Monthly Archive: August 2014

IRS or State Law For Medical Marijuana

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Medical marijuana is now legal in at least 23 states and the District of Columbia, and two of those states, Washington and Colorado, have legalized marijuana for recreational use. If you are one of the many taxpayers out there thinking about operating a medical or recreational marijuana retail store there are some unique tax consequences that you will face as you file your annual business tax return. Regardless of which State you are operating in you are well advised to retain the best tax attorney you can find to bullet proof your tax return in accordance with IRS Code 280E which disallows deductions for any amount paid or incurred in carrying on any trade or business consisting of trafficking of controlled substances which is prohibited by Federal law. Does State law conflict with IRS tax law? Stay with us on TaxView as we explore the Kafkaesque surreal and adverse tax consequences of operating a retail marijuana store in states where it is legal to do so.

Martin Olive operated a sole proprietorship in 2004 he called the Vapor Room Herbal Center (Vapor). Vapor sold medical marijuana in California, pursuant to the California Compassionate Use Act of 1996. The Vapor Room was open weekdays from 11am to 8:30pm and weekends noon to 8pm and sold nothing but medical marijuana. Vapor’s sole source of revenue was its sale of medical marijuana. Employees explained to customers the benefit of vaporizing marijuana as opposed to smoking it and helped customers operate the vaporizers. Olive filed his income tax return for 2004 and 2005 reporting sales of over $1M in 2004 and over $3M in 2005. Vapor’s Cost of Goods Sold (COGS) or how much Vapor paid for the marijuana was high. For every million in sales Vapor COGS was $900K in 2004. In 2005 Vapor’s $3M in sales had a COGS of $2.8M. In addition Vapor had normal administration costs associated with any retail business.

The IRS audited Vapor’s returns for 2004 and 2005 and the IRS disallowed all Vapor’s expenses relying on Section 280E. Based on examination of Vapor’s bank statements the IRS determined tax deficiencies for Vapor of over $600K and $1.1M for 2004 and 2005. Vapor appealed to US Tax Court and the Court rendered its Opinion in Olive v IRS in 2012. Judge Kroupa almost immediately points out that while numerous medical marijuana dispensaries were formed in California to dispense medical marijuana to recipients, medical marijuana is nevertheless a “controlled substance” under Federal Law.

The case did not go well for Vapor. Judge Kroupa found that Olive’s testimony was “rehearsed, insincere and unreliable”. The Court also found that Vapor’s reported revenue was substantially understated. Worse yet is that Olive did not dispute that he under-reported Vapor’s receipts. Moreover, the Court could not ascertain the actual amount of COGS even with the help and an expert Henry C Levy CPA. Unfortunately for Vapor, the Court found Levy’s testimony to be “unreliable”. The Court eventually estimated a COGS based on a percentage of sales, but at a much lower percentage than Vapor originally reported. The IRS, however, even wanted the COGS disallowed citing Section 280E. Just when the IRS was about to vaporize Vapor into a puff of smoke, the Court took notice of another California case Californians Helping to Alleviate Medical Problems (CHAMP)..

CHAMP provided counseling and other caregiving services including medical marijuana. The IRS audited CHAMP and determined that all of CHAMP’s expenses were nondeductible under Section 280E in connection with the trafficking of a controlled substance. CHAMP appealed to US Tax Court. Judge Laro noted that CHAMP furnished its services at is main facility in San Francisco California where customers received medical marijuana. The IRS argued that all of CHAMP expenses where in connection with the illegal sale of drugs and therefore all expenses were nondeductible under Section 280E. The Court disagreed. Citing the Senate Finance Committee report, the Court found that COGS would be exempt from 280E in order “to preclude possible challenges on constitutional grounds.” Senate Finance Report S. Rept. 97-494 (Vol. 1). Likewise citing Champs, Judge Kroupa’s Vapor Opinion also concluded that Section 280E did not apply to Vapor COGS. Nevertheless, the Court disallowed all other expenses incurred by Vapor, even though the Vapor Room was a legitimate operation under California law, citing CHAMP US Tax Court.

