IRS Capital Gains to Ordinary Income Audit

by Chris Moss CPA

Chris Moss CPA Tax Attorney

Welcome to TaxView with Chris Moss CPA Tax Attorney

Do any of you plan on selling land this year for a large gain under IRS Section 1221 which perhaps can be offset by stock losses in your brokerage account? Seems easy enough. But unfortunately the Government looks closely at your land sales when the IRS in many cases years later commences a Capital Gain to Ordinary Income Audit disallowing all your capital gain and converting those gains to ordinary income under IRS Section 61. When the audit is over, the IRS agent then explains to you that you owe a great deal of tax, interest and penalty now that your brokerage capital losses cannot offset ordinary income.  So how do you protect your capital gain from converting to ordinary income when the IRS comes knocking on your door? Stay with us here on TaxView with Chris Moss CPA Tax Attorney to find out how to bulletproof your capital gain from an IRS Capital Gain to Ordinary Income Audit.

Selling land, real estate or stock always results in a capital gain right? Well not quite always as is currently trending in 2015 and as Greg and Melanie Boree discovered in Boree v IRS US Tax Court (2014). The facts are simple. Boree purchased 1,982 acres in Florida with a 1.8M loan from Perkins State Bank in 2002, plans were submitted to the County and various lots were sold during the next 5 years. However, in 2007 a new investor Adrian Development purchased 1067 acres for $9,600,000 from Boree.

Boree recorded all lot sales from 2005, 2006 and 2007 on his income tax form 1040 Schedule C as ordinary income but the sale in 2007 to Adrian as long term capital gain.  The IRS came visiting in 2011 and commenced a Capital Gain to Ordinary Income Audit, disallowing the entire capital gain resulting in a tax bill of almost $2M. Boree appealed to US Tax Court in Boree v IRS US Tax Court (2014).

Judge Foley cuts right to the core issue:  Was the $9.6M sale of land part of inventory of a business or was this sale unique, different from the other sales to be treated as a capital asset held for investment. The Court notes that sales of lots were made to customers in the normal course of business from 2002 to 2007 and were frequent and substantial with no distinction made in the books and records to treat the Adrian sale any differently, citingSlappey Drive Industrial Park v US 561 F.2d 572 (5th Cir 1977). Indeed the Court concluded there was no evidence presented contemporaneously by Boree in his 2007 tax return that the Adrian sale was being considered for tax purposes “segregated from the rest of the property” as property held for investment. IRS Wins Boree Loses.

Timothy and Deborah Phelan had a very different experience in Phelan v IRS US Tax Court (2004) when the IRS came knocking on their door for a Capital Gains to Ordinary income audit. The facts are very complex so I have simplified as best I could as follows: Phelan purchased 1050 acres in Colorado in 1994 with possible plans for development. There were various agreements with the County, municipal town and other developers but no sales to the public. In 1998, Phelan sold 45 acres were sold to Elite Development and Vision Development for $1.5M and recognized a 1998 capital gain on his personal tax return. The IRS commenced a Capital Gain to Ordinary Income Audit and converted the capital gain to Ordinary income claiming that Phelan was in the business of selling real estate. Phelan appealed to US Tax Court in Phelan v IRS US Tax Court (2004) claiming he had no employees nor did he engage in any business activities outside of holding and selling a limited number of parcels with the ultimate hope of appreciation of the value of the land.

Judge Gerber easily finds for Phelan because the facts showed that other than the 2 sales in 1998 there was no other activity. The Court concluded that during the 4 years that Phelan held the land, the property did in fact appreciate according to plan and the investment goals had indeed been achieved by Phelan. Phelan wins IRS Loses.

Our final case involves Frederic and Phyllis Allen who in 1999 sold 2.63 acres of undeveloped real estate in East Palo Alto to property developer Clarum Corporation. He reported the sale as an installment sale as per the sales agreement with Clarum and in 2004 Allen received the final installment of $63K from Clarum. Allen did not report this income on his 2004 tax return. On advice of tax professionals Allen amended his 2004 return in 2008 reporting the $63K as long term capital gain. The IRS audited Allen’s amended return and converted the capital gain to ordinary income after an IRS Capital Gain to Ordinary Income Audit. Allen bypassed US Tax Court by paying the tax and then suing for a refund in US Federal District Court for the Northern District of California inAllen v US No 3.2013cv02501.

