



B. When “gifts” can be taxable (#2)

1. First case -- Gifts resulting in taxable income3

Mr. Burns (age 72) and Ms. Blagaich (age 54) were involved in a relationship from November 2009 until March 2011. In 2010, Burns provided Blagaich with cash ($673,819) and a Corvette automobile ($70,000). Neither desired to marry, and in lieu they entered into a written agreement intended in part to confirm their commitment to each other and to provide financial accommodation for her. The agreement, which included a $400,000 cash transfer, was at least in some respects, intended to formalize their "respect, appreciation and affection for each other." Within three months, the relationship deteriorated, and in March 2011 Burns sent a notice of termination of the agreement. Late in March 2011, Burns initiated a civil suit against Blagaich seeking nullification of the agreement due to fraudulent inducement, and a return of the Corvette automobile, a diamond "engagement ring," and a further order to “disgorge all cash and other accommodations that total in excess of $700,000.” A trial was held in State court, which found that Blagaich had fraudulently induced Burns to enter into the agreement, and the court entered a judgment against her of $400,000, payable to Burns’ estate (he having passed away shortly after the trial). The State court’s ultimate finding was that the Corvette, and $273,819 cash were “clearly gifts,” and that she was entitled to keep them. He had given her the Corvette automobile because he did not want her to ride her Harley Davidson motorcycle, an activity which frightened him. He had wired $200,000 to her account to entice her to leave her job and to travel with him, and he gave her the various checks, totaling $73,819, under similar circumstances. The supposed “engagement ring” was not an “engagement” ring, as they had no intention to marry; hence, it was a “ring,” and a gift.

2. The “Revenge” 1099

On April 8, 2011, Burns caused to be filed with the IRS a Form 1099-MISC, reporting that he had paid Blagaich $743,819 in 2010. Blagaich did not report the income, and IRS therefore made a positive adjustment of $743,819 to her reported 2010 gross income. After the State court trial, one of the executors of Burns’ estate issued a revised 2010 Form 1099-MISC reducing the amount of compensation reported to $400,000. On March 25, 2014, the executor mailed a letter to the Internal Revenue Service, a copy of the revised Form 1099-MISC attached, confirming that petitioner had paid $400,000 in compliance with the State court order.

3 Diane Blagaich v. Commissioner, TC Memo 2016-2, January 4, 2016.


3. Is the State court determined “gift” taxable?

Code Section 102(a) provides that gross income does not include the value of property acquired by gift. Neither the Code nor legislative history accompanying §102 defines the term “gift.”4 A leading authority on the meaning of the term “gift” for §102 purposes is Duberstein v. Commissioner.5 In Duberstein, the Supreme Court explained that a gift proceeds from a “detached and disinterested generosity,” and is made “out of affection, respect, admiration, charity or like impulses.” However, if a payment proceeds primarily from “any moral or legal duty” or from “the incentive of anticipated benefit” of an economic nature, it is not a gift. In this case, the IRS claims that, while a voluntary transfer may constitute a “gift” in the common law sense, the transfer might not constitute a “gift” as the term is used in §102(a), as the statute uses the term “gift” in a more colloquial sense: The mere absence of a legal or moral obligation to make a payment does not establish that it is a gift. In short, the Court feels all payments to Blagaich were not from detached and disinterested generosity.

Note: Illegal gains

The Tax Court did not allude as to the nature of the income, whether it be considered a prize, award, consideration for entering the “declaration of relationship” agreement or other. What the Court did conclude was the income was not a gift excludable under §102. The Sixteenth Amendment intended no safe harbor for illegal income. If a taxpayer receives income -- legally or illegally -- without recognition of obligation to repay (i.e., a loan) that income is taxable, unless excluded elsewhere. The income was generated by a fraudulent agreement.

Practice note: Collateral estoppel

In the Blagaich case, upon realizing the IRS would consider “gifts” as determined in a State court, to be “taxable gifts” within the context of §102, her defense cried for collateral estoppel. Once a court has decided an issue of fact or law necessary to its judgment, collateral estoppel precludes re-litigation of that issue on a different cause of action involving the same party. Somewhat like “double-jeopardy,” the rationale is the prevention of legal harassment and abuse of judicial resources. Their attempt did not hold water, as the IRS did not have privity (standing) in the State court trial. Hence, the IRS could litigate or question the payments as “gifts vs. taxable gifts,” as they had not previously litigated the item.

4. Regarding the amount to be repaid -- Can the income qualify for rescission?

Code Section 451(a) provides in pertinent part: “The amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer.” That section reflects the annual accounting period principle, which requires that each taxable year be treated as a separate unit for tax accounting purposes. The doctrine of rescission represents a minor exception. Pursuant to the exception, a taxpayer need not report as an item of gross income an amount received under a claim of right if the recipient’s right to the amount is rescinded and, within the year of receipt, the parties to the payment are restored “to the relative positions that they would have occupied had no contract been made.” 4 See Chief Council Memo 200708003: February 23, 2007. 5 Duberstein v. Commissioner, 363 U.S. 278 (1960).

https://en.wikipedia.org/wiki/Cause_of_action

https://en.wikipedia.org/wiki/Judicial_economy

https://en.wikipedia.org/wiki/Judicial_economy


In general, the annual accounting period principle reflected in §451, considered in the light of the judicially articulated claim-of-right doctrine, limits application of the rescission exception such that, without regard to subsequent events, income received by the taxpayer under a claim of right and retained at the close of the taxable year must be included in gross income for that year. The facts show that, in 2010, Blagaich took possession of the whole amount in question, $400,000, without any substantial limitations or restrictions as to its disposition. She recognized no liability and made no provision to repay that amount until nearly three years later. The doctrine of rescission does not save Blagaich from the IRS’s adjustment including in her 2010 gross income the $400,000 that, in that year, she received from Burns.

Practice note: Repayments of income

If a taxpayer has to repay an amount that was included in income in an earlier year, they may be able to deduct the amount repaid from income for the year in which it is repaid. If the amount repaid is more than $3,000, a taxpayer may be able to take a credit against tax for the year in which repaid. Generally, one can claim a deduction or credit only if the repayment qualifies as an expense or loss incurred in a trade or business or in a for-profit transaction.

5. Second case -- Gifts resulting in gift tax -- A $10 million tip6 -- It could happen to you

Tonda Dickerson, while a waitress at Waffle House, received from a customer, a winning lottery ticket from the prior night's Florida lottery drawing. The ticket’s winning status was at the time apparently unknown to the customer. The winning ticket was estimated to have a value near $10 million. On the day after receipt of the ticket, Dickerson and members of her family formed a corporation, with the name “9 Mill” to claim the proceeds. Dickerson held 49 percent of the 9 Mill stock while other members of her family held the remainder. The IRS alleges Dickerson’s family members, because they owned 51 percent of the 9 Mill stock, received a gift, valued at $2,412,388, when she signed the winning ticket as president of the corporation and submitted it to the Florida lottery as the corporation’s property. Dickerson claims it was not a gift because a long-standing enforceable agreement existed among her family that mandated she share the winning proceeds with them, or because she and her family members were members of an existing partnership that was the true owner of the ticket. Former coworkers of Dickerson filed suit against her claiming that they had a preexisting agreement to share the proceeds of any winning lottery ticket received as a gift or tip from a customer. An Alabama trial court sided with the coworkers, but that decision was ultimately overturned by the Alabama Supreme Court. However, given the fact the coworkers did file suit, Dickerson argues in the alternative that if a gift did occur, then the value of the gift should be discounted.

6. Where is the mistake? Do not forget about gift taxes!

The tax imposed by §2501 applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. Gift Tax Regulations provides that a transfer of property to a corporation for less than adequate consideration represents gifts to the other individual shareholders of the corporation to the extent of their proportionate interests.

6 Dickerson v. Comm., TC Memo 2012-60, March 6, 2012.


Dickerson argued that no taxable gift occurred because at the time of the lottery ticket transfer, there had previously existed and remained in effect, a binding and enforceable contract under Alabama State law requiring the transfer, or, alternatively the family members and petitioner were all members of an existing partnership under federal tax law which was the true owner of the lottery ticket or its proceeds. The argument was not recognized as the “terms” of the so-called family agreement consist solely of offhand statements made throughout the years about sharing and taking care of one another in the event someone came into a substantial amount of money. This is not enough. There was no requirement that each family member buy lottery tickets. There was no pattern. There was no pooling of money. There were no predetermined sharing percentages. Additionally, even if otherwise enforceable, the alleged family agreement would be rendered void pursuant to Alabama’s antigambling statute.7

Note: An “agreement to agree”

At most, the family had an “agreement to agree.” Generally, such a situation that leaves material portions open for future agreement is nugatory and void for indefiniteness. In contrast, an enforceable agreement to share was found to exist pursuant to the contract law of the District of Columbia in Pearsall v. Alexander, 572 A.2d 113 (D.C. 1990). In that case, evidence existed establishing an agreement to share equally in the proceeds of a “jointly-purchased winning lottery ticket.” The court, looking at the longstanding pattern of conduct between the two and the exchanging of promises to share in the proceeds, held that there was an enforceable agreement to share 50-50.

The Family Partnership rules under §704(e) were enacted in 1951 “to harmonize the rules governing interests in the so-called family partnership with those generally applicable to other forms of property or business.” A person shall be recognized as a partner if he or she owns a capital interest in a partnership in which capital is a material income-producing factor. In this case, the conclusion that no partnership exists among the family is the same regardless of the applicability of §704(e)(1) because there was no showing that capital is a material income-producing factor.

C. Are IRA distributions directly to a charity only for the wealthy? (#3)

1. Background

CBO estimates8 about 60 million people received Social Security benefits. Up to 85 percent of a recipient’s benefits are subject to the individual income tax, depending on the recipient’s overall income. CBO estimates that income taxes on Social Security benefits totaled $51 billion in 2014, an amount that will be credited to the Social Security and Medicare trust funds. About half of all Social Security beneficiaries owed some income tax on their benefits in 2014 CBO estimates.

7 AAlabama law provides in part: “All contracts founded in whole or in part on a gambling consideration are void.” 8 CBO publication 49948.


2. Truth, like light, blinds. Falsehood, on the contrary, is a beautiful twilight that enhances every object9

Protecting Americans from Tax Hikes (PATH) Legislative Update:

The §408(d)(8) qualified charitable distribution (QCD) provisions have expired several times since its inception in 2006. However, the PATH Act permanently extends the popular provision, as it is beneficial to both taxpayers and charities.

Generally, if a distribution from an IRA (including a Roth IRA or deemed IRA; however, the IRA must be other than an ongoing SEP or SIMPLE IRA) owned by an individual after the individual has attained age 70½ is made directly by the trustee to certain organizations, the distribution is excluded from gross income. The exclusion is only available to the extent that the distribution would otherwise have been includable in gross income, and only if the contribution would otherwise qualify for a charitable contribution deduction under §170 [without regard to the percentage limitations of §170(b)]. A distribution that is eligible for this exclusion is called a qualified charitable distribution (QCD). The QCD provision offers older owners of individual retirement arrangements (IRAs) a different way to give to charity and can be used regardless of whether the owners itemize their deductions. An IRA owner can exclude from gross income up to $100,000 of a QCD made for a year, and a QCD can be used to satisfy any IRA required minimum distributions (RMDs) for the year. To qualify, the funds must be transferred directly by the IRA trustee to the eligible charity. Distributed amounts may be excluded from the IRA owner’s income -- resulting in lower taxable income for the IRA owner. However, if the IRA owner excludes the distribution from income, no deduction, such as a charitable contribution deduction on Schedule A, may be taken for the distributed amount. Amounts transferred to a charity from an IRA are counted in determining whether the owner has met the IRA’s required minimum distribution. Where individuals have made nondeductible contributions to their traditional IRAs, a special rule treats amounts distributed to charities as coming first from taxable funds, instead of proportionately from taxable and nontaxable funds, as would be the case with regular distributions.

Practice note:

Not all charities are eligible to receive QCDs. For example, donor-advised funds and supporting organizations are not eligible recipients.

Practitioners observing the $100,000 limitation of QCD may have overlooked the planning opportunity in lower income taxpayers. The following table indicates a single taxpayer claiming the standard deduction, receiving $20,000 from Social Security and utilizing the QCD benefit at differing levels of contribution. The QCD not only reduces AGI, it also reduces taxable Social Security benefits, resulting in an amplified tax benefit.

9 Albert Camus.


Amount of QCD $0 $1,000 $3,000 $5,000 Sample Tax Return 2016

Taxable Interest

Income $10,000 $10,000 $10,000 $10,000

Taxable IRA Distribution

$20,000 $19,000 $17,000 $15,000

Taxable Social Security

1099-SSA $20,000

$9,600 $8,750 $7,050 $5,350

AGI $39,600 $37,750 $34,050 $30,350 Taxable Income $27,700 $25,850 $22,150 $18,450

Tax $3,691 $3,414 $2,859 $2,304 Savings $0 $277 $832 $1,387

3. Tax-free charitable distributions from an IRA are not just for the original IRA owner The QCD provision also applies to beneficiaries of inherited IRAs. The exclusion from gross income is available for distributions from an IRA maintained for the benefit of a beneficiary after the death of the IRA owner if they attained age 70½ before the distribution is made. The age of the decedent is not applicable.

4. Tax-free charitable distributions from an IRA are not just for electronic transfers

Many clients in the target for the QCD planning are reluctant, unacquainted, and afraid or petrified of electronic transfers. In such cases, practitioners may suggest the IRA owner instruct the IRA custodian to prepare a check from an IRA made payable to a charitable organization described in §408(d)(8). The IRA owner may even personally deliver the check to the charitable organization. The payment to the charitable organization will be considered a direct payment by the IRA trustee to the charitable organization for purposes of §408(d)(8)(B)(i).

D. Not all forgiven principal residence debt is excludable (#4)

1. “Qualified” principal residence indebtedness

a. Mike Diamond incurred recourse debt of $800,000 when he purchased his principal residence for $880,000. When the FMV of the property was $1,000,000, Mike refinanced the debt for $850,000.

b. At the time of the refinancing, the principal balance of the original mortgage loan was $740,000. Mike used the $110,000 difference he obtained from the refinancing ($850,000 minus $740,000) to pay off his credit cards and to buy a new car.

c. About two years after the refinancing, with the mortgage still at a balance of $850,000, Mike lost his job and was unable to get another position paying a comparable salary. Mike's residence had declined in value to between $700,000 and $750,000.

d. Based on Mike's circumstances, the lender agreed to allow a short sale of the property for $735,000 and to cancel the remaining $115,000 of the debt.

e. Mike receives a Form 1099-C in the amount of $115,000.


2. The blunder

How does Mike report the Form 1099-C income of $115,000? He remembers to when the mortgage debt crisis was first surfacing, and that The Mortgage Forgiveness Debt Relief Act of 2007 added “Qualified Principal Residence Indebtedness” to the excludable items under §108.10 Armed with this information, Mike prepares Form 982, checks box 1e and reports $115,000 on line 2.

3. The law – what exactly is qualified principal residence debt? To qualify for exclusion under §108, qualified principal residence debt must have been used to buy, build or substantially improve the principal residence and be secured by that residence. Refinanced debt proceeds used for the purpose of substantially improving a principal residence also qualify for the exclusion. However, proceeds of refinanced debt used for other purposes (for example, to pay off credit card debt) do not qualify for the exclusion. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for relief. The maximum amount a taxpayer can treat as qualified principal residence indebtedness is $2 million ($1 million if married filing separately). If the discharge occurs in a title 11 case, Form 982, check box 1e may not be checked. In this case the taxpayer must check box 1a noting the bankruptcy exclusion. If the taxpayer is insolvent (and not in a title 11 case), they can elect to follow the insolvency rules by checking Form 982 box 1b instead of box 1e and complete the form. To show that all or part of a canceled debt is excluded from income because it is qualified principal residence indebtedness, attach Form 982 to the federal income tax return and check the box on line 1e. On line 2 of Form 982, include the amount of canceled qualified principal residence indebtedness, but not more than the amount of the exclusion limit. If a taxpayer continues to own the residence after a cancellation of qualified principal residence indebtedness, they must reduce the basis in the residence. If the taxpayer disposes of the residence, they may also be required to recognize a gain on its disposition. If the taxpayer continues to own the residence after the discharge, enter on Form 982 line 10b the smaller of: (a) the amount of qualified principal residence indebtedness included on line 2, or (b) the basis (generally, cost plus improvements) of the principal residence.

4. Conclusion and solution

Include on Form 982 line 2 the amount of discharged qualified principal residence indebtedness that is excluded from gross income. Any amount in excess of the excluded amount (assuming no other §108 exclusion applies) will result in taxable income, which should be reported on line 21 of the taxpayers personal income tax return, Form 1040. Under the ordering rule, Mike can exclude only $5,000 of the canceled debt from his income under the exclusion for canceled qualified principal residence indebtedness ($115,000 canceled debt minus the $110,000 amount of the debt that was not qualified principal residence indebtedness). Barring another

10 The Mortgage Forgiveness Debt Relief Act was applicable to discharges after 2007 – 2009; however, the Emergency

Economic Stabilization Act of 2008 extended exclusion three years through 2012. The American Taxpayer Relief Act of 2012 further extended the provision through 2013.


exception or exclusion, Mike must include the remaining $110,000 of canceled debt in income on line 21 of his Form 1040.

Real life issue: Debt tracking

In the above example, Mike refinances the home for $850,000. At that time, the loan actually is a “hybrid” loan consisting of three classifications, $740,000 acquisition debt, $100,000 home equity debt, and $10,000 personal debt. Had the loans actually been three separate and distinct loans, tracking would be rather easy. (The $740,000 is also qualified personal residence indebtedness for COD purposes, while $110,000 is not qualified for exclusion). In the reality of refinancing, Mike has one loan. The Service lacks guidance regarding tracking the principal payments on “hybrid” loans. For example, suppose in Mike’s case, the mortgage balance had been reduced to $782,000 at the time the lender agrees to the short sale, resulting in cancelled debt of $47,000 ($782,000 - $735,000). How much of the $782,000 is acquisition debt, home equity debt and personal debt, respectively? A straight “pro-rata” approach would result in $680,800 acquisition debt, $92,000 home equity, and $9,200 personal. In that case, under the ordering rule Mike would include the entire $47,000 in income. Mike would not benefit under §108 unless the amount canceled exceeds the amount of the loan (immediately before the cancellation) that is not qualified principal residence indebtedness.



E. How much trouble do you get in for not filing FinCEN Form 114 (FBAR)? (#5)

1. More on income being income Many practitioners who have been prepared tax returns for more than a few years remember the days before the computer matching of W-2’s, 1099’s etc. We were not always informed of all income generating accounts. A practitioner passes along the following story. Many years ago, a taxpayer received a notice from the IRS in which the computer cross-checked several 1099’s, none of which appeared on the taxpayers return. The practitioner checked his file, and found no records of these 1099’s (Yes, in those days we also copied much of the source data!). The practitioner questioned the taxpayer, wondering why the 1099’s were not included in the information provided for the preparation of the return. The taxpayer’s response: “If I don’t tell you about the income, then it’s not taxable.”

2. The blooper a. Failure to report an interest in a foreign financial account. With the globalization of the

economy, more and more people in the U.S. have foreign financial accounts. While there are many legitimate reasons to own foreign financial accounts, there are also responsibilities that go along with owning such accounts.

b. In general, individuals must first fulfill this requirement by answering questions regarding foreign accounts or foreign trusts that are contained in Part III of Schedule B of the IRS Form1040. Taxpayers who answer "yes" in response to the question regarding foreign accounts must then file FinCEN Form 114 (FBAR). This form must be filed with the Department of the Treasury, and not as part of the tax return that is filed with the IRS.

c. Account holders who do not comply may be subject to both civil and criminal penalties.

3. The law Each United States person, who has a financial interest in or signature authority, or other authority over any financial accounts, including bank, securities, or other types of financial accounts in a foreign country, if the aggregate value of these financial accounts exceeds $10,000 at any time during the calendar year, must report that relationship each calendar year by filing FinCEN Form 114 with the Department of the Treasury, generally by April 15 of the succeeding year.

a. Civil and criminal penalties, including in certain (willful) circumstances a fine of not more than $500,000 and imprisonment of not more than five years, are provided for failure to file a report, supply information, and for filing a false or fraudulent report.

b. Effective with respect to failures to report occurring on or after October 22, 2004, an additional civil penalty may be imposed on any person who violates this reporting requirement (without regard to willfulness). This new civil penalty is up to $10,000.11 1) The penalty may be waived if any income from the account was properly reported on the

income tax return and there was reasonable cause for the failure to report. 2) In addition, the penalty for willful behavior is the greater of $100,000 or 50 percent of the

amount of the transaction or account. c. Civil penalties can be assessed anytime up to six years after the date of the violation.