Judge William Orrick opines that the evidence is compelling that Allen intended to develop the property when he purchased the property and that he undertook substantial efforts to develop the property during the time he owned it. Even Allen in his own deposition indicated to the Court that his original intent was to develop the property. While Allen then argues to the Court in that same deposition that his intent changed over time, the Court found that Allen presented no credible evidence to prove that his intent changed, citing Tibbals v US 362 F.2d 266 (Ct Cl 1966). The Tibbals Court held that a taxpayer’s purpose can change based on the facts the taxpayer presents to the Court but Judge Orrick inAllenconcluded that because Allen provided no evidence that he had held the land for anything other than development the sale of the property therefore resulted in ordinary income. IRS Wins, Allen loses.

So for anyone out there planning to buy land, real estate or some other capital asset what can you do right now to protect your long term capital gain from ordinary income conversion when the IRS Capital Gain to Ordinary Income Audit commences years from now. First before you purchase your land have your tax attorney contemporaneously create the facts and evidence you will need to win an IRS Capital Gain to Ordinary Income Audit. Tibbal makes clear you need to prove to the Court that the purpose for which the property was acquired, the motive for selling it, the taxpayer’s method of selling the land, taxpayer’s income from the sale of it compared with his other income, the extent of the improvements made to facilitate the sale of it, the frequency and continuity of sales, and the time and effort expended by taxpayer in promoting the sales in relation to his other activities all must be factually presented as evidence to the Court in order to win against an IRS Capital Gain to Ordinary Income Audit. Second, after you purchase your land, feel free to outsource development to developers creating written extemporaneous documentation of your intent to sell property to those developers at some point in time but only after the land appreciates in value. Finally make sure the same tax attorney who represented you on both the buy and sell side of the transaction prepares and files your tax return claiming capital gain treatment of the sale. When the IRS Capital Gain to Ordinary Income Audit commences years later your tax attorney will easily be able to present the facts to the Court you will need to win the audit, keep intact your long term Capital Gain, and prevent the Government from taxing you at much higher ordinary income rates.

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

See you next time on TaxView.

Kindest regards,

Chris Moss CPA Tax Attorney

ESTATE PLANNING GIFTING

Estate Planning: Gifting

by Chris Moss CPA

Welcome to TaxView with Chris Moss CPA Tax Attorney

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

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

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

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

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

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

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

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

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

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

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

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

See you next time on TaxView

Kindest regards

Chris Moss CPA Tax Attorney

IRS GIG WORKER AUDIT

The IRS Gig Worker Audit

by Chris Moss CPA

Welcome to TaxView with Chris Moss CPA Tax Attorney

All business owners at one time or another have had to make a choice between classifying a new worker as an employee or an independent contractor.  For most part in the 20^th century these choices were easy to make.  But in the 21^st century a unique worker has begun to emerge that is somewhere between an employee and an independent contractor, the “Gig Worker” or what some may call the Gigs.  While Judge Edward Chen O’Conner v Uber 3:13-cv-03826 ruled against the existence of Gigs, the California Uber case is far from over.  Whatever the ultimate outcome in Uber, in my view Gigs are here to stay.  What or who are the Gigs and how will they be evaluated during an IRS audit of your business?   Stay with us here on TaxView with Chris Moss CPA Tax Attorney to see where Gig law is trending in the 21^st century and what you need to do now to protect yourself from an IRS Gig Worker Audit.

So what is Gig and who are the Gigs?  It all started with Uber.  Not only are there now Gig Uber Drivers but Uber Medicine Gigs called “healers”.  In the last few years we are being invaded and inundated by Gigs.  Unfortunately US tax law has not caught up with the rapid rise of Gigs, who in my view are simply independent contractors being directed by cell phone apps by you all out there to fulfill an immediate need, either providing a service, product or both.