11 Section 5321(a)(5) of title 31, United States Code.


4. The conclusion, solution, and Form 8938 The harsh penalties coupled with the: “If I don’t tell you about the income then it’s not taxable.” philosophy has resulted in many professional offices drawing specific attention to this item. Clients across America are notorious for not completing an organizer (or is it just my clients?) or skipping questions. Directing attention to the foreign account information in an organizer, an engagement letter or whatever means necessary may hopefully keep this steep penalty at bay. The Foreign Account Tax Compliance Act (FATCA) is an important development in U.S. efforts to combat tax evasion by U.S. persons holding investments in offshore accounts. FATCA requires certain U.S. persons holding foreign financial assets to report information about those assets on Form 8938. The Form 8938 instructions impart filing thresholds for taxpayers living in the U.S.12 and married filing a joint income tax return if the total value of specified foreign financial assets is more than $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year. For unmarried taxpayers or married filing separately, the reporting threshold is more than $50,000 of specified foreign financial assets on the last day of the tax year or more than $75,000 at any time during the tax year. Specified foreign financial asset means: (a) any financial account maintained by a foreign financial institution; and (b) any of the following assets which are not held in an account maintained by a financial institution: (i) any stock or security issued by a person other than a United States person; (ii) any financial instrument or contract held for investment that has an issuer or counterparty which is other than a United States person; and (iii) any interest in a foreign entity.

Practice note: Assets not required to be reported on Form 8938

The following financial accounts and the assets held in such accounts are not specified foreign financial assets and do not have to be reported on Form 8938. 1. A financial account that is maintained by a U.S. payer, such as a domestic financial

institution. In general, a U.S. payer also includes a domestic branch of a foreign bank or foreign insurance company and a foreign branch or foreign subsidiary of a U.S. financial institution. Examples of financial accounts maintained by U.S. financial institutions include:

• U.S. mutual funds accounts; • IRAs (traditional or Roth); • Section 401(k) retirement accounts; • Qualified U.S. retirement plans; or • Brokerage accounts maintained by U.S. financial institutions. 2. A financial account that is maintained by a dealer or trader in securities or commodities if

all of the holdings in the account are subject to the mark-to-market accounting rules for dealers in securities or an election under §475(e) or (f) is made for all of the holdings in the account.

12 Thresholds are higher for taxpayers living outside the United States, see instructions to Form 8938.


5. Question and Answer examples provided by IRS13 Q. Is a U.S. resident with power of attorney on his elderly parents’ accounts in Canada required to

file an FBAR, even if the resident never exercised the power of attorney? A. Yes, if the power of attorney gives the U.S. resident signature authority, or other authority

comparable to signature authority, over the financial accounts. Whether or not such authority is ever exercised is irrelevant to the FBAR filing requirement.

Q. A person owns foreign financial accounts X, Y, and Z with maximum account balances of $100,

$12,000, and $3,000, respectively. Does the person have to file an FBAR and if so, which accounts must be listed on the FBAR? A. The FBAR instructions require the filing of the FBAR form “ … if the aggregate value of these

financial accounts exceeds $10,000 at any time during the calendar year … ” In this scenario, the person has an FBAR filing obligation because the aggregate value of foreign financial accounts X, Y, and Z is $15,100. The person must report foreign financial accounts X, Y, and Z on the FBAR even though accounts X and Z have maximum account values below $10,000.

Q. A person owns foreign financial accounts A, B, and C with account balances of $3,000, $1,000,

and $8,000, respectively. Does the person have to file an FBAR and if so, which accounts must be listed on the FBAR? A. Even though no single account is over $10,000, because the aggregate value of accounts A,

B, and C is over $10,000, the person has to file an FBAR and must report foreign financial accounts A, B, and C on the FBAR.

Practice point: Do we file BOTH the FBAR and Form 8938?

The filing of Form 8938 does not relieve a taxpayer of the separate requirement to file the FBAR if they are otherwise required to do so, and vice-versa. Depending on the situation, taxpayers may be required to file Form 8938 or the FBAR or both forms, and certain foreign accounts may be required to be reported on both forms. The IRS has created a chart: “Comparison of Form 8938 and FBAR Requirements” which is a side by side analysis of the two. This comparison chart can be found at http://www.irs.gov/businesses/article/0,,id=255986,00.html. Form 8938 and FBAR were developed to meet two different governmental needs—tax administration and law enforcement. Since Form 8938 is a new requirement, there is no data available to determine the number of filers facing duplicative reporting requirements.

13 See irs.gov - FAQs Regarding Report of Foreign Bank and Financial Accounts (FBAR) - Financial Accounts.










II. Capital gains and losses

A. Hazy tax situation -- Gain on property, ordinary or capital? 14 (#6)

Note: The next two cases -- Heads they win, tails we lose

In reporting income, errors can be made by professionals by misclassifying income. The following two cases should be read in tandem, as they represent an overall look at classification of real property transactions. In the first case, a taxpayer has gains from dealings in real property. A question arises as to the classification of the income, capital gain or ordinary income. Obviously, the taxpayers holds a slant as to the classification they desire. Which would you want, capital gain or ordinary income? In the second case, a taxpayer incurs losses from dealings in real property. A similar question arises, and the taxpayer also holds a slant as to their desired classification. Which would you want, capital loss or ordinary loss?

1. Income from real estate sale

Frederic Allen purchased property in 1987, for purposes of developing it himself for sale. Between 1987 and 1995, Mr. Allen attempted to develop the property on his own. He spent money on engineering plans and also developed approximately 10 sets of plans for the property as he "went through the process of trying to find a partner to develop the project." In March 1999, Allen sold the Property to Clarum Corporation, a property developer. Clarum paid a lump sum and agreed to pay 22 percent of its profits and a set fee whenever a developed unit was sold. The Allens received a final installment payment from Clarum of $63,662 (1099-MISC). Allen had reported the gain on the sale of undeveloped real estate as capital gains. The Service, relying on the fact taxpayer intended to develop the property and for many years made efforts to do so, characterized the gain as ordinary income.

2. Property held primarily for sale to customers

“Capital asset” is defined as “property held by the taxpayer” except for “property held by the taxpayer primarily for sale to customers in the ordinary course of his/her trade or business.” “Ordinarily, whether specified property is held by the taxpayer primarily for sale to customers in the course of his/her trade or business is a question of fact.”15 Courts consider several factors to determine whether property was held by a taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, including:

(i) The nature of the acquisition of the property;16 (ii) The frequency and continuity of sales over an extended period; (iii) The nature and the extent of the taxpayer’s business; (iv) The activity of the seller with respect to the property; and (v) The extent and substantiality of the transactions.

14 Allen v. United States, No. 3:13-cv-02501 (C.D. Cal. 2014). 15 Austin v. Commissioner, 263 F.2d 460 (9th Cir. 1959). 16 While the purpose for which the property was acquired is of some weight, the ultimate question is the purpose for which

the property is held. Pool v. Commissioner, 251 F.2d 233 236 (9th Cir. 1957) [quoting Rollingwood Corp. v. Commissioner, 190 F.2d 263 (9th Cir. 1951)].


3. Dissecting the factors a. Nature and acquisition of the property – His intent at the time of purchase (and for

some time after) was to develop it for sale. Taxpayer argued that his intent with respect to the property changed over time when it became clear to him that developing the property was beyond his means and expertise. It is the dominant purpose of his holding during the period prior to the sale which is critical.17

b. Seller’s activities with respect to the property -- His intent with respect to the property was, at all times until after the sale, one to develop and sell the property. During the time he owned the property, he and/or his firm created around 10 different sets of plans for the development. He continued that “process” of finding a partner to develop the project until shortly after the sale. He initially tried to develop the property on his own, then searched for partners to help develop the property, and finally negotiated the deal that resulted in a land sale and an initial role for civil engineering work instead of a development agreement.18

c. Nature and frequency of sales -- Infrequent sales for significant profits are more indicative of real property held as an investment.19 However, the fact that taxpayer purchased only one property for development (or as an investment) is not determinative, as there is no “one-bite” rule that precludes under any circumstances a taxpayer who engaged only in one venture or one sale from being held to be in a trade or business as to that venture or sale.20

d. Nature and the extent of the taxpayer’s business -- Taxpayer was employed full-time as a civil engineer working primarily for developers. Carrying on a business for purposes of this determination implies an occupational undertaking to which one habitually devotes time, attention, or effort with substantial regularity. Merely disposing of investment assets at intermittent intervals, without more, is not engaging in business, even though some preliminary effort is necessary to render the asset saleable.21 But cases recognize that a taxpayer can be involved in more than one business. Here, the amount of time taxpayer spent trying to develop the property was significant. Even though the development of the project may not have been his main occupation throughout taxpayer’s ownership of the property, it required substantial time, attention, and effort.

e. Extent and substantiality of the transactions -- Taxpayer only purchased investment property once and eventually sold it once. While the extent and substantiality factor might have slightly favored the taxpayers because there was only one main sale transaction, it was neutralized since the transaction came after taxpayer had failed in his efforts to develop it himself or find a developer to partner with him on the project.

4. Heads they win

Taxpayer purchased and held the property in order to develop and sell it in the ordinary course his trade or business.

17 Tibbals v. United States, 362 F.2d 266 (Ct. Clms. 1966). 18 Long v. Commissioner, T.C. Memo 2013-233 (finding that where taxpayer initially purchased land to build and sell condo

units, the fact that he changed mind and sold land ready for construction of a building did not alter view that land was held primarily for sale to customers in ordinary course of business; “The sale of a parcel of land (ready for construction) would result in a large profit from a single-sale transaction. The profit would have been from Long’s efforts to develop the land, not from the mere passage of time.”).

19 Pool v. Commissioner, T.C. Memo 2014-3. 20 See, e.g., Cottle v. Commissioner, 89 T.C. 467 (1987). 21 Austin v. Commissioner, 263 F.2d 460 (9th Cir. 1959) [quoting Fahs v. Crawford, 161 F.2d 315 (5th Cir. 1947)].


A U.S. district court held that income from the sale of undeveloped real estate was properly categorized as other income instead of capital gains, finding that the property was purchased and held to develop and sell it in the ordinary course of the husband’s trade or business.

B. Hazy corollary -- Loss on property, ordinary or capital? (#7)22

1. Theft loss, or some other kind of deductible loss

Jeffrey Evans has worked in the field of real-estate construction and development, working for firms that oversaw the construction of large high-rise buildings. As an employee of these firms, Evans was responsible for managing the architects, design teams, and other contractors that the firms hired for various development projects. Apart from his full-time job, Evans purchased for himself residential real-estate properties (the exact number of which is not revealed by the record) that he hoped to either develop for sale or rent to tenants. Evans’s plan when purchasing properties for development and sale was to tear down the existing structures, construct single or multiunit residences, then sell those residences for gain. His alternative objective was to generate income by renting these residences to tenants. Evans hoped that he would eventually be successful enough in his personal real-estate projects to pursue these projects full time, and provide a source of retirement income and/or savings. Under the above pretense, he bought one rental property in Corona del Mar, California. During that same period, Evans bought two tear-down properties: one in Corona del Mar and the other at Newport Beach. Over the course of three years, Evans developed the tear-down property in Corona del Mar into a two-condominium building, then sold it. He bought the Newport Beach property on June 26, 2006. The Newport Beach property was a plot of land which included a shack and a garage. The shack and the garage were vacant at the time Evans acquired the property. He intended to tear down the shack and the garage and build a two-unit house. If Evans was unable to sell the units, he planned to retain the property and rent them. Evans paid $1,400,000 in cash for the Newport Beach property. To cover some of the purchase price, he liquidated some of his family’s assets; he paid the rest of the purchase price using the proceeds of a loan of approximately $150,000. While he owned the Newport Beach property, Evans incurred costs to prepare the property for development. He paid an architect for drawings of the two-unit house that he intended to build there. Evans paid other individuals for electrical and mechanical plans. He incurred additional costs for permits, property taxes, and interest. In addition, Evans borrowed $250,000, which included a lien on the Newport Beach property. At some point thereafter, Evans defaulted on $250,000 loan, resulting in foreclosure proceedings. On October 30, 2008, the Newport Beach property was sold in a nonjudicial foreclosure sale for $556,000. As of the end of 2008, Evans knew that the foreclosure sale had occurred; and although he did not know whether he was entitled to receive proceeds from the sale, he could have found out if he had inquired. Of the $556,000 in foreclosure proceeds from the Newport Beach property, $250,000 was paid to satisfy Evans’s debt. He learned in January 2009 that there were proceeds that were distributable to him. On February 2, 2009, the trustee issued a check to Evans for $280,325.

22 Jeffrey J. Evans v. Commissioner, TC Memo 2016-7; January 11, 2016.


2. And the Form 1040 reports a loss! Evans and his wife attached to the 2008 return a Schedule C, Profit or Loss from Business, on which the couple reported income and expenses associated with Evans’s dealings in real estate. On the Schedule C, the couple reported-as an inventory loss $1,041,330 from the foreclosure sale of the Newport Beach property. The $1,041,330 loss was equal to the $1,597,330 they reported as their basis in the Newport Beach property minus the $556,000 that they reported as sale proceeds. The total business loss reported on the Schedule C was also $1,041,330. This is because they did not report that they had any business income or losses, other than the loss from the foreclosure sale. The couple reported a net-operating loss for 2008 of $941,548, and elected not to carry the NOL back to prior years. For the 2009 tax year, the couple included the NOL.

3. Property held primarily for sale to customers

“Capital asset” is defined as “property held by the taxpayer” except for “property held by the taxpayer primarily for sale to customers in the ordinary course of his/her trade or business.” “Ordinarily, whether specified property is held by the taxpayer primarily for sale to customers in the course of his/her trade or business is a question of fact.”23 Courts consider several factors to determine whether property was held by a taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, including:

(i) The nature of the acquisition of the property;24 (ii) The frequency and continuity of sales over an extended period; (iii) The nature and the extent of the taxpayer’s business; (iv) The activity of the seller with respect to the property; and (v) The extent and substantiality of the transactions.

4. Dissecting the factors a. Nature and acquisition of the property -- Before deciding to purchase the Newport

Beach property, Evans considered purchasing several properties on which he would have torn down existing structures and constructed new ones. Evans’s principal objective in acquiring the Newport Beach property was to tear down the existing structures, build a two-unit home, and sell the property for a gain. If Evans was unable to obtain a desirable sale price for the property, he planned to hold the property and rent it to tenants. In order to develop the property, Evans planned to (and did) work with contractors, such as an architect and an electrician. These facts indicate that, at the time he purchased the Newport Beach property, Evans’s main intention was to tear down existing structures and develop and sell the property. However, even if Evans acquired the Newport Beach property with the intention of developing it, this does not mean that he was in the business of property development and sale. Therefore, this intention does not dispose of the question of whether Evans held the Newport Beach property as part of a business of developing and selling properties to customers.

23 Austin v. Commissioner, 263 F.2d 460 (9th Cir. 1959). 24 While the purpose for which the property was acquired is of some weight, the ultimate question is the purpose for which

the property is held. Pool v. Commissioner, 251 F.2d 233 236 (9th Cir. 1957) [quoting Rollingwood Corp. v. Commissioner, 190 F.2d 263 (9th Cir. 1951)].


b. The frequency and continuity of property sales over an extended period -- Facts indicating that the taxpayer engages in regular (rather than isolated or sporadic) sales of property support a finding that he or she is engaged in a trade or business. Evans testified summarily that he began acquiring properties as early as 1980 and had acquired multiple properties since that time. However, he supplied few details about these properties. He estimated that he had invested in a total of eight or nine properties, some of which he planned to rent to tenants and some of which he planned to develop and sell. Apart from the Newport Beach property, Evans specifically identified only two properties he had previously acquired. One was the rental property in Corona del Mar, California. The other was the tear-down property in Corona del Mar. Evans developed the tear-down property in Corona del Mar into a two-unit condominium, then sold it. The Newport Beach property was sold in a foreclosure sale. Evans’s testimony about other properties he may have acquired for development and sale was too vague to be reliable. The limited record shows that Evans’s property sales were sporadic, not frequent and continuous.

c. The nature and extent of the taxpayer's business -- Evans was actively involved in developing the tear-down property in Corona del Mar and the Newport Beach property. He hired and managed contractors and dealt with permit issues. In addition to the time he spent developing these two properties, he actively sought new properties to acquire and develop. These activities notwithstanding, the record indicates that Evans held only a few properties for development and sale and that he acquired the properties sporadically. From this, Evans’s personal real-estate development activities were each rather isolated. Additionally, Evans supplied very few records related to his personal real-estate transactions, and his testimony concerning his properties was notably vague. One generally expects that a person who considers himself or herself in business will maintain books and records for that business.

Practice note: Clients who are “short” on recordkeeping take note

A party who wishes to prove to the court that he kept records may convince the court of the truth of that assertion by testifying that he kept records or by introducing actual records into evidence. Evans did neither. His failure to testify about his recordkeeping or to introduce his records, combined with the vagueness of his testimony about his properties, indicates that Evans did not maintain records of his personal real-estate-development activities. These circumstances suggest that Evans’s personal real-estate development activities did not constitute a trade or business.

d. The activity of the seller about the property -- This factor relates to the steps that the

taxpayer undertook to sell the property. The Newport Beach property was sold in a foreclosure sale in 2008. This does not detract from the fact that Evans intended to sell the property. However, this intention does not answer the question of whether Evans was in the business of selling property.

e. The extent and substantiality of transactions -- Evans testified that he had acquired several properties. However, he specifically identified only three properties he had acquired: (1) the rental property in Corona del Mar, California, (2) the tear-down property in Corona del Mar, and (3) the Newport Beach property. Evans testified that he developed and sold a two-unit condominium on the tear-down property in Corona del Mar, but he did not indicate in his testimony whether the sale generated income. The Newport Beach property was sold at a loss in a foreclosure sale. Thus, of the two


properties that Evans identified and that were potentially held for development and sale, only one may have produced any income. Evans’s primary source of income was his full-time job and that any income he may have earned from developing properties accounted for an insubstantial portion of his income.

5. Tails, taxpayer loses Although this case seems strikingly familiar to the previous case, Allen v. United States, in which a taxpayer was subjected to ordinary income rather than desired capital gain treatment, the Court utilized the same arguments to work against Evans. The Court concludes that Evans’s personal real-estate-development activities did not constitute a trade or business for purposes of §1221(a)(1) and that therefore the Newport Beach property was a capital asset. Consequently, the loss he incurred upon the foreclosure sale of the Newport Beach property was a capital loss.

6. For practitioners to avoid errors

In each of the last two cases, classification reporting errors occurred. Practitioners should evaluate scenarios on a case-by-case basis. Obviously, the intent of the taxpayer at initial acquisition is important and should be documented. Recordkeeping is also a core issue as to the businesslike manner, or investment manner a taxpayer may have. In Allen’s case, the circumstances indicated a business activity (ordinary income), while Evans’s personal real-estate development activities indicated investment activity (capital loss). Clients and practitioners should work closely to document the activity timely and properly, rather than attempt to return toothpaste to the tube after the fact.

III. Income from rents and pass-through entities

A. Is basis increased by phantom income, or reduced by losses not deducted? (#8)

1. “The hardest thing in the world to understand is the income tax”25 or perhaps calculating basis26

a. In 1995 Barnes acquired a 50% interest in Whitney by making a $44,271 contribution of capital. Whitney operated at a loss in 1995; Barnes’ pro rata share of that loss was $66,553, of which $44,271 (the amount of their basis in the Whitney stock) was allowable, and $22,282 suspended.

b. In 1996, Barnes made no contributions of capital, and received a pass-through loss of $136,228. However, Barnes’ reported on their (w/spouse MFJ) 1996 return a pro rata gain from Whitney of $22,282?

c. The parties agree that at the beginning of 1997 Barnes' basis in the Whitney stock was zero. In 1997 Barnes made a $278,000 contribution of capital to Whitney. Barnes pro rata share of Whitney's 1997 loss was $52,594, which they claimed a deduction for. They ignored the suspended losses. Barnes’ contends that they “are not required to reduce their basis for losses that were never claimed or deducted.”

25 Albert Einstein. 26 Marc S. Barnes, et ux. v. Commissioner, TC Memo 2012-80.


d. After a few years, the difference in basis calculations remains at $158,510 (represented by $22,282 1995 phantom income and $136,228 1996 non-deducted losses).

e. Subsequently Whitney reported a large loss, with Barnes share amounting to $276,289.

Begin Year Basis

K-1 Pass-Through

Correct Reporting

Reported by Taxpayer

Loss Suspended Loss Suspended $44,271 ($66,553) ($44,271) ($22,282) ($44,271) ($22,282)

$0 ($136,228) $0 $158, 510 +$22, 282 ($180,792) $278,000 New Cap

($52,594) $211,104 $0 ($52,594) ($180,792)

??? ($276,289) By 2003, the difference in basis calculations remains at $158,510 (represented by $22,282 phantom income and non-deducted losses of $136,228).

2. Error in calculating basis Barnes believed his basis before deducting the $276,289 loss amounts to $225,406. IRS believes the basis is $158,510 lower. Barnes contends:

(1) Basis increases for amounts reported by a shareholder as his or her pro rata share of pass-through S corporation income, even where the reported income amount is not actually the shareholder's pro rata share of the S corporation's income for that year; and

(2) Basis is not reduced for pass-through S corporation losses that the shareholder did not report on his or her return and did not claim as a deduction, despite being required to do so by §1366(a)(1).

3. The law - Specific order for adjustments to basis after 1996 The service in final regulations27 provides for two possible methods of accounting regarding the specific order for adjusting a shareholder’s basis.

a. First Method -- Specific order for adjustment to basis28 Unless the shareholder elects the second situation, the adjustments are to be made to the basis of a share of stock in the following order: 1) 1st -- Increases for income (including non-taxable income) items and also the excess of the

deductions for depletion in excess of the cost basis of the property subject to depletion, then,

2) 2nd --- Decreases for Distributions, then,

3) 3rd -- Decreases for nondeductible expenses, noncapital expenses and deductions for oil and gas depletion up to cost basis,

then, 4) Last -- Decreases for deductible items of loss and expenses.

b. Second Method -- Special written shareholder election to reduce basis by deductible losses and expenses first before reducing basis by nondeductible expenses.

Once this election is made it cannot be revoked in future years without IRS permission.29 If this election is made, the adjustments to basis of a share of stock will be in the following order:

27 Treas. Regs. §1.1367-1. 28 Treas. Regs. §1.1367-1(f).


1) 1st -- Increase for income (including non-taxable income items and also the excess of the deductions for depletion in excess of the cost basis of the property subject to depletion),

then 2) 2nd -- Decrease for Distributions,

then 3) 3rd -- Decrease for deductible items of loss and expense,

then 4) Last -- Decreases for nondeductible expenses, noncapital expenses and deductions for oil

and gas depletion up to cost basis.

4. Conclusion and unsuccessful last ditch attempt Regarding the upward Basis Adjustment in 1996, the IRS takes the position that Barnes' basis in the Whitney stock did not increase by $22,282. It contends that, under §1367, there is no upward basis adjustment for amounts that are erroneously reported by the shareholder as pass-through income but that do not correspond to the shareholder's actual pro rata share of pass-through income. Barnes’ seem to argue, without citation of authority, that the upward basis adjustment was appropriate because they reported $22,282 in pass-through income. The fact that they reported $22,282 of pass-through income on their return is irrelevant because they had no pass-through income from Whitney for 1996, their basis did not increase by $22,282 in that year. Regarding the failure To Make Downward Basis Adjustment for 1997, basis is reduced even if the shareholder does not actually claim the pass-through losses on his or her return. Therefore, the IRS argues Barnes' basis was reduced by $136,228 for 1997. The plain language of §§1366 and 1367 supports the interpretation. Barnes then desired to implement the “Tax Benefit Rule” which they believed should permit the benefit in 2003 of the suspended loss they did not report as a deduction in 1997.

Tax Benefit Rule:

The tax benefit rule is a judicially created principle intended to remedy some of the inequities that would otherwise result from the annual accounting system used for federal income-tax purposes. The Supreme Court explains that "[t]he basic purpose of the tax benefit rule is to achieve rough transactional parity in tax, and to protect the Government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous.” The rule has two components: an inclusionary component and an exclusionary component. The inclusionary component is a rule providing that, where a taxpayer properly deducts an outlay in one year and then, in a later year, recovers the same amount, the subsequent recovery is generally included in the taxpayer's gross income. The exclusionary component of the rule provides generally that gross income does not include amounts subsequently recovered to the extent that the prior deduction did not give rise to a tax benefit. The exclusionary component of the rule does not become an issue unless, and until, the inclusionary component of the rule is satisfied.

29 Treas. Regs. §1.1367-1(g).


The inclusionary component of the tax benefit rule would not require Barnes to include in gross income for 2003 any amount deducted in a prior taxable year and subsequently recovered. Therefore, neither component of the tax benefit rule applies and does not provide for an exclusion from income for 2003. In a last ditch effort, Barnes contends that, even if the IRS is correct with respect to basis in the Whitney stock, their failure to claim $136,228 in pass-through losses on their 1997 return caused them to incorrectly calculate their net operating loss (NOL) for that year. They argue that the amount of their 1997 NOL should be recalculated, taking into account the $136,228 they failed to deduct. They argue further that, because they “never used” this NOL, it remains available to offset their taxable income for 2003. They allude to a theory that a time bar affects the 1997 tax year, however, they did not provide a factual basis for carrying a 1997 NOL all the way forward to their 2003 tax return. For its part, the IRS argues that Barnes' NOL argument should be rejected because of the dearth of supporting evidence and should not even be considered because they waited until after trial to raise this contention. The Court agreed with both of the IRS's contentions and so rejected the NOL argument.

5. Inconsistent treatment of Schedule K-1 items

Generally, taxpayers must report items shown on Schedule K-1 (and any attached statements) the same way that the items are reported on its return. If the treatment on the original or amended return is inconsistent with the entity’s treatment, or if the entity was required to but has not filed a return, the taxpayer must file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), with its original or amended return to identify and explain any inconsistency (or to note that a return has not been filed).

Practice note:

If a taxpayer is required to file Form 8082 but does not do so, it may be subject to the accuracy-related penalty. This penalty is in addition to any tax that results from making the amount or treatment of the item consistent with that shown on the return. Any deficiency that results from making the amounts consistent may be assessed immediately.

Practice note: Errors

If a taxpayer believes an error is on Schedule K-1, it should notify the entity and ask for a corrected Schedule K-1. The taxpayer may not change any items on its copy of Schedule K-1. Verify that the entity sends the corrected Schedule K-1 to the IRS.

B. Failing to find hidden gains in Schedules K-1 (#9)

1. Hidden partnership or LLC gains A partner/member’s share of partnership/LLC liabilities is included in their adjusted basis. When liabilities are increased and each partner’s share of such liabilities is thereby increased, the amount of each partner’s increase shall be treated as a contribution of money by that partner to the partnership. Where the liabilities are decreased and each partner’s share of such liabilities is decreased, the amount of the decrease shall be treated as a distribution of money to the partner by the partnership.


1) Example: Facts

Haymitch is a member of Panem LLC, in which he maintains a basis at the beginning of the current year of $6,000. Information from his current Form K-1 is as follows: Box 1: Ordinary income $10,000 Box 19A: Cash distributions 10,000 Question K Share of Recourse Debt: 60,000 Haymitch anticipates reporting $10,000 income for the current year.

2. The error practitioners make – review of liabilities

To properly complete the current-year basis calculations, one must first review the prior-year Schedule K-1, which reveals Haymitch’s share of Recourse Debt of $100,000.

Practice note: Changes in liabilities

Changes in liabilities normally result from fluctuations in liability balances, and/or from the acceptance of new or retirement of old partners or members.

3. Solution – proper completion of basis worksheet

Haymitch must complete a basis calculation. 1) Example: continued

Analysis - Line numbers refer to the Worksheet for basis in a partnership

1) Beginning basis $6,000 2) Initial share of debt basis $100,000 3) Ending share of debt basis 60,000 4) Net change in debt basis (40,000) (Potential for Hidden Gain)

5) Taxable income 10,000 6) Nontaxable income 7) Upward adjustments 10,000 8) Tentative basis for distribution purposes 16,000

9) Actual distributions 10,000 10) Net decreases in share of debt basis 40,000 11) Total distributions 50,000 12) Downward adjustments 16,000

13) Tentative basis for loss purposes 0 14) Amount realized 50,000 15) Gain recognized $34,000 (Hidden Gain)

Haymitch expected to report only K-1 income of $10,000. He does report the ordinary income but also may be surprised to also report $34,000 gain from distributions in excess of basis.


4. Worksheet for basis in a partnership/LLC

Worksheet for Basis in a Partnership Beginning basis 1. ________ Initial share of debt basis 2. ________ Ending share of debt basis 3. ________ Net change in debt basis (Line 3 - Line 2) 4. ________ Taxable income 5. ________ Nontaxable income 6. ________ Upward adjustments (Line 5 + Line 6 + Line 4 (if positive)) 7. ________ Tentative basis (Line 1 + Line 7) for distribution purposes 8. ________ Actual distributions (money and adjusted basis of property) 9. ________ Net decreases in share of debt basis (Line 4 (if negative)) 10. ________ Total distributions (Sum of Lines 9 through 10) 11. ________ Downward adjustments (Smaller of Line 8 and Line 11) 12. ________ Tentative basis (Line 8 - Line 12) for loss purposes 13. ________ Amount realized (Greater of Line 11 and Line 8) 14. ________ Gain recognized (Line 14 – Line 8) 15. ________ Current deductible losses 16. ________ Current nondeductible expenditure not chargeable to CA 17. ________ Total current losses (Sum of Lines 16 through 17) 18. ________ Allowable current losses (Smaller of Line 18 and Line 13) 19. ________ Tentative basis (Line 13 – Line 19) 20. Excess current losses (Line 18 – Line 19) 21. ________ Deductible percentage (Line 16/Line 18) 22. _________ Nondeductible percentage (Line 17/Line 18) 23. ________ Suspended deductible loss (Line 22 x Line 21) 24. ________ Suspended nondeductible expenditures (line 23 x Line 21) 25. ________ Current allowable deductible loss (Line 16 – Line 24) 26. ________ Carryover deductible losses 27. Carryover nondeductible expenditure not chargeable to CA 28. Total carryovers (Sum of Lines 26 through 27) 29. Allowable carryovers (Smaller of Line 20 and Line 29) 30. Ending basis (Line 20 - Line 30) 31. Loss carryover to next year (Line 29 - Line 30) 32. Deductible percentage (Line 27/Line 29) 33. Nondeductible percentage (Line 28/Line 29) 34. Suspended deductible loss (Line 33 x Line 32) 35. Suspended nondeductible expenditures (line 34 x Line 32) 36. Current allowable deductible loss (Line 27 – Line 35) 37.

5. Worksheet for basis in an S Corporation Repayment of shareholder loans by an S corporation when the shareholder's debt basis has been reduced requires the shareholder to report as income some or all of the debt repayment. Practitioners must also be conscientious about hidden gains in repayment of reduced basis shareholder loans.


Worksheet for Basis in an S Corporation Beginning stock basis 1. __________ Initial debt basis 2. __________ Beginning debt reduction 3. __________ Loss carryover from prior years 4. __________ Taxable income 5. __________ Nontaxable income 6. __________ Total upward adjustments (Line 5 + Line 6) 7. __________ Amount allocated to debt restoration (Lesser of Line 3 or Line 7) 8. __________ Debt basis (Line 2 + Line 8) 9. __________ Amount allocated to stock (Line 7 - Line 8) 10. __________ Tentative stock basis (Line 1 + Line 10) 11. __________ Losses 12. __________ Losses allocable to tax-exempt income 13. __________ Losses not allocable to tax-exempt income (Line 12 - Line 13) 14. __________ Taxable income (Line 5) 15. __________ Negative adjustments to AAA (Lesser of Line 14 or Line 15) 16. __________ Total adjustments to AAA (Line 15 - Line 16) 17. __________ Beginning AAA 18. __________ AAA (Line 17 + Line 18) 19. __________ Distributions 20. __________ Amount of distribution from AAA (Lesser of Line 19 or Line 20) 21. __________ Tentative stock basis (Line 11) 22. __________ Amount of AAA distribution return of capital (Lesser of Line 21 or Line 22) 23. __________ Interim stock basis (Line 22 - Line 23) 24. __________ Gain on distribution from AAA (Line 21 - Line 23) 25. __________ Balance of distribution (Line 20 - Line 21) 26. __________ Earnings and profits 27. __________ Amount of distribution from earnings and profits (Lesser of Line 26 or Line 27) 28. __________ Balance of earnings and profits (Line 27 - Line 28) 29. __________ Balance of distribution after earnings and profits (Line 26 - Line 28) 30. __________ Interim stock basis (Line 24) 31. __________ Nontaxable portion (Lesser of Line 30 or Line 31) 32. __________ Gain portion of distribution (Line 30 - Line 32) 33. __________ Stock basis (Line 31 - Line 32) 34. __________ Losses (Line 12) 35. __________ Losses allocated to stock (Lesser of Line 34 or Line 35) 36. __________ Final stock basis (Line 34 - Line 36) 37. __________ Debt basis (Line 9) 38. __________ Losses not allocable to stock (Line 35 - Line 36) 39. __________ Maximum losses allocable to debt (Line 2) 40. __________ Losses allocable to debt (Lesser of Line 38, Line 39, or Line 40)) 41. __________ Final debt basis (Line 38 - Line 41) 42. __________ Carryover loss (Line 39 - Line 42) 43. __________ Total losses used (Line 35 – Line 43) 44. __________ If no election is made, the nondeductible losses 45. __________ Total nondeductible losses used (Lesser of Line 44 and Line 45) 46. __________ Unused nondeductible losses (Line 45 – Line 46) 47. __________ Deductible losses 48. __________ Current deductible losses (Lesser of Line 47 and Line 48) 49. __________ Carryover of deductible losses (Line 48 – Line 49) 50. __________


IV. Other income issues

A. When a “rollover” is not a rollover -- The Claim of Right Doctrine (#10)30

Practice note: Where do your clients get their best tax advice?

CPAs enjoy a heritage of being the most “trusted” advisor to many. Certain individuals use their CPA as a barometer to measure other professionals. However, in the real world, taxpayers pick up tax, investment, marital and any other advice from all corners of their sphere. In the following case, a doctor receives investment advice, which leads to a tax error from an acquaintance met in an operating room. Whether our clients receive tax advice on the golf course, at the club, from a long lost relative, or perhaps the dreaded Internet, practitioners must be able to sort through the facts to see the entire picture in order to avoid errors.

1. Trusted friends

Dr. Vandenbosch met Mr. Carver in the operating room in 1998 when Mr. Carver was working as a licensed radiology technologist. Before becoming a radiology technologist, Mr. Carver spent time working as a stockbroker. They developed a friendship outside of the hospital, as Dr. Vandenbosch sought Mr. Carver’s opinion on the stock market and investment opportunities, believing Carver was always correct in his investment advice. On March 1, 2011, Dr. Vandenbosch and Mr. Carver executed a contract memorializing an agreement to lend $125,000 to IAHL, a Corporation in which Mr. Carver was vice president of marketing and sales. A “Corporate Loan Agreement/Promissory Note,” was created with “Mark J. Vandenbosch, SEP IRA” as the lender. The note required the borrower to pay the lender $125,000 together with a flat $25,000 interest payment on the maturity date, May 31, 2011 (92 days later). The parties agreed that the borrower would repay the loan to “Mark J. Vandenbosch” at his personal residence. On the signature page, Dr. Vandenbosch and Mr. Carver signed the note in their personal capacities. Dr. Vandenbosch did not indicate he was signing on behalf of his SEP-IRA, nor did Mr. Carver indicate that he was signing on behalf of IAHL.

Caution: Passing the smell test

Dr. Vandenbosch may have overlooked a few glaring problems in this scenario. Serious reservations should have been raised by:

• Perhaps a conflict of interest on the part of Mr. Carver. • An effective 80 percent return on a 92-day investment.

Dr. Vandenbosch took the following steps to fulfill the obligation under the note:

1. He signed a form titled “Retirement Distribution or Internal Transfer.” He requested that Edward Jones distribute $125,000 from his SEP-IRA into his joint account at Edward Jones. He checked a box indicating “I am under the age of 591/2.”

2. Edward Jones distributed $125,000 into the joint account. 3. He wired $125,000 from the joint account to his personal account at BankFirst. 4. He wired $125,000 from the BankFirst account to “John R. Carver” at a JPMorgan Chase

Bank, N.A. (Chase) account.

30 Mark Vandenbosch, et ux. v. Commissioner, TC Memo 2016-29; February 24, 2016.


The loan has not been repaid. In January 2012, Edward Jones prepared Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., reporting a gross distribution of $125,000. The form bears a code indicating that the withdrawal is an early distribution and that the entire $125,000 is taxable.

2. In practice, without all the facts, errors can be made

For preparation of their personal income tax returns, the Vandenbosches have engaged the same firm for over 20 years. Dr. Vandenbosch explained to his return preparer the distribution is an investment by the SEP-IRA in IAHL. He provided his return preparer with the note and information. Their return reported that they received $125,000 in pensions and annuities; however, they reported it was a nontaxable rollover. Their return preparer did include in the return a copy of a letter which stated that they believed that the funds were directly rolled over from the SEP-IRA to IAHL’s. Upon examination of the 2011 return, the IRS issued a notice of deficiency, making adjustments to taxable income from the distribution and determining an additional tax under §72(t) and an accuracy-related penalty for a substantial understatement of income tax.

3. IRA distributions, the law, and “Claim of Right”

An IRA is a trust created or organized in the United States for the exclusive benefit of an individual or his or her beneficiaries if the trust meets the requirements of §408(a). A SEP is an IRA or an individual retirement annuity that meets the requirements of §408(k). Undistributed IRA income is generally exempt from tax unless the account ceases to be an IRA. Section 408(d)(1) provides, with certain exceptions, that any amount paid or distributed out of an IRA must be included in the gross income of the payee or distributee as provided in §72. A taxpayer who receives amounts under a claim of right or without restrictions as to its disposition must include such amounts in gross income. A taxpayer has a claim of right to income if the taxpayer:

(1) Receives the income; (2) Controls the use and disposition of the income; and (3) Asserts either a “claim of right” or entitlement to that income.

4. This is a distribution, not a rollover

Dr. Vandenbosch had unfettered control over the funds. He directed his SEP-IRA to distribute the funds into his account. Afterwards, he transferred the funds between his accounts and eventually to Mr. Carver. Accordingly, he was not acting as a mere conduit or an agent when the funds were distributed to him. Within the Note itself, perhaps most importantly, the parties agreed that the borrower would repay the loan to “Mark J. Vandenbosch” at his personal residence. Dr. Vandenbosch signed his name above the line that read “Mark J. Vandenbosch” and that denominated him as lender. He did not indicate that he was signing on behalf of his SEP-IRA. Likewise, Mr. Carver signed his name on the line that read “John R. Carver” and that denominated him as borrower. Mr. Carver did not indicate that he was signing on behalf of IAHL.


5. Solution found in different case, yet the same day In McGaugh v. Commissioner,31 (also filed the same day), the taxpayer also had a self-directed IRA. Because the IRA custodian was unwilling to purchase a particular stock, the taxpayer arranged the purchase by having the custodian wire funds directly to the issuing company, which in turn issued a stock certificate in the name of the taxpayer’s IRA and sent the stock certificate to the custodian. The Court held that the taxpayer was not a “payee or distributee” and that, to the extent he had control over the wired funds, he at most acted as a conduit. The taxpayer did not receive a distribution because no funds ever passed through his hands. Moreover, the taxpayer was not in constructive receipt of the funds because the funds went straight to the issuing company and the issuing company sent the stock shares to the custodian. At no time did the taxpayer have control over the funds, nor could he negotiate the stock certificate, which was issued in the name of the IRA.32

Practice note: Requires digging, control will not likely be found in an organizer

An old saying relates that CPAs are more interested in the numbers of a transaction, yet attorneys are more interested in the words. The fact that the return preparer included a letter with the tax return stating their belief in a rollover, indicates they may not have been privy to all the documents and detail from this long term (20 year) client. The key factual difference between the McGaugh case and Dr. Vandenbosch is the amount of control each held and exercised.

B. When a “rollover” is not a rollover -- No written plan on receiving end (#11)33

Practice note: Rollovers as business startups, or ROBS34

A version of a qualified plan is being marketed as a means for prospective business owners to access accumulated tax-deferred retirement funds, without paying applicable distribution taxes, in order to cover new business start-up costs. These arrangements are known as Rollovers as Business Startups, or ROBS. While ROBS would otherwise serve legitimate tax and business planning needs, they are questionable in that they may serve solely to enable one individual’s exchange of tax-deferred assets for currently available funds, by using a qualified plan and its investment in employer stock as a medium. This may avoid distribution taxes otherwise assessable on this exchange. Although a variety of business activity has been examined, an attribute common to this design is the assignment of newly created enterprise stock into a qualified plan as consideration for these transferred funds, the valuation of which may be questionable. The IRS has stated that a ROBS may work as a legitimate tax planning entity but recommends assessment on a case-by-case basis through IRS determination letters.

1. Business owners retirement savings account?

James and Lucy Powell, filed their 2004 joint federal tax return on which they listed $78,000 in IRA distributions as includible in income. They subsequently filed an amended 2004 return in which they claimed an overpayment of taxes based on the fact that they had purportedly rolled the $78,000 IRA distributions into another retirement account involved in commercial real estate investment, which they referred to as a “Business Owners Retirement Savings Account,” or BORSA.

31 Raymond S. McGaugh v. Commissioner, TC Memo 2016-28; February 24, 2016. 32 Similar findings in Ancira v. Commissioner, 119 T.C. 135 (2002). 33 Powell v. U.S.; 117 AFTR – 381T; March 15, 2016. 34 Michael D. Julianelle, Memorandum for Director, “Guidelines regarding rollovers as business start up;” October 1, 2008.


Apparently, BORSA is a trade name for a type of vehicle the IRS calls “ROBS” or a “rollover as business startup.” Powell conceded that they did not follow the required, formal steps to establish a ROBS.

2. Steps to create a ROBS The IRS views a ROBS as a questionable, but not necessarily abusive, mechanism for individuals to roll retirement funds into a new business. The steps generally to create a ROBS are as follows:

(1) The individual creates a new corporation for the purpose of running a qualified retirement plan.

(2) The new corporation creates a qualified employee retirement plan and allows participants to invest in the plan through corporate stock.

(3) The individual becomes an employee of the corporation and enrolls in the plan. (4) The individual either conducts a rollover or direct trustee-to-trustee transfer of funds from

a qualified personal IRA or previous employer’s §401 plan into the new corporate retirement plan.

(5) The individual directs his or her account balance in the qualified retirement plan to purchase employer stock.