Just so you know, Gig was coined in the early 20^th century as slang for a paying musical engagement.  The Urban dictionary now defines Gig as a job that could now apply to contract work in the IT and computer field or any temporary or incidental employment.  However, the Gig has traveled or “Ubered” way beyond even Urban Dictionary’s definition.

In order to best define a Gig and understand the tax law of Gigs or lack thereof, let’s take a look at the 20^th century worker.  These folks, our parents and grandparents all had a 9-5 job as their primary source of income.  Taxes were withheld and work was reviewed by the “boss” at a company office.  Independents back in those days were according to the current IRS web site the tradesmen and professionals who earned income from many customers, clients, and patients, such as Doctors, Lawyers, and other self-employed contractors.

In my view Gigs are legally somewhere in the middle between Employees and Independent Contractors.  Gigs come to life when you all click on an Uber app and ask that a Gig driver to drive you from Point A to Point B.  The Gig driver is star rated by the public and develops a “branding” based on those ratings.  Over a few months, each Gig develops a unique brand or “good will” based on their star ratings from folks around the world who have used their services. The legal status of Gig drivers, could be compared to the legal status of Gig Nurses, Gig Landscapers, Gig Fitness Trainers, Gig Pilots, and Gig Dog sitters to name a few.  The fact that Uber supplies the App to us to find us the Gig driver, or HEAL supplies the App to find us the Nurse healer, is not the point.  The point is Uber, HEAL, and all the other service Apps simply put the buyer and seller of the service together electronically, kind of like EBay does. The world wide customer base of the individual Gig “controls” how successful the Gig will be, just like EBay sellers are controlled by their star world wide ratings.

Would anyone claim sellers on EBay are employees of EBay?   The similar question was presented to Judge Chen inO’Conner v Uber 3:13-cv-03826, where the the the Court is grappling with whether Gig drivers found via the Uber app are employees.  Unfortunately, because Congress and the Courts have been caught off guard by the rise of the Gigs, the Government during an IRS Gig Worker Audit may be unable to find that middle ground in existing tax law to allow you the business owner to have a no change audit.  So listen up on TaxView with Chris Moss CPA Tax Attorney as you learn how whether or not you win comes down to one simple word: “control”.

The key issues in existing law is “control” over the worker, as in Jones v IRS US Tax Court 2014.   Facts are simple enough.  Jones an attorney hired Tarri’s Business Service (TBS) as an independent contractor owned by his wife Mrs. Jones.  They filed separate tax returns. The IRS audited and claimed TBS was really a disguised employee of Jones and should be classified as an employee.  Judge Goeke easily finds Jones for because Jones did not control the details of TBS work schedule, thereby making TBS an independent contractor.  In other words, Jones did not “control” TBS.  Jones wins, IRS loses.

The facts are just as simple in Central Motorplex v IRS US Tax Court (2014). Central Motorplex (CM) engaged in buying, repairing and selling used autos. Mr. Smith was contracted to pick up and deliver license plates and title certificate as an independent contactor.  The IRS audited and claimed Smith was an employee.  Judge Lauber easily found for the Government because CM assigned Smith tasks, supervised his performance and set his compensation.  In other words, CM was in “control” of Smith. IRS wins, CM Loses.

So what does this all mean for all of us out there who might be paying for Gig services?  While Judge Edward Chen opines in his Order of March 11, 2015 “…it is conceivable that the legislature would enact rules particular to the new so-called “sharing economy..,” the IRS, Congress and the Courts, have yet to recognize the legal significance of the 21^stcentury Gig worker.  So first, for now, our best practice perhaps is to have your tax attorney create standard “Gig Contracts” showing you have absolutely no control over the Gigs.  The easiest way to do this is to allow your Gig to receive public ratings so the public  controls the Gig not your business.  Second, include the Gig Contract in a PDF file attached to your business tax return so that if you are audited years later you will have a document in the tax return supporting your Gig strategy. Finally have your tax attorney standing by with the contemporaneously created documentation, so that when the IRS Gig Worker Audit comes your way you can be confident you will win and save taxes.

Thanks for joining us on TaxView with Chris Moss CPA Tax Attorney

See you next time on TaxView

Kindest regards

Chris Moss CPA Tax Attorney