(6) The individual then uses the transferred funds to begin a business enterprise.

3. If IRA funds are used, is it still an IRA? The Powell’s did not produce a written plan for the IRA or the name of the trustee. Mister Powell admitted that they purchased the property in their individual capacities and held it individually until 2012, when it was sold to a corporation. The property has never been held in trust or in an IRA account. Mister Powell’s understanding was merely that any money withdrawn from an IRA and invested in a business still counted as being in an IRA.

4. Without an established plan, how could there be a rollover?

Under §401 and its implementing regulations, “one participant retirement plans” need written trust instruments and certain other formalities. The Powell’s did not have a written plan. And while it may be true that one participant plans with less than $250,000 worth of assets are not required to file annual reports until their final year of existence, to be plans in the first place such entities need trust instruments, and “a definite written program and arrangement.” With no written plan in existence under which the IRA distributions were reinvested, the arrangement could not have employed a qualified trust under §401.

C. Understanding the risks in non-traditional IRA investments (#12)

1. Background

In passing the Employee Retirement Income Security Act of 1974 (ERISA), Congress sought to encourage individuals to save for retirement in tax-favored retirement arrangements. Traditionally, account owners participating in these arrangements defer taxes on contributions to these accounts up to certain statutory limits, and in general, contributions and investment earnings on those contributions are not taxed as income until the account owner withdraws them from the account. IRAs have become a key retirement savings vehicle for many individuals, including small business owners, independent contractors, and other workers who are not covered by an employer-sponsored retirement plan.


401(k) plans have become the most common employer-sponsored retirement savings vehicle in the United States. These plans were created by the Revenue Act of 1978. The DOL’s Employee Benefits Security Administration (EBSA) is responsible for, among other things, administering and enforcing the fiduciary, reporting, and disclosure provisions of Title I of ERISA. Self-employed individuals or owners of small businesses with no employees may sponsor a 401(k) plan, known as a solo 401(k) plan.

2. Types of investments

Account owners have wide latitude in the types of assets in which they can invest and custodians can choose to limit which type of assets they will allow. While some custodians generally limit investments to publicly traded assets, other custodians allow investments in a range of unconventional assets.35 The following table details some of the unconventional assets found in retirement accounts:36

35 A custodian is not precluded from holding both conventional and unconventional assets. 36 Table reproduced from – U.S. GAO; Report to the Ranking Member, Committee on Finance, U.S. Senate; RETIREMENT

SECURITY - Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets; December 2016.


3. Risk No. 1 -- Loss of tax-favored status

IRA owners who invest in unconventional assets take on a heightened risk of engaging in a prohibited transaction and losing tax-favored status for their retirement savings. IRS officials stated that prohibited transactions are the most prominent compliance risk associated with investing IRA savings in unconventional assets. Prohibited transactions are more likely to arise with investments in promissory notes, private equity, and real estate because -- unlike publicly traded stocks, bonds, and mutual funds --these investments can involve disqualified family members or other disqualified persons. Similarly, IRA investments in rental real estate, with its many transactions, for example, can leave IRA owners susceptible to a number of prohibited transactions, any one of which would result in the loss of the IRA’s tax-favored status. IRA owners and 401(k) plans are not permitted to engage in certain prohibited transactions. Prohibited transactions generally fall into two categories:

• Involving disqualified persons. An IRA owner and 401(k) plan are prohibited from engaging in a transaction with a range of entities, including a fiduciary, a person providing services, or members of the IRA owner’s family, including a spouse, ancestor, or descendant.

• Involving self-dealing. An IRA owner and 401(k) plan fiduciary are prohibited from engaging in a transaction where the account owner or the fiduciary benefits from the asset prior to retirement.

Specifically, if the IRA owner engages in a prohibited transaction, the IRA loses its tax-favored status as an IRA, and the account is treated as distributing all of its assets to the IRA owner at the FMV on the first day of the year in which the transaction occurred. The IRA owner may also be subject to a 10 percent additional tax on early distributions unless an exception applies.

Practice note:

Examples of a prohibited transaction in an IRA may include: 1. Directing the IRA to purchase a vacation home as a rental property for personal

use; 2. Selling their own property to the IRA; and 3. Taking a salary from an IRA-funded business. Additionally, see the following figure.


4. Risk No. 2 -- Unforeseen federal tax liability

Earnings and profits made in tax-favored savings vehicles are generally reinvested in the account with taxes deferred until distribution. However, two circumstances can generate current tax liability for retirement account owners:

• Unrelated Business Taxable Income (UBTI). Unrelated business taxable income is gross income generated from an ongoing trade or business (less allowable deductions) that is not related to the exempt or tax-deferred entity, such as an IRA. An IRA or 401(k) plan that earns $1,000 or more of gross income from an unrelated business must file Form 990-T with IRS and pay related taxes.

• Unrelated Debt-Financed Income (UDFI). Unrelated debt-financed income is a form of UBTI. If an asset purchased by an IRA is debt-financed (e.g., a mortgage on a rental property), income produced by that asset could be subject to taxes.


Practice note:

Having to pay taxes from the IRA can pose additional challenges for account owners who invest in illiquid assets that cannot easily be sold to pay applicable taxes. First, illiquid unconventional assets, such as real estate, private equity, and promissory notes, may require account owners to find another investor to purchase their interest in the asset. Second, the account owner cannot pay the taxes with personal funds (a prohibited transaction) and must arrange to have a custodian pay the taxes from their IRA. Third, IRA owners may not realize that once a retirement investment generates UBTI or UDFI, taxes must be estimated and paid quarterly if the tax is expected to be $500 or more, necessitating a certain level of liquidity to be maintained in the account.

5. Risk No. 3 -- Difficulty obtaining fair market value heightens the risk of noncompliance IRA owners who invest in unconventional assets may face challenges meeting their responsibilities to provide updated FMV information to their custodian to meet the IRS’s annual FMV reporting requirement because some unconventional assets are inherently hard to value. Some unconventional assets, such as precious metals, have a readily available FMV; other assets, such as undeveloped land and private equity, may require IRA owners to obtain a third-party appraisal or rely on investment sponsors to provide the information. Many custodial agreements make the IRA owners responsible for obtaining and providing a year-end FMV of unconventional assets in their accounts to the custodian each year. However, if an updated FMV is not provided, the custodian may report the last-known FMV or the original purchase price. As a result, the FMV reported to the IRS may not reflect a nonpublicly traded asset’s current value. IRA owners who fail to provide updated FMV to their custodian within a specified time limit run the risk of their custodian distributing their assets from the IRA, which could lead to a loss of the account’s tax-favored status if the owner cannot identify a successor custodian willing to hold the assets.


Practice note: Last known FMV

Even though the last-known FMV that the custodian reports to the IRS may not necessarily reflect the current estimated value of an asset, it can be treated as an asset’s true value and result in federal tax consequences for IRA owners. For example, the last-known FMV can be used to calculate federal tax liability for IRA owners: 1. When calculating RMDs; 2. When determining the distribution due to a prohibited transaction; and 3. When reporting an in-kind distribution in the event a custodian resigns an

account (e.g., IRA owner fails to pay custodial fees or to provide updated FMV).

Practice note: Savage and prolonged battle utilizing Form 5498

In tax year 2015, the IRS began requiring that custodians or trustees report selected information on unconventional assets in their clients’ accounts. Specifically, Boxes 15a and 15b on the form provide space for identifying the FMV and type of unconventional assets. As of November 2016, the IRS plans to begin compiling the new IRA asset data in 2017, but has not specified when the new IRA asset data will be available for analysis. The ultimate goal appears to have been reported in an October 2014 report,37 which noted Congress should consider revisiting the use of IRAs to accumulate large balances and consider: 1. The types of assets permitted in IRAs; 2. The minimum valuation for an asset purchased by an IRA; or 3. The amount of assets that can be accumulated in IRAs and employer sponsored

plans that get preferential tax treatment.

37 U.S. GAO; Report to the Chairman, Committee on Finance, U.S. Senate; US GAO; Report to the Chairman, Committee

on Finance, U.S. Senate; IRS Could Bolster Enforcement on Multimillion Dollar Accounts, but More Direction from Congress Is Needed.


6. Risk No. 4 -- Difficulty in distributing retirement income

Account owners may also face challenges when trying to liquidate certain unconventional assets to distribute as retirement income. Unlike publicly traded assets, which can be purchased and sold with relative ease in retirement accounts, account owners may experience difficulty finding a secondary market in which to sell certain unconventional assets. Account owners who have difficulty liquidating unconventional assets may instead be required to accept in-kind distributions rather than cash to comply with the minimum distribution requirements. For example, an account owner invested in real estate may need to request that a custodian distribute a percentage of the property equivalent to their calculated annual RMD. In such a case, that individual would own an illiquid portion of the property personally while the account would own the rest. The account owner in this


scenario would not be able to receive a cash distribution to use as retirement income, yet would be responsible for paying applicable income taxes on the in-kind distribution.

D. Reporting negative “other income” -- Why are manhole covers round? (#13)38

1. Litigation is a battle that bruises both sides, at an hourly or fixed fee

In 2008, Seattle Bank hired Ms. Sas as president and chief executive officer. On or around July 9, 2010, Ms. Sas received a “change of control” bonus of $612,000, properly reported as wage income on her jointly filed return with Roger Jones. Two months later, Seattle Bank terminated Ms. Sas’ employment, followed by a complaint against her alleging breach of fiduciary duty thereby attempting to recover the $612,000 bonus. Her counterclaims included a claim of employment discrimination. Both parties resolved within a settlement agreement and mutual releases that Seattle Bank and Ms. Sas each pay nothing and release and dismiss all claims against each other. In the course of the legal process, Ms. Sas paid $25,000 and $55,798 in legal expenses in 2010 and 2011, respectively.

2. How to avoid reporting a large questionable expense

On Sas and Jones’ Forms 1040 for 2010 (Schedule C, Mr. Jones) and 2011 (Schedule E)39, they reported on “other income” in the negative amounts of $25,000 and $55,798, respectively, for the legal fees paid for the lawsuit with Seattle Bank. The notice of deficiency disallowed these expenses as negative other income but allowed them as miscellaneous itemized deductions subject to the limitation in §67(a), reducing the deductible amounts to $4,525 and $50,579 for 2010 and 2011, respectively. Sas and Jones offer two theories for deducting the legal fees without limitation. First, they claim that the legal fees are deductible under §62(a)(20) as legal fees paid in connection with an action involving a claim of unlawful discrimination. Alternatively, they argue that the legal fees are deductible under §§62(a)(1) and 162 as ordinary and necessary business expenses.

3. A novel concept Generally, when a litigant's recovery constitutes taxable income, that income may include the portion of the recovery paid to the litigant's attorney. In the case of a litigant’s taxable recovery, which includes legal fee and court costs; §62(a)(20) allows a deduction for the legal fees and court costs provided the action involves:

• A claim of unlawful discrimination [as defined under §62(e)]. The Supreme Court explained40 “unlawful discrimination” to include a number of specific Federal statutes, §§62(e)(1) to (16), any Federal whistle-blower statute, §62(e)(17), and any Federal, state, or local law “providing for the enforcement of civil rights” or “regulating any aspect of the employment relationship or prohibiting the discharge of an employee, the discrimination

38 Ellen M. Sas, et al. v. Commissioner, TC Summary Opinion 2017-2, 01/30/2017. 39 It appears they reported the amount on Mr. Jones accounting and consulting Schedule C in 2010, and Schedule E for

2011. The Court assumed for purposes of analysis, and therefore find, that taxpayers co-owned an accounting and consulting business in 2011 and reported income from their business on their 2011 Schedule E.

40 Commissioner v. Banks, 543 U.S. at 433.


against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law;”

• A claim of a violation of subchapter III of Chapter 37 of Title 31, USC (Claims Against the U.S. Government); or

• A claim made under §1862(b)(3)(A) of the Social Security Act (a private cause of action under the Medicare Secondary Payer statute).

Expenses are deductible under §162 if the taxpayer establishes that they were ordinary, necessary, and paid or incurred during the tax year and were directly connected with, or proximately resulted from, a trade or business of the taxpayer. The deductibility of legal fees under §162 depends on the origin and character of the claim for which the legal fees were incurred and whether that claim bears a sufficient nexus to the taxpayer’s business or income-producing activities. The Supreme Court stated that “the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test.”41

4. Why are manhole covers round? Sas and Jones attempt to fit their claimed deductions within this unlawful discrimination limitation, but their argument falls into itself. Section 62(a)(20) allows a deduction for the litigant’s legal fees and court costs when a recovery constitutes taxable income. There is no taxable recovery component in this case. Ms. Sas’ bonus was received and includible in gross income because of her employment with Seattle Bank. Under the settlement agreement between Ms. Sas and Seattle Bank, neither party received any amount includible in gross income. Assuming arguendo that Ms. Sas’ counterclaims were in connection with unlawful discrimination, she did not receive, and did not include in gross income for 2010 or 2011, any amount because of the settlement of her claims.

Practice note:

Contrary to Sas and Jones’ view, the “amount includible in the taxpayer’s gross income” cannot reasonably be interpreted to include prevention of potential loss of income that would be includible in the absence of any claim.

Sas and Jones’ second argument claims that the legal fees are deductible as ordinary and necessary business expenses under §162. They do not argue that Ms. Sas’ claim was rooted where deducted, in their accounting business; rather, they argue that the lawsuit would have an adverse effect on Ms. Sas’ professional reputation. This in turn could damage the reputation of their accounting business and therefore the legal fees were necessary expenses of their business. The Court must look to the origin of the claim, not the potential consequences of a win or loss, and therefore found that Ms. Sas’ claims arose from her status as a former employee of Seattle Bank, not from their accounting business. They hired an attorney because Seattle Bank was attempting to claw back a bonus Ms. Sas received in connection with her employment at Seattle Bank. Therefore, they are not permitted to deduct the legal fees as ordinary and necessary expenses of their business.

41 United States v. Gilmore, 372 U.S. 39 [11 AFTR 2d 758] (1963).


Sas and Jones may only deduct the legal fees as miscellaneous itemized deductions subject to the 2 percent limitation in §67(a) rather than under either §62(a)(20) or §162. The miscellaneous itemized deduction also results in alternative minimum tax of $12,888 for tax year 2011, which is a computational adjustment.

Engineering note: Manhole covers are generally cast iron weighing more than 100 lbs.

Why are they round? The answer depends upon your perspective. Utility workers desire round manhole covers so that they do not fall into its own hole that it covers (i.e., it does not fall within itself). If they were square the diagonal would be larger than a side, resulting in the covers being able to fall into the opening. For anyone, a heavy manhole cover is easier to move if its round. Mechanical engineers may say the round covers are easier to manufacture. Advanced mathematicians may argue the manhole covers could be “Reuleaux Polygons,”42 which are shapes of constant width whose boundaries are formed by finitely many circular arcs of equal length. More commonly, the constant width of these shapes allows their use as coins that can be used in coin-operated machines. The United Kingdom has minted seven sided 20 and 50 pence coins in the shape of a Reuleaux heptagon. The Canadian Loonie dollar coin is also a Reuleaux polygon, with 11 sides. The rotary engine found in certain automobiles is a design based upon a Reuleaux triangle. Regardless, in this case, Sas’ argument fell within itself, as §62(a)(20) allows a deduction for legal fees when a recovery constitutes taxable income. There is no taxable recovery component in this case; hence, the application of §62(a)(20) is moot.

V. Adjustments to income

A. Failing alimony’s same household requirement (#14)

1. Practitioner error in noting addresses of taxpayers

Practitioners routinely prepare income tax returns for divorced individuals. Assume the following scenario:

a. 2014, typical client, Married filing Jointly.

b. 2015, clients complete divorce calling for $50,000 alimony from taxpayer to ex-spouse. Clients move to separate households and file as single taxpayers. Alimony of $50,000 deducted by taxpayer; included by ex-spouse.

42 Named for Franz Reuleaux (1829 - 1905), mechanical engineer, known as the “father of kinematics.”

Taxpayer Spouse

Taxpayer 125 Main

Street ($50,000)

Ex-Spouse 250 Walnut

Street +$50,000


c. 2016, for sake of the children, taxpayer and ex-spouse move into the same household. Continue filing as single taxpayers, keeping all income and expenses separated. Alimony of $50,000 deducted by taxpayer; included by ex-spouse.

2. The law Code Section 71(a)(3) provides that the husband and wife must be separated and living apart when the support payments are made before the payments will be considered alimony includible in the ex-spouse’s gross income and deductible by the taxpayer. To satisfy the “separated and living apart” requirement of §71(a)(3), each former spouse must live in separate residences. The relevant Treasury regulations specify that §71(a)(3) applies only where husband and wife “are separated and living apart.”43 In Lyddan v. U.S.,44 the second Circuit Court found the phrase requires a geographical separation and means living in separate residences. Accordingly, even if the former spouses used separate bedrooms when they both lived at the same residence, they are not separated during those times for purposes of §71(a)(3).

3. Could this error occur at your office?

Unfortunately, the above scenario has occurred with practitioners reporting the issue incorrectly in many multiple cases. With the two parties keeping their finances separately, they may very likely engage different tax practitioners. However, it has also been reported that offices preparing BOTH returns failed to note the common address and, in following how the return was prepared in the prior year, deducted alimony paid and included income by the recipient while they resided in the same household. The situation has also been “discovered” in a subsequent year, many times by a different (new) practitioner; assume the scenario continued as:

d. 2017, taxpayer and ex-spouse again just cannot live in the same household, and possibly for the sake of the children again reside in separate households, filing as single taxpayers. Alimony of $50,000 deducted by taxpayer; included by ex-spouse. Ex-spouse does not trust taxpayer’s practitioner, and engages a new professional. Such new preparer, in gleaning knowledge of the client, discovers the prior year alimony was included in ex-spouse’s income.

Practice question: This is based upon a true case

Your office is preparing the 2017 tax return for one of the above single taxpayers. You “discover” that while living in the same household in 2016, the alimony was improperly deducted by the payor and included in income by the recipient. What is your action? Amend, call the prior practitioner to have them amend, let sleeping dogs lie? There is not one correct answer, but doing nothing is not an option.

43 Treas. Regs. §1.71-1(b)(3)(i). 44 Lyddan v. U.S., 52 AFTR 2d 83-6254, (CA2), 11/01/1983.

Taxpayer 375 East

Street ($50,000)

Ex-Spouse 375 East

Street +$50,000


4. Solution -- Know your client The anatomy of an effective and efficient tax return begins prior to vouching numbers, reviewing diagnostics, or researching tax questions. All effective and efficient returns start with knowledge of the taxpayer. Practitioners must glean knowledge of the client from copies of prior year returns, an organizer, a personal interview, discussion or review of related parties, or business connections. A solution to this error would be the questioning of either party in an alimony situation: Do you or have you lived in the same household as the person paying or receiving the alimony?

B. Getting the “last word” on divorce agreement sinks a deduction (#15)45

1. Income, deductions, and dollar amounts are important to taxpayers

Mark Quintal filed Federal income tax returns for the taxable years 2011, 2012, and 2013, and on each return, he claimed a deduction of $46,800 for alimony paid to his ex-spouse, Ms. Gramlich-Quintal. Ms. Gramlich-Quintal, however, did not report the payments as income on her tax returns. The couple separated and divorced in 2010. The parties executed a separation and property settlement agreement (separation agreement), which included Exhibits A through M which were incorporated in the separation agreement by reference. The separation agreement stated that the children “are still principally dependent upon the parties for support and entitled to such.” Before the separation agreement was executed, the parties engaged in last-minute negotiations, and several of the exhibits were substantially revised manually. In some instances, entire paragraphs of an exhibit were lined through and replaced with handwritten statements.

Discussion note:

“Replaced with handwritten statements?” Watch-out -- Why are manhole covers round?

Exhibit B, originally titled "ALIMONY", was revised to read “Unallocated Support.” Exhibit B stated in part that Quintal would pay to the former spouse:

“…the sum of $900.00 per week commencing forthwith by implemented wage assignment. (See Exhibit J)” and that “any alimony payments shall terminate” upon the earlier of the death of Quintal or Ms. Gramlich-Quintal or the latter’s remarriage.

Exhibit B further stated that the parties:

“…acknowledge that husband anticipates that the above payment is deductible to him and includable to wife.”

Exhibit J was titled “CUSTODY, SUPPORT, VISITATION.” Although Exhibit J originally referred to Quintal’s obligation to make child support payments, that statement was lined through and was replaced with the phrase:

45 Mark A. Quintal v. Commissioner, TC Summary Opinion 2017- 3, Feb. 2, 2017.


“See Exhibit B implemented wage assignment forthwith.” Exhibit J further included the following two items:

Support as to the child as termed in this agreement shall end upon emancipation… The Husband and Wife expressly agree to designate and hereby do designate all payments required in this Exhibit as excludable and non-deductible payments for purposes of Sections 71 and 215 of the Code, respectively.

2. Words are important to lawyers and judges

Section 71(a) provides the general rule that gross income includes amounts received as alimony or separate maintenance payments. Section 215(a) allows a deduction to the payor for an amount equal to the alimony paid during the taxable year to the extent it is includable in the recipient spouse’s gross income under §71(a). Whether a payment constitutes alimony is determined by reference to §71(b)(1), which defines “alimony” as any cash payment if:

(A) Such payment is received by (or on behalf of) a spouse under a divorce or separation instrument;

(B) The divorce or separation instrument does not designate such payment as a payment that is not includable in gross income under §71 and not allowable as a deduction under §215;

(C) In the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made; and

(D) There is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.46

Section 71(c)(1) provides the general rule that the inclusion of alimony as income shall not apply to that part of any payment which the terms of the divorce or separation instrument fix (in terms of an amount of money or a part of the payment) as a sum which is payable for the support of children of the payor spouse. Under §71(c)(2), however, if any amount specified in the divorce instrument “will be reduced” on the happening of a contingency specified in the instrument that relates to a child of the payor spouse, then an amount equal to the amount that “will be reduced” is treated as fixed as a sum payable for the support of the children of the payor spouse. Events that relate to a child of the payor spouse include the child’s attaining a specified age or income level, dying, marrying, leaving school, leaving the payee spouse’s household, or gaining employment. The IRS concedes that Quintal's support payments to Ms. Gramlich-Quintal satisfy §71(b)(1) items noted above as requirements (A), (C). and (D).

46 I.R.C. §71(b)(1).


However, they gave a thorough examination of §71(b)(1)(B) [item (B) as noted above], to determine if Quintal’s payments do not constitute alimony because, Exhibit J designated all payments required (in this Exhibit) as excludable and non-deductible payments for purposes of §71 and §215 of the Code, respectively.

3. Eager carelessness

Quintal relies on Exhibit B of the separation agreement, which expressly provides for “unallocated support” payments, as opposed to alimony or child support payments. He noted that, although the separation agreement stated that the children are still principally dependent upon the parties for support and entitled to such, that Exhibit J does not expressly require any form of payment.

Practice note: Intent is disregarded

Quintal did assert that the parties’ last-minute negotiations and revisions to the separation agreement were intended to ensure that the disputed payments would be treated as alimony for purposes of §71 and §215. However, unfortunately for Quintal, the IRS must disregard the intent regarding the characterization of the disputed payments. Congress eliminated any consideration of intent in determining the deductibility of a payment as alimony in favor of a more straightforward, objective test that rests entirely on the fulfillment of explicit requirements set forth in §71.47

The Court therefore focused on the requirement in §71(b)(1)(B) that the settlement agreement not state that the payment is neither includible in gross income nor allowable as a deduction. They acknowledge, as Quintal contends, that Exhibit J does not expressly require any payment or otherwise fix an amount to be paid. However, his narrow focus on Exhibit J gives no effect to the cross-references in both Exhibit B and Exhibit J. As the Court sees, a proper consideration of the separation agreement requires a construction of the document as a whole, including the exhibits and the cross-references within the Exhibits. In reading the separation agreement as a whole, the Court concludes that Exhibit B and Exhibit J must be read in tandem and that the unallocated support payments prescribed in Exhibit B are subject to the provisions of both that Exhibit and Exhibit J. In this regard, the handwritten revisions to the settlement agreement were poorly conceived. Specifically, although Exhibit B was revised to state that the parties “acknowledge that husband anticipates that the unallocated support payment is deductible to him and includable to wife” (emphasis added), Exhibit J states more definitively: “In accordance with §71(b)(1)(B) of the Code, the Husband and Wife expressly agree to designate and hereby do designate all payments required in this Exhibit as excludable and non-deductible payments for purposes of §71 and §215 of the Code, respectively.” The Court concludes that the latter, more definitive statement controls in this case. The IRS determined that Quintal is liable for a Federal income tax deficiency of $15,210 and an accuracy-related penalty under §6662(a) of $3,042 for each of the taxable years 2011, 2012, and 2013 (years in issue).

47 See Okerson v. Commissioner, 123 T.C. 258, 264-265 (2004) (citing Hoover v. Commissioner, 102 F.3d 842, 844-845 [78

AFTR 2d 96-7589] (6th Cir.1996), aff'g T.C. Memo. 1995-183).


Practice note: Sometimes you need more deliberation and less speed

With just a little focus and hindsight, one can see what was done at the last minute, by hand written entries. The Exhibit B title was changed from “ALIMONY” to “UNALLOCATED SUPPORT.” Exhibit J originally referred to child support payments, only to be replaced with a reference to the wage assignment on Exhibit B. The Court, in reading the document as a whole, concluded along this phraseology, beginning in Exhibit B, which is NOT alimony, with …UNALLOCATED SUPPORT… the sum of $900.00 per week commencing forthwith by implemented wage assignment. (See Exhibit J) …(continuing in Exhibit J due to the cross reference)… Husband and Wife expressly agree to designate and hereby do designate all payments required in this Exhibit as excludable and non-deductible payments for purposes of Sections 71 and 215 of the Code, respectively. In being brought before the bar of justice, this last-minute correction looks to have cost Quintal about $55,000. But one must add to that total the lost alimony deductions of future years.

VI. Itemized deductions

A. Would $37,000 unsubstantiated non-cash charitable contributions be noticed? (#16)48

1. Not too much of a stretch here, the IRS disallowed all non-cash donations

Kenneth and Susan Kunkel (taxpayers) claimed a charitable contribution deduction of $42,455. Of this amount, $5,140 represented alleged cash contributions. This case focused on taxpayers’ claimed deduction of $37,315 for noncash charitable contributions, which the IRS disallowed in its entirety. Taxpayers contend that they donated property to four charitable organizations: the Upper Dublin Lutheran Church (Church), Goodwill Industries (Goodwill), the Military Order of the Purple Heart Service Foundation (Purple Heart), and Vietnam Veterans of America (Vietnam Veterans).

• Taxpayers’ noncash contributions to the Church consisted of items they allegedly donated to its annual flea market. These items included books valued at $8,000, household items valued at $1,303, clothing valued at $1,000, toys valued at $822, telescopes valued at $800, jewelry valued at $780, and household furniture valued at $410, for a total of $13,115. o Taxpayers did not produce a receipt or an acknowledgment from the Church for

their donations of any of these items. The Church was evidently equipped to provide such receipts, because taxpayers claimed to have a receipt from the Church for their contributions to another flea market.

o Taxpayers produced no evidence, such as photographs, that any of the listed items were actually delivered to the Church.

• Taxpayers’ noncash contributions to Goodwill, Purple Heart, and Vietnam Veterans allegedly consisted of clothing valued at $20,920, household furniture valued at $2,680, household items valued at $350, and toys valued at $250, for a total of $24,200. o Taxpayers produced no documentary evidence, and had no recollection, as to

which items were donated to which charity.

48 Kenneth J. Kunkel, et ux. v. Commissioner, TC Memo 2015-71; April 8, 2015.


• For Goodwill, taxpayers testified that they took batches of items at various times to a Goodwill location. o They generally made these trips in the early morning or evening, when the

Goodwill warehouse was unattended. They placed soft goods in large bins intended for after-hours drop-offs. They left large items, such as furniture, outside the warehouse door.

o Taxpayers testified that they were careful to ensure that the items in each batch were worth less than $250 because they thought this eliminated the need to get receipts.

• For Purple Heart and Vietnam Veterans, taxpayers allegedly scheduled a pickup and left the items outside their house. o The charity sent a truck to pick up the items, generally while taxpayers were

away, and usually left a doorknob hanger saying, “Thank you for your contribution.” These doorknob hangers contained no other information. They were undated; they were not specific to taxpayers; and they did not list or describe the property contributed.

Taxpayers testified that they created index cards recording the items as they were delivered to Goodwill or left for pickup by Purple Heart or Vietnam Veterans. Taxpayers later aggregated this information into a master list.

• Taxpayers did not introduce into evidence the index cards they allegedly prepared or any other contemporaneous records supporting their contention that they made the alleged gifts.

• They supplied no evidence concerning their cost bases in these items or the manner in which they determined fair market values.

2. The law for donations Section 170 allows as a deduction any contribution made within the taxable year to a charitable organization but such deductions are allowed only if the taxpayer satisfies statutory and regulatory substantiation requirements. The nature of the required substantiation depends on the size of the contribution and on whether it is a gift of cash or property.

a. For all contributions of $250 or more, the taxpayer generally must obtain a contemporaneous written acknowledgment from the donee. Separate contributions of less than $250 are not subject to the requirements of §170(f)(8), regardless of whether the sum of the contributions made by a taxpayer to a donee organization during a taxable year equals $250 or more. (i) Additional substantiation requirements are imposed for contributions of property

with a claimed value exceeding $500. (ii) Still more rigorous substantiation requirements, including the need for a “qualified

appraisal,” are imposed for contributions of property with a claimed value exceeding $5,000.

(iii) Similar items of property must be aggregated in determining whether gifts exceed the $500 and $5,000 thresholds. The term similar items of property is defined to mean property of the same generic category or type, such as clothing, jewelry, furniture, electronic equipment, household appliances, or kitchenware.

b. An individual may deduct a gift of $250 or more only if he or she substantiates the deduction with “a contemporaneous written acknowledgment” of the contribution by the


donee organization.49 This acknowledgment must: (1) include “a description (but not value) of any property other than cash contributed;” (2) state whether the donee provided any goods or services in exchange for the gift; and (3) if the donee did provide goods or services, include a description and good-faith estimate of their value.50 The acknowledgment is “contemporaneous” if the taxpayer obtains it from the donee on or before the earlier of: (1) the date the taxpayer files a return for the year of contribution; or (2) the due date, including extensions, for filing that return.51

c. For non-cash contributions in excess of $500, taxpayers are also required to maintain additional reliable written records with respect to each item of donated property.52 These records must include, among other things: (1) the approximate date the property was acquired and the manner of its acquisition; (2) a description of the property in detail reasonable under the circumstances; (3) the cost or other basis of the property; (4) the fair market value of the property at the time it was contributed; and (5) the method used in determining its fair market value.53 Taxpayers allegedly made noncash contributions to four different charities of seven categories of items, each with a claimed value exceeding $500. But they did not maintain written records establishing when or how these items were acquired or what their cost bases were. Nor did taxpayers maintain written records establishing how they calculated the items’ fair market value.

Note:

For contributions of property (other than publicly traded securities) or similar items of property valued over $5,000, the taxpayer must generally satisfy the substantiation requirements discussed above and must also: (1) obtain a “qualified appraisal” of the items; and (2) attach to his or her tax return a fully completed appraisal summary. Taxpayers did not obtain a qualified appraisal for any of the items and did not a fully complete an appraisal summary to their tax return. Thus, they failed to satisfy the substantiation requirements for their claimed contributions of clothing ($21,920) and books ($8,000).

3. Are door-hanger receipts satisfactory?

a. Taxpayers did not provide a “contemporaneous written acknowledgment” from any of the four charitable organizations. Taxpayers produced no acknowledgment of any kind from the Church or Goodwill. And the doorknob hangers left by the truck drivers from Vietnam Veterans and Purple Heart clearly do not satisfy the regulatory requirements. These doorknob hangers are undated; they are not specific to taxpayers; they do not describe the property contributed; and they contain none of the other required information.

b. Taxpayers were required to obtain, but did not obtain, contemporaneous written acknowledgments for their contributions of property. Their claimed deductions must be denied for lack of substantiation.

c. No deduction is allowed for any contribution of clothing or a household item unless such property is “in good used condition or better.”54 The term household items includes furniture, furnishings, electronics, appliances, linens, and other similar items.55 Most of the items taxpayers allegedly donated consisted of clothing and household items. They failed to present credible evidence that these items were in good used condition or better, and

49 I.R.C. §170(f)(8)(A). 50 I.R.C. §170(f)(8)(B); Treas. Regs. §1.170A-13(f)(2). 51 I.R.C. §170(f)(8)(C). 52 Treas. Regs. § 1.170A-13(b)(2) and (3); see Gaerttner v. Commissioner, T.C. Memo. 2012-43. 53 I.R.C. §170(f)(11)(B); Treas. Regs. §§1.170A-13(b)(2)(ii)(C) and (D), (3)(i)(A) and (B). 54 I.R.C. §170(f)(16)(A). 55 I.R.C. §170(f)(16)(D).


they did not furnish a qualified appraisal with their return.56 For all these reasons, taxpayers have not satisfied the substantiation requirements for donations of property valued over $500.

4. Are written acknowledgements necessary if the donated items are less than $250?

Taxpayers contend that they did not need to get written acknowledgments because they made all of their contributions in batches worth less than $250. Taxpayers allegedly donated property worth $13,115 to the Church; this donation occurred in conjunction with a single event, the Church’s annual flea market. Taxpayers’ testimony was that they intentionally made all other contributions in batches worth less than $250 and requires the assumption that they made these donations, with an alleged value of $24,200, on 97 distinct occasions. This assumption is implausible.

Practice note: For the client who pushes the “non-cash” contribution envelope

Even if taxpayers could be excused from the “contemporaneous written acknowledgment” requirement on the theory that they made all gifts in batches worth less than $250, they were still required to maintain records to document their donations, which generally must include receipts from the donees.57 Receipts are not required where a contribution is made in circumstances where it is impractical to obtain a receipt (e.g., by depositing property at a charity’s unattended drop site). In that event, however, the taxpayer shall maintain reliable written records with respect to each item of donated property, including the name of the donee, the date and location of the contribution, a description of the property, and the method used to determine its fair market value.58 If it was impractical for taxpayers to obtain receipts from Goodwill or the truck drivers who picked up their goods, they nevertheless failed to keep reliable written records because they did not record the dates of any of their contributions; they did not record which items were donated to which charity; and they did not record how they determined the fair market value of any items.

VII. Other selected planning issues

A. Do not let your children grow up to be lying, drug dealing, tax cheats (#17)59

1. Let them be doctors and lawyers and tax professionals and such…

For all of 2012, Smyth’s adult son, his wife, and their two young children, who were then 2 and 4 years old, lived with Smyth in her home. The children are Smyth’s grandchildren. Smyth’s job is hard, and it does not pay much. But with her wages and Social Security benefits, Smyth had a higher adjusted gross income than either her son or his wife. She provided all the financial support for the household because her son “did not work, and he was into dealing drugs” while his wife “stayed home and took care of the babies.” Smyth claimed the two grandchildren as her dependents after her son told her that he and his wife were not going to file. All seemed well until Smyth received a notice of deficiency from the IRS that increased her tax by more than $5,000 and determined a penalty of another $1,000. The notice told her that the IRS had decided that the grandchildren were not her “qualifying children.”

56 See I.R.C. §170(f)(16)(C) (exception where “qualified appraisal” is supplied). 57 Treas. Regs. §1.170A-13(b)(1). 58 Treas. Regs. §1.170A-13(b)(2). 59 Grisel A. Smyth v. Commissioner, TC Memo 2017-29, Feb. 7, 2017.


The IRS determined that the son was not truthful to his mother, as the son and his wife, the children’s parents, claimed them on their on their joint return.60 In trying to help his mother’s case, the son did prepare an amended return, delivered to the Commissioner’s counsel two weeks before trial.

Practice note: Qualifying children tax advantages can add up

“Qualifying children” is a phrase in tax law that has a very specific meaning, and if a taxpayer like Smyth does not have “qualifying children,” it means that she does not get dependency exemption deductions, child tax credits, or earned-income credits, and cannot even use the head-of-household filing status. There is, however, a catch -- a taxpayer can claim these benefits only if the “child” is a “qualifying child,” which is a simple idea in life, but in law is elaborately defined. In this case, due to the above benefits, Smyth claimed $0 tax, requesting a refund of $2,900 in tax withheld plus $2,400 in refundable credits, for a total refund of approximately $5,300. In addition to coordinating for a non-duplication of the dependency deduction, this case screams for proper dependency planning. Although not mentioned in the case, the son’s joint return with a non-working spouse very well may have been prepared only to claim an Earned Income Tax Credit. The EITC varies based on income and family size, but for the year in question if the net tax savings to the son was less than the $5,000 added tax to Smyth’s return,61 the dependency deductions could have been reviewed to determine a maximum benefit. The fact that the son amended the return indicates his tax benefit was much less than $5,000. The same family tax planning is present in non-EITC cases. Coordinating the dependency deduction and the American Opportunity Credit is another. Practitioners may assist a family in finding the best tax benefit in the case of high income parents phased-out of education credits, or middle income families with college seniors who generate earnings after a mid-year graduation.

2. Qualifying children and tiebreaker

Most people would think they know what a “child” is, but in tax law having a “child” is not enough -- the little one must be a “qualifying child.” To be a taxpayer’s “qualifying child” he or she must:

• Bear a certain relationship to the taxpayer, including child or grandchild; • Share a home with the taxpayer for more than half of the tax year; • Be less than 19 years old; • Not provide more than half of his or her own support; and • Not file a joint return.

The Code, however, lets only one person claim each “qualifying child” each year. Smyth’s grandchildren are also the “qualifying children” of their parents, Smyth’s son and his wife. And that is the problem here. Congress predicted that there would be some families where more than one person could say a child was their “qualifying child,” so the Code has tie-breaking rules. Under this rule, generally the parents get to claim the children.

a. In general, if (but for these tie-breakers) an individual may be and is claimed as a qualifying child by two or more taxpayers for a taxable year beginning in the same calendar year, such individual is treated as the qualifying child of the taxpayer who is a parent of the individual, or where the parent is not one of the taxpayers who may claim

60 The cases of duplicate taxpayer identification number (DUP TIN program); are systemically processed using Automated

Correspondence Exam (ACE) processing. 61 For the year in question, the maximum credit with two qualifying children was $5,236.


the individual as a qualifying child, the taxpayer with the highest adjusted gross income for such taxable year.62

b. If the parents claiming any qualifying child do not file a joint return together, such child shall be treated as the qualifying child of: (i) the parent with whom the child resided for the longest period of time during the taxable year; or (ii) if the child resides with both parents for the same amount of time during such taxable year, the parent with the highest adjusted gross income.63

c. If a child would be a qualifying child with respect to more than one individual (e.g., a child lives with his or her mother and grandmother in the same residence) and more than one person claims a benefit with respect to that child, then the following “tie-breaking” rules apply. First, if only one of the individuals claiming the child as a qualifying child is the child’s parent, the child is deemed the qualifying child of the parent. Second, if both parents claim the child and the parents do not file a joint return, then the child is deemed a qualifying child first with respect to the parent with whom the child resides for the longest period of time, and second with respect to the parent with the highest adjusted gross income. Third, if the child’s parents do not claim the child, then the child is deemed a qualifying child with respect to the claimant if that taxpayer has a higher adjusted gross income than either parent.

Example: J is A’s daughter and B’s granddaughter (A is B’s daughter) and is a qualifying

child for A and B, living in the same residence with them (B’s residence). Since A is J’s parent, A can claim J as a qualifying child. Should A not claim J, B may be allowed to claim J, provided B’s adjusted gross income is greater than A’s (J’s parent).

3. Busted! Caught in a Code section specific trap

Smyth argues that the IRS is wrong for two reasons. The first is that Smyth’s son and his wife never filed an original return. The second is that, even if he and his wife did file an original return, they also filed an amended return before trial in which they released any claim they had to the children. The IRS has a program that automatically flags returns for further investigation if it notices (by searching for duplicate Social Security Numbers) that more than one taxpayer has claimed the same “qualifying child.” It is therefore highly likely that Smyth’s return was chosen for review because her son and his wife had already filed an original return on which they claimed the children. Smyth also testified that her son admitted he filed a return in order to get the refund “for his drugs,” and prepared an amended return presumably to correct his previously filed original return. Both support our finding that Smyth’s son and his wife filed an original 2012 return. Smyth’s son offered to support his mother’s case and even went so far as to prepare an amended return that deleted his claim for the children as his dependents. A copy of this amended return was given to the Commissioner’s counsel two weeks before trial. Does this constitute the “filing” of a return? The Code does not define the word “file,” but §6091 helps. That section says that a taxpayer must file an income tax return in the internal revenue district where they reside or at the service center for that same district. Most taxpayers also have to file any amended return with the correct service center. Regulations under §1.6091-2(e)(1), indicate a taxpayer who wants to file an amended return does not have to mail it

62 I.R.C. §152(c)(4)(A). 63 I.R.C. §152(c)(4)(B).


to the IRS. He or she can hand carry it and turn it in to “any person assigned the responsibility to receive hand-carried returns in the local Internal Revenue Service office.” It is undisputed that Smyth’s son and his wife prepared an amended return. Smyth claims that they “filed” this amended return when a copy was delivered by their return preparer to the Commissioner’s counsel. However, “’hand delivery of a return to counsel for respondent does not constitute the filing of that return.”64 Here, the problem is that the Commissioner’s counsel is neither the service center that serves taxpayers living in El Paso nor a person that the IRS has assigned to receive returns for the local IRS office. Therefore, we have to find that the amended return was not properly “filed” and cannot be the basis for a claim that Smyth’s son and his wife gave up their right to claim the children as their “qualifying children.” That means that under the tie-breaker rules they, and not Smyth, get to claim the children.

Practice note: “What if” the amended return was properly filed?

A few cases imply that an amended return could under the right circumstances be used to give up a previously claimed dependency exemption deduction. In Brooks,65 the Court suggested that if the taxpayer’s daughter had prepared an amended return releasing her claim before the IRS started auditing her mother and had filed it with the IRS before trial, then the court might have reached a different result. In McBride,66 the Court suggested that a grandfather might be entitled to a dependency exemption deduction for his grandchild if the child’s mother had correctly filed an amended return giving up her claim before the IRS was barred from determining a deficiency against her. In wrapping up the Smyth case, the Court also noted that the Commissioner points out in his brief that allowing a taxpayer to amend his return-and essentially give his dependency exemption deduction to another-after he has already received a refund because of that deduction effectively puts the IRS in an unmanageable situation. We do not have to decide this question now, but will have to think about it carefully when someone in a case like this one actually files an amended return to give up a qualifying-child claim. Practitioners who properly advance plan will eliminate the need for amending in hindsight.

4. A compassionate yet incapable court

The Court was sympathetic to Smyth’s position. She provided all of the financial support for the children, had been told by her son that she should claim the children as her dependents, and is now stuck with a hefty tax bill. “It is difficult for us to explain to a hardworking taxpayer like Smyth why this should be so, except to say that we are bound by the law. And it is impossible for us to convince ourselves that the result we reach today -- that the IRS was right to send money meant to help those who care for small children to someone who spent it on drugs instead -- is in any way just. Except for the theory of justice that requires a judge to follow the law as it is but explain his decision in writing so that those responsible for changing it might notice.”

64 Quarterman v. Commissioner, T.C. Memo. 2004-241. 65 Brooks v. Commissioner, T.C. Memo. 2013-141. 66 McBride, v. Commissioner, T.C. Memo. 2015-6.


VIII. Getting caught watching the paint dry -- Failing to look at Emerging Issues (#18)

A. Future State Initiative

Ticking away the moments that make up a dull day Waiting for someone or something to show you the way.67

The IRS “Future State” changes underway and those being considered will not be completed overnight. These changes are all part of improving IRS operations to better serve taxpayers and support the nation’s tax system. In December 2016, the first step toward a fully functional IRS online account was launched within an application on IRS.gov that provides information to taxpayers who have straightforward balance inquiries. This new feature allows taxpayers to view their IRS account balance, including the amount they owe for tax, penalties, and interest, in a secure, easy, and convenient way. Soon, we will add another feature that will let taxpayers see recent payments posted to their account. These balance-due and recent-payment features, when paired with existing online payment options, will increase the availability of self-service interactions with the IRS. This is just the first step, but an important one. Over time, the IRS will be adding other features to this platform as they are developed and tested with taxpayers and tax professionals. One such service improvement is Taxpayer Digital Communications. This feature, now being tested, provides a secure online messaging capability so that taxpayers, their authorized representatives, and IRS employees can correspond electronically and resolve issues more quickly than through traditional mail. Practitioners must monitor the initiative and public feedback on these efforts to maintain a tacit understanding of how their offices and engagements may operate in the future.

1. Think ahead or fall behind. Time will slip by, don’t wait until it’s too late

The IRS continues to take advantage of changing technology to enhance taxpayer experience. Practitioners should bear close examination of how the IRS plans to evolve, and consider evolving with them. Investing in technology, human resources, physical resources, and so on, practitioners should take precaution not to wait until it is too late. Preparing the IRS to adapt to the changing needs of taxpayers is described generally as the IRS “Future State” Initiative. The IRS Future State efforts continue to evolve, receiving and evaluating feedback from many sources to help improve tax administration in a rapidly progressing world. The exact brew that finally emerges from the fiery cauldrons of the IRS “Future State” will encompass some of the following aspects.

2. The taxpayer component -- Virtual Taxpayer Assistance Taxpayers should expect the same level of service when dealing with the IRS in the future as they have now from their financial institution or a retailer. The idea is that taxpayers would have an account at the IRS where they, or those they authorize, can log in securely, get the information about their account, and interact with the IRS as needed.

67 Waters, Roger; Gilmour, David; Mason, Nick; Wright, Richard. “Time.” Lyrics. The Dark Side of the Moon. Pink Floyd

Music Publishers Ltd., September 1972 – January 1973.


By reaching the taxpayer through their mobile smart-phone, laptop computer, or a self-service kiosk, taxpayers would be empowered with the ability to take more active control of their tax account.

Practice note:

This approach also has a goal of freeing up limited IRS in-person resources -- such as phone lines -- to more easily serve people and tax professionals who need one-on-one assistance. This personal assistance remains a critical part of any IRS Future State; however they envision IRS employees having quicker digital communication with taxpayers rather than land telephone line and snail mail.

Example 1: Jamie forgets to include something on his original return. Currently, he must

prepare an amended return on a paper form and mail it to the IRS. The settlement of the matter may take several months or even a year.

In the future Whether Jamie recognizes an issue OR the IRS detects it later, Jamie’s preferred communication channel could be used to alert him to access his account and provide the information he needs to resolve the issue. Jamie or his representative would access the online information needed to properly complete or correct his return, including information that shows him how the tax law applies to his circumstances. Jamie could digitally correct his account, upload supporting documents, and authorize tax payment or direct deposit of a refund to his bank account or card. Through the same communications channel, the IRS would send Jamie a clear message letting him know they received his information, and his account reflects the resolution.

Example 2: As the owner of a growing small business, Matthew has just moved his offices,

changed his tax representative, and hired a new finance manager. Rapid growth and change has made it harder to manage his taxes and stay current with new tax issues. Currently Matthew hires competent representatives, or obtains answers to his questions by visiting a Taxpayer Assistance Center, calling the IRS Help line, or falling onto a black hole by exchanging letters with the IRS.

In the future

Matthew could create an online account from his mobile device or computer. Through this virtual tool, he would be able to file his estimated payroll taxes, figure out how to set up pensions for his employees and get information on the new health care law. Or, he could authorize his finance and human resources managers and/or his competent tax representative to manage part or all of the company’s tax data and account history. Just as Matthew can do his banking online, through ATM’s, or through a branch office; he, his colleagues, and his representatives could do the same with IRS online, through a virtual visit, or via an automated or assisted phone call.


Questions to Ponder:

The above examples included with the IRS “Future State” Initiative indicate the IRS will desire to save time, money, resources all their ancillary costs (which could include professional costs) by digitally communicating directly with the taxpayer. Before moving to Other Components of the “Future State” Initiative, the following questions and Note Box are provided for review purposes. Why do practitioners prefer clients not directly correspond with IRS? Can we discourage it? Should we discourage it?


“Thermopylae had its Messenger of Defeat; The Alamo Had None.”

Visitors to the site of The Battle of the Alamo may observe the above quotation as a heading upon The Defense of the Alamo Marker (Official Historic Marker).68 In 480 B.C. upon entering Greece, Xerces massive Persian army was held back at Thermopylae by a small force led by Leonidas. All three hundred legendary Spartan soldiers died holding the pass. Other Greek soldiers nearby, not engaged in the battle, survived and returned to report of the heroic stand. In 1836, at the Siege of the Alamo, all defenders were killed, leaving no combatant messenger to document the battle. Historically and continuing into the future, practitioners have and should remind their clientele that the best chance for victory is having a practitioner as their professional messenger. It has always been a sound practice for practitioners to represent clients before the IRS, and in the emerging world of on-line accounts and communication via mobile devices, it may be in the clients’ best interest to let the professionals handle correspondence. The above example of Jamie corresponding directly with IRS via an online account to provide information, digitally correct his account, or upload supporting documents, screams for a professional messenger, or at least a professional filter. Why do we prefer clients not directly correspond with the IRS? In short, they may say the wrong thing. Cases in point: • Taxpayers who have informed the IRS, “I only drive my car from home to work,

and then from work to home, therefore all my mileage is business related.” • In defending the number of hours in a real estate professional case, a taxpayer

noted: Overbilling was common among computer consultants in her position, and their accounting for hours worked included “billing for hours not really worked.”69

• The highly educated college professor who explained that individuals holding such degrees bear a lifelong burden of “developing knowledge, finding knowledge, exploring, [and] essentially self-educating.” Therefore, 100 percent of his home Internet expenses, cellular phone expenses, computer equipment expenses, professional library, and satellite television expenses are allowable expenses.70

• Clients who have voluntarily provided information to the IRS which is utilized to prove willfulness.

• Clients who have failed to recognize the severity of their situation, and communicated with the IRS in a potential criminal investigation prior to engaging outside qualified legal advisors.

Practitioners should not be remiss in reminding clients of our need to perform or monitor ALL communications with the IRS. “Remember the Alamo” and “Don’t shoot the Messenger!”

3. Other components of the “Future State” Initiative

The IRS is thinking about the entire taxpayer service and enforcement mission in new ways -- in a transformative way that will be cost-effective for taxpayers.

• Tax Exempt/Government Entities has many initiatives underway, including a Lean Six Sigma review of determination letter processes in Exempt Organizations and Employee Plans and developing web-based solutions for taxpayer service and outreach.

68 Marker is at or near this postal address: 300 Alamo Plaza, San Antonio, TX 78205. 69 Hanna v. Commissioner; T.C. Summ. Op. 2006-57. 70 Tanzi v. Commissioner, T.C. Memo 2016-148.


• Wage & Investment has been steadily moving toward the Future State, taking advantage of long-term planning, engagement, and collaboration.

• Small Business/Self-Employed is looking to find better and more efficient ways of doing business, including using technology to transform taxpayer service and enforcement.

• Large Business & International has several efforts underway to support a flexible and well-trained workforce, select better work, tailor work streams to achieve compliance outcomes and to promote innovation and feedback-based improvement.

• Security Summit -- Tax industry and state tax authorities have joined with the IRS to implement several initiatives to combat identity theft and refund fraud.

• Taxpayer Assistance Center (TAC) appointment test -- Allows taxpayers to schedule appointments at TACs.

• Web-first service strategy -- Provides taxpayers with immediate options to get tax information and automated services online, which allows customer-facing employees to help more taxpayers who need person-to-person assistance.

• Compliance realignment -- Realigned organizations inside the IRS mean that most post-filing compliance activities now reside within Small Business/Self-Employed and most pre-refund compliance activities and pre-/post-refund Earned Income Tax Credit activities are worked within Wage & Investment.

• Identity Theft Victim Assistance Directorate -- Centralizes the identity theft victim assistance work and provides end-to-end accountability, all with the goal of helping taxpayers to receive timely and consistent help in resolving their cases.

• The Enterprise eRecords Management Team is working to develop IRS policies, procedures, and IT solutions for electronic records management and archiving (including e-mail). The team has made progress toward implementing a Service wide electronic records management process.

Practice note: Security concerns of Virtual Taxpayer Assistance

Given the current era of data breaches and identity theft, proceeding with the Future State plans will be postponed until an absolute protection of taxpayers’ private information is developed and tested. Additional hurdles include a confirmation process that online interactions are with the right person. Practitioners should envision account names, numbers, passwords, security questions, and real-time verification procedures.

B. Private tax debt collection (#19)

1. Fiction is the truth inside the lie71 Unfortunately accounting and tax practitioners, financial institutions, and the IRS are all being caught in a lie. For decades, we have informed the public that the IRS will not call taxpayers to demand payment. On April 4, 2017,72 the IRS announced the start of its program to use private contractors to collect overdue, largely inactive, tax debts. Affected taxpayers will be sent written notification, followed by phone calls that their accounts are being turned over. Practitioners have encouraged taxpayers to be vigilant against phone and e-mail scams that use the IRS as a lure. We report the IRS does not initiate contact with taxpayers by e-mail to request personal or

71 Stephen King. 72 News Release 2017-74, 04/04/2017.


financial information, including any type of electronic communication, such as text messages and social media channels. The IRS also does not ask for PINs, passwords, or similar confidential access information for credit card, bank, or other financial accounts. Authorized under a federal law enacted by Congress in December 2015, §32102 of the Fixing America’s Surface Transportation Act (FAST Act) requires the IRS to use private collection agencies for the collection of outstanding inactive tax receivables.

2. Authorized collection agencies

The IRS has named four designated contractors to collect, on the government’s behalf, outstanding inactive tax receivables.

• Conserve -- Fairport, New York • Pioneer -- Horseheads, New York • Performant -- Livermore, California • CBE Group -- Cedar Falls, Iowa

If a taxpayer does not wish to work with the assigned private collection agency to settle an overdue tax account, they must submit a request in writing to the private collection agency.

3. Operating ground-rules

The private collectors will be able to identify themselves as contractors of the IRS collecting taxes. Employees of these collection agencies must follow the provisions of the Fair Debt Collection Practices Act, and like IRS employees, must be courteous and must respect taxpayer rights. The private firms are authorized to discuss payment options, including setting up payment agreements with taxpayers. But as with cases assigned to IRS employees, any tax payment must be made, either electronically or by check, to the IRS. A payment should never be sent to the private firm or anyone besides the IRS or the U.S. Treasury. Checks should only be made payable to the United States Treasury. To find out more about available payment options, visit IRS.gov/Payments. Private firms are not authorized to take enforcement actions against taxpayers. Only IRS employees can take these actions, such as filing a notice of Federal Tax Lien or issuing a levy. To learn more about the new private debt collection program, visit the Private Debt Collection page on IRS.gov. The IRS will do everything it can to help taxpayers avoid confusion and understand their rights and tax responsibilities, particularly in light of continual phone scams where callers impersonate IRS agents and request immediate payment. Private collection agencies will not ask for payment on a prepaid debit card. The IRS will not assign accounts to private collection agencies involving taxpayers who are:

• Deceased. • Under the age of 18 • In designated combat zones. • Victims of tax-related identity theft. • Currently under examination, litigation, criminal investigation, or levy. • Subject to pending or active offers in compromise. • Subject to an installment agreement.


• Subject to a right of appeal. • Classified as innocent spouse cases. • In presidentially declared disaster areas and requesting relief from collection.

To make a complaint about a private collection agency or report misconduct by its employees, individuals may call the TIGTA hotline at 800-366-4484 or visit www.tigta.gov or write to:

Treasury Inspector General for Tax Administration Hotline Post Office Box 589 Ben Franklin Station Washington, DC 20044-0589

4. More phone scams may be expected The IRS reminds taxpayers to be on the lookout for scammers posing as private collection firms. The IRS will be watching for these schemes as the collection program begins, and this effort will include working with partners in the tax community and law enforcement about emerging scams. People should remember that these private collection firms will only be calling about a tax debt the person has had -- and has been aware of -- for years and had been contacted about previously in the past by the IRS. If taxpayers are unsure if they have an unpaid tax debt from a previous year -- which is what the private collection firms will handle -- they can go to IRS.gov and check their account balance: www.irs.gov/balancedue. If the account balance says zero, that means nothing is due, and they typically would not be getting a contact from the IRS or the private firm. Here are some things the scammers often do but the IRS and its contractors will never do:

• Call to demand immediate payment using a specific payment method such as a prepaid debit card, gift card, or wire transfer. Generally, the IRS will first mail a bill to any taxpayer who owes taxes, and if a case is assigned to a PCA, both the IRS and the authorized collection agency will send the taxpayer a letter. Payment will always be to the United States Treasury.

• Threaten to immediately bring in local police or other law-enforcement groups to have the taxpayer arrested for not paying.

• Demand that taxes be paid without giving the taxpayer the opportunity to question or appeal the amount owed.

• Ask for credit or debit card numbers over the phone. “Unexpected and threatening calls out of the blue from someone saying they're representing the IRS to collect a tax debt is a warning sign people should watch out for,” Commissioner John Koskinen said.

5. Payment plans

As always, the IRS encourages taxpayers behind on their tax obligations to come forward and either pay what they owe or set up a suitable payment plan. This means there is no need to wait for a phone call or letter from the IRS or any of its contractors. Frequently, taxpayers qualify for one of several payment options, and taking advantage of them is often easier than many people think. These include the following:


• Most people can set up a payment agreement with the IRS online in a matter of minutes. Those who owe $50,000 or less in combined tax, penalties, and interest can use the Online Payment Agreement to set up a monthly payment agreement for up to 72 months.

• Some struggling taxpayers may qualify for an offer-in-compromise. This is an agreement between a taxpayer and the IRS that settles the taxpayer’s tax liabilities for less than the full amount owed.

C. Identity Theft Affidavit for seasoned preparers (and taxpayers) (#20)

1. The Identity Protection PIN (IP PIN)

The PTIN was created in 1999 to protect the privacy of tax return preparers. Prior to the implementation of the PTIN, preparers were required to include their Social Security Numbers on all returns they filed. An example from 1998 follows:

Beginning in 1999, the IRS gave preparers the option of using either their SSNs or PTINs, which has evolved to fully eliminate the Social Security Number requirement. Therefore, preparers signing returns prior to the PTIN introduction have released their personal Social Security Number hundreds if not thousands of times. Such individuals may desire to file Form 14039. An example for a practitioner signing returns (and listing SSN) beginning in 1982 until receipt of a PTIN follows:


2. A sensible part of ID theft defense

To assist in combating identity theft and refund fraud, the IRS has introduced Form 14039, Identity Theft Affidavit. Filers will be issued an identity protection personal identification number (IP PIN) to be included near the signature line of Form 1040. The IP PIN is good for only one year and a new one will be issued as long as the identity theft indicator is on the tax account. Form 14039 is filed by an individual falling into two possible scenarios. First, Section B, Checkbox 1 should be checked by a victim of identity theft whose tax records are affected. Check this box if, for example, if a taxpayers attempt to file electronically was rejected because someone had already filed using the Social Security Number (SSN), ITIN, or the individual received a notice or correspondence from the IRS indicating someone was otherwise using their number. The second group of Form 14039 filers (Section B, Checkbox 2) are individuals who have experienced an event which may affect tax records in the future, such as the misuse of personal identity information to obtain credit. This second category is utilized if personal information is breeched so that it could result in identity theft. Examples include a lost/stolen purse or wallet, home robbery, etc. The IP PIN is a unique six-digit number that a victim of ID theft uses to file a tax return.

Example: Assume a taxpayer received IP PIN 787878. Include the IP PIN on Form 1040, as follows.


Practice note:

Once a taxpayer receives an IP PIN, they may not opt-out of its use. Taxpayers must use the IP PIN to confirm their identity on all federal tax returns they file for the current year and in future tax years.

The IRS launched an IP PIN Pilot program. The program offers residents of Florida, Georgia, and Washington, D.C., the opportunity to apply for an IP PIN, due to high levels of tax-related identity theft there.




D. Failing in advance to protecting taxpayers from increased 1099 penalties (#21)

1. Trade Preferences Extension Act of 2015

On June 29, 2015, the Trade Preference Extension Act of 2015 increased penalties for failure to file correct information returns effective for returns and statements required to be filed after December 31, 2015. The penalties are:73

• $50 per information return if correctly filed within 30 days (by March 30 if the due date is February 28); maximum penalty $500,000 per year ($175,000 for small businesses). o Increased from $30/per, maximum of $250,000 ($75,000 small businesses).

• $100 per information return if correctly filed more than 30 days after the due date but by August 1; maximum penalty $1,500,000 per year ($500,000 for small businesses). o Increased from $60/per, maximum of $500,000 ($200,000 small businesses).

• $250 per information return if filed after August 1 or not filed; maximum penalty $3,000,000 per year ($1,000,000 for small businesses). o Increased from $100/per, maximum of $1,500,000 ($500,000 small businesses).

Small-business amounts apply if the average annual gross receipts for the three most recent tax years (or for the period in existence, if shorter) ending before the calendar year in which the information returns were due are $5 million or less.

Note: Trade Preferences Extension Act of 2015

The increases in the Information Returns penalty are revenue offsets within the Trade Preferences Extension Act. Another revenue offset is the removal of the “refundable” portion of the Child Tax Credit for taxpayers electing to exclude foreign earned income.

2. 2016 Updated Publication 1586, Reasonable Cause Regulations

The Code imposes a penalty on taxpayers that fail to file correct information returns (e.g., IRS Form 1099) with IRS, as well as a separate, but parallel, penalty on taxpayers that fail to provide the payee with a correct copy of the information return filed with IRS. IRC §6721 imposes up to $250 penalty for information returns after January 1, 2016, for each of the following infractions related to information returns:

• Filed with a missing/incorrect taxpayer identification number (TIN), • Filed untimely, • Filed on incorrect media, • Filed in an incorrect format, or • Any combination of the above.

Additionally, all persons who may be subject to penalty for failure to comply with the information reporting requirements of:

• §6722-1, Failure to furnish correct payee statements. • §6723-1, Failure to comply with other information reporting requirements. • §6724-1, Reasonable cause.

73 If the failure is due to intentional disregard of the filing requirement (or the correct information reporting requirement), the

penalty may be increased.


If a taxpayer fails to file a correct information return by the due date and cannot show reasonable cause, a penalty may be assessed.74

3. Front-end advisory required to meet the Reasonable Cause Regulations IRS Publication 1586, Reasonable Cause Regulations & Requirements for Missing and Incorrect Name/TINs, was revised in February 2016. Practitioners should review the publication for information needed to avoid penalties for information returns filed with missing or incorrect taxpayer identification numbers (TINs). The publication also describes how to request a TIN, and explains the requirements for establishing reasonable cause. To support the showing that the failure was due to reasonable cause and not willful neglect, filers must establish that they acted in a responsible manner both before and after the failure occurred, and that:

• There were significant mitigating factors, or • The failure was due to events beyond the filer’s control.

Acting in a responsible manner before the failure occurs includes making an initial solicitation (request) for the payee’s name and TIN and, if required, an annual solicitation. Publication 1586 describes the requirements for solicitations by mail, telephone, or electronically. The publication also addresses actions required for missing TINS and incorrect Name/TIN combinations. Taxpayers will first receive Notice 972CG -- proposing the penalty. A reasonable cause answer must be filed within 45 days or assessment of the full amount of the proposed penalty and a balance due notice will occur.

74 I.R.C. §6721.


Practice note: Good for the goose, is NOT good for the gander

Interesting to note the IRS strictly adheres to 45 days for the reasonable cause letter, yet they may take MORE than 45 days to respond. Practitioners have indicated the length of time for the IRS to provide the courtesy of a response to correspondence has increased significantly. Delays in processing taxpayers’ correspondence create a burden for taxpayers who must wait to obtain assistance and, in some cases, receive refunds. In addition, these delays can result in the IRS unnecessarily paying interest to taxpayers. In FY 2014, the IRS paid more than $27.6 million to taxpayers as a result of not timely processing or resolving correspondence cases. In February 2016, TIGTA released a study regarding IRS correspondence backlog.75 The IRS’s internal guidelines state that correspondence is generally considered over-aged if not resolved within 45 days. When a response to the taxpayer is necessary, providing a “quality response” is required within 30 calendar days of the receipt of the taxpayer’s correspondence. The IRS defines a quality response as one that: • Is timely. • Is accurate. • Addresses all of the taxpayer’s issues. • Requests additional information, if needed, from the taxpayer. • Is written in plain language the taxpayer can understand. If the 30-day time frame cannot be met, practitioners are all too familiar with the interim response. The Correspondence Imaging System (CIS) generates Letter 2645C, Interim Letter, which is mailed to taxpayers acknowledging receipt of their correspondence and informing them that the IRS will respond to their inquiry. Over-aged correspondence has steadily increased from 40 percent in Fiscal Year 2012 to 49 percent in Fiscal Year 2015. The TIGTA study included a report on the number of days in inventory “over-aged” cases were held. The Philadelphia office was noted to have cases up to 390 days. Other offices studied generally were 6 to 12 months in arrears.

IX. Social Security and Retirement Many people mistakenly believe that Social Security will pay for all or most of their retirement needs. The fact is, since its inception, Social Security has provided a minimum foundation of protection. Retirement planners frequently state a secure retirement income rests on the three primary sources - hence the concept of the three legged stool. If any one of the three “legs” of the stool is missing it makes it very uncomfortable to sit down for long. The three primary sources of income for retirement are:

• Social Security Benefits; • Personal Savings and Investments; and • Company Retirement Benefits

A multitude of financial planning bloopers may unquestionably affect each leg of the stool. Some items are not in an individual’s control, such as the stability of the social security system, or absence of a company retirement plan. The following topics detail a few of the trends or items that may be within an individual’s control and an update on maximizing retirement benefits.

75 Continued Inconsistent Use of Over-age Correspondence Lists Contributes to Taxpayer Burden and Unnecessary Interest

Payments; February 17, 2016.


A. Social Security 2017 and forward (#22)

Note: 2017 Social Security Benefits76

For 2017 the maximum Social Security benefit for a worker retiring at full retirement age (FRA) is $2,687 per month. However, if one retires at age 62 in 2017, the maximum benefit would approximately be $2,150. If one retires at age 70 in 2017, the maximum benefit would approximately be $3,550. The 2017 estimated average monthly Social Security benefits for all retired workers is $1,360, and $2,260 for a couple with each receiving benefits.

1. File and suspend

The President signed into law on November 2, 2015, legislation that makes significant changes to current Social Security benefit planning strategies. Access to a spousal benefit (as well as a child’s or ex-spouse’s benefit) required the other spouse to have claimed his or her own retirement benefit. The 2000 law permitted workers to file-and-suspend, i.e., to suspend taking the retirement benefit and accrue delayed retirement credits up to age 70. By doing so, access for the derivative benefits is triggered. A spouse could claim spousal benefits even as the other spouse continued working to increase the worker’s retirement benefit. While workers may still file-and-suspend, the new law precludes a filer-and-suspender from receiving any benefit during the suspension. Thus, if a working spouse has claimed, the other spouse may suspend his or her own benefit at normal retirement age but may not claim spousal benefits based on the earnings of the working spouse. Previously, the spouse could file-and-suspend and take a spousal benefit for the period between normal retirement age and age 70. Likewise, no person (ex-spouse, child, parent) may claim any benefits that derive from the spouse’s retirement benefit (that he or she has suspended). These new rules limiting suspended benefits apply to anyone who files-and-suspends beginning 180 days or more after the effective date of the legislation (November 2, 2015), or after April 29, 2016.

76 Official Social Security website, https://faq.ssa.gov/link/portal/34011/34019/Article/3735/What-is-the-maximum-Social-

Security-retirement-benefit-payable.


Practice note: File and suspend alternative -- One file/One delay

Losing the file and suspend strategy is not as massive as some prognosticators have suggested. In reality, only a small percentage of taxpayers utilized the plan, generally recipients in higher income/net worth stratums. Demographically, many of these recipients are from a generation of a primary insured, plus a spouse who would receive a lower benefit (or NO benefit) on their own Social Security account. Hence, the spousal benefit applied, and file and suspend worked very well. Demographically, many 50 somethings and younger are from two-worker households. In the next 10-year period, many first-time Social Security recipients will be from households in which each spouse will receive benefits on their own record; access to a spousal benefit will be moot. In that case, should one spouse choose to receive benefits on their own record, and the other delay, they may accomplish nearly the same result as file-and-suspend. In essence a “One file and One delay” tactic, will allow one spouse to delay receiving benefits, thus increasing their future benefit, while the other spouse does collect current benefits.

B. Determining when it is best to claim your Social Security

1. Reduced retirement benefits commencing at age 62 Bill is age 62, healthy, and does not like the word “retired.” Rather, he claims he has recently moved to life in the “slow-lane.” His former hobby has just become his next vocation, which generates about $1,000/month net income. He has a significant personal portfolio, two homes, and a large retirement account balance. Bill calls you to inquire about claiming Social Security. Many individuals are reluctant to pass up the opportunity to collect a monthly cash payment from Social Security rather than dip into their nest-egg. The first question from Bill is, “Should I begin now?” The second question is, “If not now, WHEN?”

a. Deciding when to retire from a financial perspective is a question of whether one is better off making 75 percent of the primary insurance amount (PIA) at 62 or waiting to get 100 percent at age 66 (for those currently reaching full retirement). Generally, the future value of full retirement payments commencing at age 66 will not equal the future value of reduced retirement benefits commencing at age 62 until many years in the future.

Full Retirement and Age 62 Benefit By Year of Birth

Year of Birth Full (normal) Retirement Age

Age 62 Reduction

Months

Total % Reduction

A $1000 retirement benefit would be

reduced to

Total % Reduction (spouse3.)

Spouse's $500 benefit would be reduced to

1937 or earlier 65 36 20.00 $800 25.00 $375 1938 65 and 2 months 38 20.83 $791 25.83 $370 1939 65 and 4 months 40 21.67 $783 26.67 $366 1940 65 and 6 months 42 22.50 $775 27.50 $362 1941 65 and 8 months 44 23.33 $766 28.33 $358 1942 65 and 10 months 46 24.17 $758 29.17 $354 1943-1954 66 48 25.00 $750 30.00 $350 1955 66 and 2 months 50 25.83 $741 30.83 $345 1956 66 and 4 months 52 26.67 $733 31.67 $341 1957 66 and 6 months 54 27.50 $725 32.50 $337 1958 66 and 8 months 56 28.33 $716 33.33 $333 1959 66 and 10 months 58 29.17 $708 34.17 $329 1960 and later 67 60 30.00 $700 35.00 $325


2. Delayed retirement

Chart of Delayed Retirement Credit Rates If you reached full retirement age...

Then your monthly percentage is...and

Your yearly percentage is...

Prior to 1982 1/12 of 1% 1% 1982-1989 1/4 of 1% 3% 1990-1991 7/24 of 1% 3.5% 1992-1993 1/3 of 1% 4% 1994-1995 3/8 of 1% 4.5% 1996-1997 5/12 of 1% 5% 1998-1999 11/24 of 1% 5.5% 2000-2001 1/2 of 1% 6% 2002-2003 13/24 of 1% 6.5% 2004-2005 7/12 of 1% 7% 2006-2007 5/8 of 1% 7.5% 2008 or later 2/3 of 1% 8%

3. When to retire? a. Example: based upon 2017 retirement at age 66 years.

Assume a client has been subject to the maximum Social Security tax since the 1950s, and the primary insurance amount is $2,150 per month or $25,800 annually; the reduced PIA for early retirement is $1,612.50 ($2,150 x 0.75) per month, or $19,350 annually. It takes the normal retiree about 16 years to catch up in total benefits paid—the higher the compounding rate, the longer the catch-up period; the lower the compounding rate, the shorter the catch-up period.

b. From an actuarial viewpoint, assuming everyone lives to the 22.5-year average life expectancy of a 62-year-old, it seems that retirement that begins at 66 years with full benefits has an advantage. Individuals in poor health or those able to produce after-tax returns higher than five percent may be better off opting for benefits at 62.

c. If returns are less than five percent, the present value will be reduced and one may be better off working to age 66.

4. 2017 Earnings limits

May Earn up to: If in Excess, the amount withheld

Younger than Full Retirement Age

$16,920/year ($1,410/month)

$1 for every $2 over the annual limit

The year reaching Full Retirement Age

$44,880/year ($3,740/month)

$1 for every $3 over the annual limit

Commencing the month an individual attains Full

Retirement Age

No limit

No limit


C. Current discussions to buttress Social Security

1. The time frame keeps shortening

Social Security, which was established in 1935, is the largest single program in the federal budget. About 73 percent of the roughly 61 million people who currently receive Social Security benefits are retired workers or their spouses and children, and another 10 percent are survivors of deceased workers; all of those beneficiaries receive payments through Old-Age and Survivors Insurance (OASI). The remaining 17 percent of beneficiaries are disabled workers or their spouses and children; they receive Disability Insurance (DI) benefits. In fiscal year 2016, spending for Social Security benefits totaled $905 billion, or almost one-quarter of federal spending. OASI payments accounted for about 84 percent of those outlays, and DI payments made up about 16 percent. Each year the Congressional Budget Office prepares long-term projections of the federal government’s revenues and outlays, including those for the Social Security program. The most recent set of projections—which cover the period from 2016 through 2046 for the federal budget as a whole and 2016 through 2090 for Social Security—was published in July 2016.77 In the most recent report, the Congressional Budget Office projects that, without legislative action, the worsening shortfall in the Social Security program’s finances would cause the program’s combined trust funds to be exhausted in calendar year 2029. After exhaustion, trust fund balances would no longer be available to make up the gap between benefits specified in current law and annual trust fund receipts. If benefits were limited to the amounts payable from dedicated funding, benefits would be reduced by 29 percent in 2030 and by greater percentages in later years in relation to the amounts in CBO’s extended baseline.

2. CBO, 11 Options for Social Security over the next 10 years78

Note: Politicians find it easier to ladle out benefits than curtail them

In 1980 when economist looked 30 to 40 years into the future they anticipated a tsunami wave of Baby Boomers hitting the Social Security ranks this decade. In preparation Congress raised the payroll taxes which provide the bulk of Social Security’s revenue, to build up a reserve. Technically the first Baby Boomers hit the Social Security docks on January 1, 2011. Just a couple of years ago estimates still calculated a 20-year buffer before Social Security funds would be exhausted, sometime in the mid-2030s. With CBOs recent shortening of the time frame to 2029, and time continuing to run clockwise (we can personally try but time will not run in reverse), we are now down to about a dozen years to either rectify or accept the issue. This of course puts all politicians on the spot. The days of fawning statesman and stateswomen dishing out dollars with willful recklessness may soon be replaced with choruses of buck-passing claims of innocence. Let us not regress to finger pointing, they were all adding to the same fiery cauldron.

a. Link Initial Social Security Benefits to Average Prices Instead of Average

Earnings -- One approach to constrain the growth of Social Security benefits would be to change the computation of initial benefits so that the real (inflation-adjusted) value of average initial benefits did not rise. That approach, often called “pure” price indexing,

77 Congressional Budget Office, The 2016 Long-Term Budget Outlook, July 2016. 78 Congressional Budget Office, Options for Reducing the Deficit: 2017 to 2026, December 2016.


would allow increases in average real wages to result in higher real Social Security payroll taxes but not in higher real benefits.

Another approach to constrain the growth of initial Social Security benefits, called progressive price indexing, would keep the current benefit formula for workers who had lower earnings and would reduce the growth of initial benefits for workers who had higher earnings. (That approach would be implemented by adding a new bend point and reducing the factors that determine the primary insurance amount above that bend point.)

b. Make Social Security’s Benefit Structure More Progressive -- This option would make the Social Security benefit structure more progressive by cutting benefits for people with higher average earnings while either preserving or expanding benefits for people with lower earnings.

c. Raise the Full Retirement Age for Social Security -- Under this option, the FRA would continue to increase from age 67 by two months per birth year, beginning with workers turning 62 in 2023, until it reaches age 70 for workers born in 1978 or later (who turn 62 beginning in 2040). As under current law, workers could still choose to begin receiving reduced benefits at age 62, but the reductions in their initial monthly benefit from the amounts received at the FRA would be larger, reaching 45 percent when the FRA is 70. This option would not reduce the benefits for workers who qualify for Social Security Disability Insurance (DI).

d. Reduce Social Security Benefits for New Beneficiaries -- This option includes two ways to adjust the benefit formula to reduce Social Security benefits by two amounts, 5 percent and 15 percent. Both alternatives would phase in the reductions starting with people who would be newly eligible in 2018.

Under the 5 percent reduction, benefits would be permanently lowered by 2.5 percent for newly eligible beneficiaries in 2018 and by 5 percent for newly eligible beneficiaries beginning in 2019. (Benefits for newly eligible beneficiaries in 2018 would remain 2.5 percent lower throughout their lifetime.)

Under the 15 percent reduction, benefits would be permanently reduced by 2.5 percent for people newly eligible in 2018, 5 percent for people newly eligible in 2019, and so on, up to 15 percent for people newly eligible beginning in 2023.

Planning point: Reduce benefits and still keep the block of senior voters!

Serving as a benchmark, this option shows that policymakers might achieve substantial savings by cutting benefits for new Social Security beneficiaries, only about 3 million people per year. This option would not affect current beneficiaries (read – voters - about 61 million) or those who will become eligible before 2018. CBO estimates that, between 2018 and 2026, federal outlays would be reduced by $105 billion under the 5 percent alternative and by $190 billion under the 15 percent reduction.

e. Require Social Security Disability Insurance Applicants to Have Worked More in

Recent Years -- To be eligible for benefits under Social Security Disability Insurance (DI), disabled workers must generally have worked 5 of the past 10 years. Specifically, workers over age 30 must have earned at least 20 quarters of coverage in the past 10 years (which is the time span used to evaluate that requirement, also known as the look-


back period). In calendar year 2016, a worker receives one quarter of coverage for each $1,260 of earnings during the year, up to four quarters; the amount of earnings required for a quarter of coverage generally increases annually with average wages. This option would raise the share of recent years that disabled workers must have worked while shortening the look-back period by requiring disabled workers older than 30 to have earned 16 quarters in the past 6 years— usually equivalent to working 4 of the past 6 years.

f. Eliminate Eligibility for Starting Social Security Disability Benefits at Age 62 or Later -- Under current law, people are eligible for Social Security Disability Insurance (DI) until they reach full retirement age -- currently 66 years for workers who turn 62 in 2016. The full retirement age will rise gradually, starting at 66 and 2 months for workers born in 1955 (who will turn 62 in 2017) and eventually reaching 67 for people born in 1960 (who will turn 62 in 2022) or later.

Workers who claim retirement benefits at age 62 rather than at their full retirement age receive lower benefits for as long as they live. By contrast, workers who claim DI benefits at age 62 are not subject to a reduction. Instead, they receive in each year approximately the same retirement benefits that they would have received had they claimed retired-worker benefits at their full retirement age. That difference in benefits encourages some people between age 62 and their full retirement age to apply for DI at the same time that they apply for Social Security retirement benefits. If their DI application is approved, they receive higher benefits for the rest of their life than if they had applied only for retirement benefits.

g. Use an Alternative Measure of Inflation to Index Social Security and Other Mandatory Programs -- Cost-of-living adjustments (COLAs) for Social Security and many other parameters of federal programs are indexed to increases in traditional measures of the consumer price index (CPI). The CPI measures overall inflation and is calculated by the Bureau of Labor Statistics (BLS). In addition to the traditional measures of the CPI, that agency computes another measure of inflation -- the chained CPI --designed to account for changes in spending patterns and to eliminate several types of statistical biases that exist in the traditional CPI measures.

Beginning in 2018, this option would use the chained CPI for indexing COLAs for Social Security and parameters of other programs.

The chained CPI has grown an average of about 0.25 percentage points more slowly per year over the past decade than the traditional CPI measures have, and the Congressional Budget Office expects that gap to persist. Therefore, the option would reduce federal spending, and savings would grow each year as the effects of the change compounded. Outlays would be reduced by $182 billion through 2026.

h. Increase the Maximum Taxable Earnings for the Social Security Payroll Tax -- This option considers two alternative approaches that would increase the share of earnings subject to payroll taxes.

The first alternative would increase the taxable share of earnings from jobs covered by Social Security to 90 percent by raising the maximum taxable amount to $245,000 in calendar year 2017. (In later years, the maximum would grow at the same rate as


average wages, as it would under current law.) Implementing such a policy change would increase revenues by an estimated $648 billion over the 2017–2026 period, according to the staff of the Joint Committee on Taxation (JCT). Because Social Security benefits are tied to the amount of earnings on which taxes are paid, however, some of the increase in revenues from this alternative would be offset by the additional benefits paid to people with earnings above the maximum taxable amount under current law. On net, this alternative would reduce federal budget deficits by an estimated $633 billion over the 10-year period.

The second alternative would apply the 12.4 percent payroll tax to earnings over $250,000 in addition to earnings below the level specified by the current-law taxable maximum. The taxable maximum would continue to grow with average wages, but the $250,000 threshold would remain at that level, so the gap between the two would shrink. CBO projects that the taxable maximum would exceed $250,000 in calendar year 2037; after that, all earnings would be subjected to the payroll tax. The current-law taxable maximum would still be used for calculating benefits, so scheduled benefits would not change. This alternative would raise $1.0 trillion over the 2017–2026 period, according to JCT.

Practice note: The horse is inside the gates

Just as the citizens of Troy found a shocker within the horse, the IRS presently has Form 8959, Additional Medicare Tax. This form could easily be transfigured to adapt the second alternative discussed above.

i. Expand Social Security Coverage to Include Newly Hired State and Local

Government Employees -- Nearly all private-sector workers and federal employees are covered by Social Security, but a quarter of workers employed by state and local governments are not. Under federal law, state and local governments can opt to enroll their employees in the Social Security program, or they can opt out if they provide a separate retirement plan for those workers instead. (State and local governments may also have their employees participate in both Social Security and a separate retirement plan.)

By contrast, all federal employees hired after December 31, 1983, are covered by Social Security and pay the associated payroll taxes. Furthermore, all state and local government employees hired after March 31, 1986, and all federal government employees pay payroll taxes for Hospital Insurance (Medicare Part A). Under this option, Social Security coverage would be expanded to include all state and local government employees hired after December 31, 2016.

j. Increase the Payroll Tax Rate for Medicare Hospital Insurance by 1 Percentage Point -- This option would increase the basic HI tax on total earnings by 1.0 percentage point. The basic rate for both employers and employees would increase by 0.5 percentage points, to 1.95 percent, resulting in a combined rate of 3.9 percent. The rate paid by self-employed people would also rise to 3.9 percent. For taxpayers with earnings above $200,000 ($250,000 for married couples who file jointly), the HI tax on earnings that exceed the surtax threshold would increase from 3.8 percent to 4.8 percent; employees would pay 2.85 percent, and employers would pay the remaining 1.95 percent.


k. Tax All Pass-Through Business Owners Under SECA and Impose a Material Participation Standard -- This option would require owners of all pass-through businesses to pay the SECA tax on their share of net income. In the case of S corporations, owners would no longer pay the FICA tax on their reasonable compensation. In addition, the option would change the definition of self-employment income so that it would no longer depend on whether a taxpayer was classified as a general partner or a limited partner. That distinction would be replaced with a “material participation” standard in which the primary test would be whether the individual engaged in the operation of the business for more than 500 hours during a given year.

Partners, LLC members, and S corporation owners categorized as material participants would pay SECA tax on both their guaranteed payments and their share of the firm’s net income. Those not deemed to be material participants would pay SECA tax on their reasonable compensation. All sole proprietors would be considered material participants.

D. A self-directed IRA miscue eliminates bankruptcy exemption79 (#23)

1. Can I borrow from my IRA? In the personal bankruptcy of Ernest W. Willis (“Willis”), he claimed the full value of three IRAs as exempt assets per bankruptcy regulations.

a. The three accounts amounted to $1,499,000. The accounts only permitted withdrawals and deposits, and the agreement stated “the Tax Code prohibits you from using your IRA to engage in certain transactions under penalty of losing your tax-deferred status. For example, you may not borrow from your account, sell property to it or buy property from it.”

b. On December 20, 1993, Willis transferred $700,000 from his IRA to a Sun Bank Account. Willis then used the IRA funds to purchase the assignment of the Ocean One Property Mortgage. Willis did not place the mortgage into an IRA account. In 1998 Willis sold the Ocean One Property for approximately $1,200,000 and deposited the sum into his personal account.

c. In order to repay the IRA, Willis borrowed funds from five friends and family members, and on or about February 22, 1994, he returned $700,000 into the IRA.

d. Beginning in February 1997, Willis engaged in a series (more than one) of transfers from and to the IRA in order to cover a shortfall in a joint brokerage account. Willis in essence borrowed money from the IRA to put into a joint brokerage account, so he could then write another check to the IRA in an attempt to avoid tax on the IRA withdrawals by returning funds within 60 days. This series of transactions had the effect of providing an extension of credit between the IRA and Willis.

2. Taxpayers always have two reasons for doing anything: a good reason and the real reason Willis claimed he withdrew funds from the IRA, and subsequently “re-deposited” funds, but he did not “borrow.”

a. In bankruptcy proceedings, the Trustee and a Creditor presented evidence to establish Willis used the IRA funds in a manner as to make them taxable, and therefore, ineligible for exemption from the bankruptcy estate.

b. In short, the Trustee claims Willis used funds from an IRA to purchase an assignment of mortgage, and also used funds from the IRA to cover a shortfall in a joint personal stock brokerage account.

79 Willis v. Menotte (CA 11 4/21/2011) 107 AFTR 2d ¶ 2011-752; 105 AFTR 2d 2010-1877, 04/06/2010.


3. The Law

Per bankruptcy regulations IRA funds may be excluded from a bankruptcy estate.80 I.R.C. §408(e)(1) allows that any individual retirement account is exempt from taxation unless such account has ceased to be an individual retirement account. Loss of exemption is detailed in §408(e)(2), which states - In general, if, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by §4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year. In any case in which any account ceases to be an individual retirement account as of the first day of any taxable year, the account is treated as if there were a distribution on such first day in an amount equal to the fair market value of all assets in the account. Generally, a prohibited transaction is any improper use of an IRA account or annuity by the taxpayer or any disqualified person.81 Some examples of prohibited transactions with an IRA are:

a. A sale or exchange, or leasing, of any property between a plan and a disqualified person; b. Lending of money or other extension of credit between a plan and a disqualified person; c. Furnishing of goods, services, or facilities between a plan and a disqualified person; d. Transfer to, or use by or for the benefit of the income or assets of a plan by a disqualified person; e. Act by a disqualified person who is a fiduciary whereby he or she deals with the income or assets

of a plan in his or her own interest or for his or her own account; or f. Receipt of any consideration for his or her own personal account by any disqualified person who

is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

g. Borrowing on an IRA annuity contract. h. Pledging an IRA account as security. i. Investment in Collectibles82, such as art works, rugs, antiques, metals, gems, stamps, coins,

alcoholic beverages, and certain other tangible personal property. Tax exempt rollovers may only occur once per year, per §408(d)(3)(B). A “disqualified person” includes a “fiduciary” including any person who exercises: (1) any discretionary authority or discretionary control of the management of the plan; or (2) any authority or control of the management or disposition of plan assets. Examples of disqualified persons include the trustee/fiduciary and members of the taxpayer’s family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).

4. Conclusion and solution – Bankruptcy Court, District Court, and Court of Appeals all agree

Section 408,83 governs IRAs. In addition to other requirements, the law identifies events that disqualify accounts from tax-exempt status such as borrowing against the IRA, pledging the account as security, and commingling IRA accounts with common funds. Under §4975(c)(1)(D), any direct or indirect transfer to, or use by or for the benefit of a disqualified person of the income or assets of a plan constitutes a prohibited transaction. 80 U.S. Bankruptcy Code §522(b)(4)(A)'s. 81 I.R.C. §4975. 82 An exception is provided for one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins

minted by the Treasury Department, and certain platinum coins and certain gold, silver, platinum or palladium bullion. 83 Which is referred to in §522(b)(4) of the Bankruptcy Code.

http://localhost:49253/NXT/gateway.dll?f=id$id=sec%204975$cid=codew$t=document-frame.htm$3.0$p=#sec 4975


In its analysis, the bankruptcy court first considered whether Willis was a “disqualified person.” Because he exercised discretionary authority and responsibility over the administration of his IRA, the court properly determined Willis to be a fiduciary and thus, a disqualified person. The bankruptcy court then evaluated the account activity for prohibited transactions and correctly found Willis had engaged in two such transactions: the direct or indirect “transfer to, or use by or for the benefit of a disqualified person of the income or assets of a plan,” and “lending of money or other extension of credit between a plan and a disqualified person.” Consequently, the Court finds that Willis engaged in a prohibited transaction under §4975(c)(1)(B) by borrowing $700,000 from the IRA to acquire the assignment of the Ocean One Property Mortgage. Willis personally benefitted from the use of IRA funds because the use of funds enabled him to later sell the Ocean One Property for approximately $1,200,000. Willis claims the bankruptcy court erred in concluding he “borrowed” from his IRA. Willis provides no legal argument to support the claim, but points the Court to testimony regarding the nature of the account. Because the account only permitted withdrawals and deposits, Willis argues the word “borrow” was an incorrect characterization of his use of the IRA funds. The argument is superfluous; the fact of the matter is Willis withdrew funds from an IRA, used them improperly, and then re-deposited them. “Borrowed” or not, the bankruptcy court arrived at the correct conclusion: the IRA became nonexempt, and any purported roll-overs from the IRA into other IRA accounts were also non-exempt.

Practice note: Protecting an IRA bankruptcy exclusion

Practitioners have always informally preached the importance of protecting IRA investments from penalties. However, for clients that may be in torment with the possibility of pending bankruptcy, practitioners may be more attentive to the protection of IRA status. The downside risk for such clients is not just taxable income and penalty, but also the loss of the bankruptcy exemption for IRA funds.

E. IRS levy on pension account -- Excepted v. exempt property84 (#24)

1. An abundance of caution Stuart Gross filed a petition under Chapter 7 of the Bankruptcy Code. He listed his interest in the Director's Guild of America (the DGA plan, an ERISA-qualified pension plan) valued at $300,000 on Schedule B and Schedule C of his bankruptcy petition. He attached as an explanation: “This is an ERISA Qualified Pension Plan which is not property of the estate but in an abundance of caution has been listed herein and exempted.”

Practice note:

Gross did not need to list the asset in bankruptcy, an ERISA-qualified pension plan account is per se excluded from the bankruptcy estate -- the exclusion is mandatory. It could not be included in the bankruptcy estate, not even for the sole purpose of listing it as exempt.

At the time of his bankruptcy petition, Gross owed federal income taxes totaling $270,041.15.

2. Was the pension excluded from, or included and exempted in bankruptcy estate

Gross argues that the exclusion of his interest in an ERISA-qualified pension plan is permissive, and that he properly included the DGA plan account in his Chapter 7 bankruptcy estate and claimed it as exempt

84 Gross v. Comm., (CA 9) 113 AFTR 2d 2014-529, 02/25/2014.


without objection. Therefore, he contends that the IRS may not levy on the DGA plan account because they did not file a valid lien.

3. The law Under §6321, when a person owes tax liabilities, a lien automatically attaches to the taxpayer’s property in favor of the IRS. The IRS need not release a valid tax lien when the underlying tax debt is discharged in bankruptcy. The filing of a petition in bankruptcy automatically creates a bankruptcy estate consisting of “all legal or equitable interests of the debtor in property as of the commencement of the case.” The bankruptcy estate includes all of the debtor’s prepetition property and rights to property except property excluded from the estate, including an interest in an ERISA-qualified pension plan. In addition, a debtor is allowed to exempt from his bankruptcy estate certain property, including retirement funds, to ensure that the debtor has at least some property with which to make a fresh start. Nonetheless, with regard to assets that are part of the bankruptcy estate but exempt from the bankruptcy proceedings, the Bankruptcy Code provides that such property: “is not liable during or after the case for any debt of the debtor that arose... before the commencement of the case, except a debt secured by a tax lien, notice of which is properly filed under I.R.C. §6323.” Unlike liens on exempt assets, liens on prepetition assets that are not included in the bankruptcy estate (i.e., excluded property) are not affected by the bankruptcy proceeding.85

Practice note:

Unlike exempt property, excluded property never becomes part of the bankruptcy estate and is therefore never subject to the bankruptcy estate trustee’s or the debtor’s power to avoid the §6321 lien. Thus, if a §6321 lien on excluded property has not expired or become unenforceable, it survives the bankruptcy.

4. Phraseology does not change the unfortunate result Simply listing an ERISA-qualified pension plan account, an excludable asset, on Schedule C is not necessarily sufficient to claim an exemption if all of the facts, including any statements made on the bankruptcy schedules, indicate that the debtor excluded the ERISA-qualified pension plan account from his bankruptcy estate. The IRS maintains a valid lien on Gross’ interest in his ERISA-qualified pension plan. The Supreme Court held that an ERISA plan is properly excluded from a bankruptcy estate under 11 U.S.C. §541(c)(2).86 Here, Gross’ Chapter 7 schedules explicitly state that his ERISA plan is not part of the estate. Although the schedules go on to suggest that the ERISA plan might be “exempted,” any ambiguity in a bankruptcy schedule is construed against the debtor. Because Gross’ ERISA plan was not part of Gross’ Chapter 7 estate, the bankruptcy proceedings did not affect the IRS’ §6321 lien. Accordingly, the lien remains attached to Gross’ interest in the ERISA plan, and the IRS may levy this asset.

85 Rains v. Flinn, 428 F.3d 893, 905–06 (9th Cir. 2005). 86 Patterson v. Shumate, 504 U.S. 753, 759–60 (1992).


Practice point: Is repayment of First Time Home Buyers Credit dischargeable?

In an unrelated case,87 a taxpayer who had received a first-time home buyer credit in a year prior to filing for bankruptcy, claimed the tax credit was in essence an interest free loan (repayment at 6.67 percent of the credit amount for 15 years), and her obligation to repay it was discharged by her bankruptcy. Unfortunately in this case, the taxpayer learned the repayment is imposed as an increased tax rather than a general obligation, it is therefore not dischargeable pursuant to the Bankruptcy Code.

F. Missed the 60 day rollover, can we find someone to blame? (#25)

1. The best-laid plans of mice and men Some of today’s taxpayers can craft a scheme even Robert Burns may appreciate. A taxpayer retired in his mid 50’s. A few years later he was set to turn 59½ in late December. In dire need to tap his IRA account he hatched the following plan to defer income and avoid penalty.

a. In early November he withdrew a significant amount from his IRA. Without any further action this distribution would be included in income and subject to the 10 percent penalty under §72(t).

b. In early January of the next year he would take an additional distribution from his IRA and deposit it into his personal account.

c. Also in January, within the first distributions 60 day rollover period, taxpayer would then return (rollover) the November distribution accomplishing his goal to defer income and avoid the 10 percent penalty.

2. Often go awry a. The blunder: taxpayer forgot the final step of the plan. b. The taxpayer remembered to take the distributions in November and the subsequent January.

Taxpayer realized the “rollover” part of the plan was forgotten when his tax practitioner presented him with his tax return in early April.

3. The law a. A tax-deferred rollover occurs when a taxpayer withdraws cash or other assets from one

eligible retirement plan and contributes all or part of it within 60 days to another eligible retirement plan.88

b. The rollover must be completed by the 60th day following the day on which the distribution is received.

c. From time to time, the IRS has extended the 60 day requirement for affected taxpayers in Presidential Disaster areas struck by hurricanes and other natural disasters. In addition, the 60 day period is extended for the period during which the distribution is in a frozen deposit in a financial institution.

d. A taxpayer who rolls over a distribution to a traditional IRA cannot subsequently deduct the amount rolled over as an IRA contribution. An eventual withdraw from the recipient IRA cannot utilize the optional Lump-Sum Distribution rules to figure tax.

e. Self-employed individuals are generally treated as employees for the rules on the tax treatment of distributions, including the rules for rollovers.

87 Bryan, Dawn, Bankruptcy Court CA, 113 AFTR 2d 2014-558, February 27, 2014. 88 The 60 day rollover requirement is contained in I.R.C. §§402(c)(3), 408(d)(3), 403(b)(8) etc and the regulations

promulgated thereunder.


f. An eligible rollover distribution is any distribution of all or any part of the balance in a qualified retirement plan except the following: 1) Any of a series of substantially equal distributions paid at least once a year over:

a) The taxpayer’s lifetime or life expectancy, b) The joint lives or life expectancies of the taxpayer or beneficiary, or c) A period of ten years or more;

2) A required minimum distribution; 3) Hardship distributions; 4) Corrective distributions of excess contributions or excess deferrals, and any income

allocable to the excess, or of excess annual additions and any allocable gains; 5) A loan treated as a distribution because it does not satisfy certain requirements either when

made or later (such as upon default), unless the participant's accrued benefits are reduced (offset) to repay the loan;

6) Dividends on employer securities; and 7) The cost of life insurance coverage.

g. A distribution to a plan participant's beneficiary generally is not treated as an eligible rollover distribution unless it is made pursuant to a qualified domestic relations order or made to a surviving spouse.

h. See Rollover Chart at the end of this blooper.89

4. Conclusion and solution a. The 60 day rollover requirement can be waived automatically if all of the following apply.90

1) The financial institution receives the funds on the taxpayer’s behalf before the end of the 60 day rollover period.

2) The taxpayer followed all the procedures set by the financial institution for depositing the funds into an eligible retirement plan within the 60 day period (including giving instructions to deposit the funds into an eligible retirement plan).

3) The funds are not deposited into an eligible retirement plan within the 60 day rollover period solely because of an error on the part of the financial institution.

4) The funds are deposited into an eligible retirement plan within 1 year from the beginning of the 60 day rollover period.

5) The transaction would have been a valid rollover if the financial institution had deposited the funds as instructed.

b. The IRS may waive the 60 day requirement where failure to do so would be against equity or good conscience such as in the event of a casualty, disaster, or other event beyond ones reasonable control. As part of the Katrina Emergency Tax Relief Act of 2005 qualified individuals are allowed up to three years to roll over a distribution.

c. Taxpayers who do not qualify for an automatic waiver may apply to the Service for a waiver of the 60 day rollover requirement.91 To obtain the waiver in most cases a request for a letter ruling must be made which includes an applicable user fee. Refer to the Internal Revenue Procedure for requesting a letter ruling.92

d. Taxpayers have been quite successful in obtaining favorable letter rulings in the waiver of the 60 day rollover rule provided they can find someone or something to blame the error upon.

89 Rollover Chart at www.irs.gov/ep. 90 Rev. Proc. 2003-16. 91 Rev. Proc. 2003-16. 92 See Rev. Procs 2007-4 and 2007-8.


e. Taxpayers with a legitimate reason may desire to request a ruling. In determining whether to grant a waiver the Service will consider all relevant facts and circumstances, including: 1) Whether errors were made by the financial institution (other than those described under

automatic waiver above), 2) Whether the taxpayer was unable to complete the rollover due to death, disability,

hospitalization, incarceration, restrictions imposed by a foreign country or postal error, 3) Whether the taxpayer used the amount distributed (for example, in the case of payment by

check, whether the check was cashed), and 4) The amount of time that has passed since the date of distribution.

f. For the taxpayer and his plan noted at the beginning of this blooper, good luck.

5. Self-certification procedure for a waiver of the 60-day rollover limit93

Effective August 24, 2016, the IRS has provided a self-certification procedure designed to help recipients of retirement plan distributions who inadvertently miss the 60-day time limit for properly rolling these amounts into another retirement plan or IRA. Eligible taxpayers, encountering a variety of mitigating circumstances, can qualify for a waiver of the 60-day time limit and avoid possible early distribution taxes. Normally, an eligible distribution from an IRA or workplace retirement plan can only qualify for tax-free rollover treatment if it is contributed to another IRA or workplace plan by the 60th day after it was received. In most cases, taxpayers who failed to meet the time limit could only obtain a waiver by requesting a private letter ruling from the IRS.

93 Rev. Proc. 2016-47.


Practice note: Waiver may be challenged

It is important to remember that this self-certification is not a per se waiver by the IRS of the 60-day rollover requirement; however, a taxpayer may report the contribution as a valid rollover unless later informed otherwise by the IRS.

6. Conditions for self-certification a. No prior denial by the IRS. The IRS must not have previously denied a waiver request

with respect to a rollover of all or part of the distribution to which the contribution relates. b. Reason for missing 60-day deadline. The taxpayer must have missed the 60-day

deadline because of the taxpayer’s inability to complete a rollover due to one or more of the following 11 reasons: (i) An error was committed by the financial institution receiving the contribution or

making the distribution to which the contribution relates; (ii) The distribution, having been made in the form of a check, was misplaced and

never cashed; (iii) The distribution was deposited into and remained in an account that the taxpayer

mistakenly thought was an eligible retirement plan; (iv) The taxpayer’s principal residence was severely damaged; (v) A member of the taxpayer’s family died; (vi) The taxpayer or a member of the taxpayer’s family was seriously ill; (vii) The taxpayer was incarcerated; (viii) Restrictions were imposed by a foreign country; (ix) A postal error occurred; (x) The distribution was made on account of a levy under §6331 and the proceeds of

the levy have been returned to the taxpayer; or (xi) The party making the distribution to which the rollover relates delayed providing

information that the receiving plan or IRA required to complete the rollover despite the taxpayer’s reasonable efforts to obtain the information.

c. Contribution as soon as practicable; 30-day safe harbor. The contribution must be made to the plan or IRA as soon as practicable after the reason or reasons listed in the preceding paragraph no longer prevent the taxpayer from making the contribution. This requirement is deemed to be satisfied if the contribution is made within 30 days after the reason or reasons no longer prevent the taxpayer from making the contribution.

7. Effect of self-certification a. Effect on plan administrator or IRA trustee. For purposes of accepting and reporting a

rollover contribution into a plan or IRA, a plan administrator or IRA trustee may rely on a taxpayer’s self-certification in determining whether the taxpayer has satisfied the conditions for a waiver of the 60-day rollover requirement. However, a plan administrator or an IRA trustee may not rely on the self-certification for other purposes or if the plan administrator or IRA trustee has actual knowledge that is contrary to the self-certification.

b Effect on taxpayer. A self-certification is not a waiver by the IRS of the 60-day rollover requirement. However, a taxpayer may report the contribution as a valid rollover unless later informed otherwise by the IRS. The IRS, in the course of an examination, may consider whether a taxpayer’s contribution meets the requirements for a waiver. (i) For example, the IRS may determine that the requirements for a waiver were not

met because of a material misstatement in the self-certification, the reason or


reasons claimed by the taxpayer for missing the 60-day deadline did not prevent the taxpayer from completing the rollover within 60 days following receipt, or the taxpayer failed to make the contribution as soon as practicable after the reason or reasons no longer prevented the taxpayer from making the contribution. In such a case, the taxpayer may be subject to additions to income and penalties, such as the penalty for failure to pay the proper amount of tax under §6651.

8. Sample self-certification letter In addition, the revenue procedure includes a sample self-certification letter that taxpayers can use to notify the administrator or trustee of the retirement plan or IRA receiving the rollover that they qualify for the waiver. The sample letter is replicated herein as follows.

Certification for Late Rollover Contribution

Name Address City, State, ZIP Code Date:

Plan Administrator/Financial Institution Address City, State, ZIP Code Dear Sir or Madam: Pursuant to Internal Revenue Service Revenue Procedure 2016-47, I certify that my contribution of $ [ENTER AMOUNT] missed the 60-day rollover deadline for the reason(s) listed below under Reasons for Late Contribution. I am making this contribution as soon as practicable after the reason or reasons listed below no longer prevent me from making the contribution. I understand that this certification concerns only the 60-day requirement for a rollover and that, to complete the rollover, I must comply with all other tax law requirements for a valid rollover and with your rollover procedures. Pursuant to Revenue Procedure 2016-47, unless you have actual knowledge to the contrary, you may rely on this certification to show that I have satisfied the conditions for a waiver of the 60-day rollover requirement for the amount identified above. You may not rely on this certification in determining whether the contribution satisfies other requirements for a valid rollover. Reasons for Late Contribution I intended to make the rollover within 60 days after receiving the distribution but was unable to do so for the following reason(s) (check all that apply): An error was committed by the financial institution making the distribution or receiving the

contribution. The distribution was in the form of a check and the check was misplaced and never cashed. The distribution was deposited into and remained in an account that I mistakenly thought was a

retirement plan or IRA.


My principal residence was severely damaged. One of my family members died. I or one of my family members was seriously ill. I was incarcerated. Restrictions were imposed by a foreign country. A postal error occurred. The distribution was made on account of an IRS levy and the proceeds of the levy have been

returned to me. The party making the distribution delayed providing information that the receiving plan or IRA

required to complete the rollover despite my reasonable efforts to obtain the information. Signature I declare that the representations made in this document are true and that the IRS has not previously denied a request for a waiver of the 60-day rollover requirement with respect to a rollover of all or part of the distribution to which this contribution relates. I understand that in the event I am audited and the IRS does not grant a waiver for this contribution, I may be subject to income and excise taxes, interest, and penalties. If the contribution is made to an IRA, I understand you will be required to report the contribution to the IRS. I also understand that I should retain a copy of this signed certification with my tax records. Signature:

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