What does all this mean for any of you out there who want to run a legal retail operation in a state where sale of medical or recreational marijuana is legal? First, until and if Congress changes the law, COGS may be the only deduction you are allowed for marijuana retail expense. That being said, make sure you have excellent books and records that separates out the marijuana retail portion of your business from any other retail operations you may have so all expenses can be deducted. Second, get support from State government and local tax departments on how best to set up your business so that you are not in violation of Section 280E of the IRS code. In other words, be prepared to deal with the fact that the Federal Government still views what you are doing as illegal, and make sure your COGS is well documented. Finally be prepared for an IRS audit, retain the best tax attorney you can afford, and file a bullet proof tax return with full disclosure to the Federal Government as to exactly how your deductions are not subject to Section 280E limitations. Years later if you get audited by the IRS you will be happy you did.

Thank you for joining Chris Moss CPA on TaxView

Kindest regards
Chris Moss CPA

Tax Free Housing Allowance For Clergy

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If you are a minister of the Gospel you most likely have heard of the Parsonage Allowance Exclusion or the tax free housing allowance for clergy under Section 107 of the IRS Code. First enacted in 1921 the Allowance excludes the rental value of a dwelling house furnished to a minister from Federal Income tax. Congress kept the Allowance rules substantially unchanged until amendments were added by Congress in 2002 in response to Rick Warren’s battle with the IRS regarding his Allowance from Saddleback Valley Community Church vs IRS The case worked its way up to the US Court of Appeals for the 9th Circuit. However Rick Warren and the US Government suddenly settled out of court and the case was dismissed. But 10 years later in a surprise move that even caught TaxView off guard last year, one provision of the Allowance, 107(2), was ruled unconstitutional by Judge Barbara Crabb on November 21, 2013 in Freedom From Religion v Lew US District Court Wisconsin. In response to Judge Crabb’s ruling, the US Government appealed to the 7th Circuit arguing that the Allowance does not endorse a religious message but merely adapts the IRS Code’s general exemptions for certain types of employer-provided housing to the unique context of a church and its minister. TaxView asks why the Parsonage Allowance is being challenged for the first time in almost 100 years. Stay with us on TaxView for the answer.

Let’s first look at what Section 107 is all about. Simply stated if you are a preacher you get to exclude from your income the fair rental value of the home or what the church pays you for the home, whichever is less. Section 107(1) excludes the value of your housing provided by the Church. Section 107(2) excludes direct cash compensation paid to the preacher for housing that the preacher pays for. Further regulations added requirements that the Allowance be officially approved by the Vestry or similar church Board See IRS Ministers’ Compensation and IRS topic 417. Various tax court rulings, including US Tax Court Driscoll v IRS imply that Congress had viewed the the relationship between a Church and its ministers in a similar manner as they viewed the relationship between an Employer and its Employees. Congress reasons that if Employees were exempted on housing provided for the convenience of their employer, then why not have the Clergy exempt on similar housing allowance income when they would travel to a new Church to preach the Gospel. Interestingly, while the US Tax Court has ruled for or against the clergy over the years for abuse of the Exclusion, the Court has never before challenged Section 107 on Constitutional grounds, that is until now.

So why now after 100 years was the Parsonage Allowance Section 107(2) ruled unconstitutional by Judge Crabb? How did FFRF manage to persuade the Wisconsin Federal Courts to strike down Section 107(2)? As I see it, the whole of FFRF’s argument revolved around one Supreme Court case Texas Monthly. As you read Judge Crabb’s opinion see if you can spot the 1989 Supreme Court ruling in Texas Monthly. Justice Brennan joined by Marshall and Stevens held that a Texas law that gave tax free status to religions publications was unconstitutional. Justice Brennan concludes “In this case, by confining the tax exemption exclusively to the sale of religious publications, Texas engaged in preferential support for the communication of religious messages.” However Justice Scalia in his dissent joined by Justice Kennedy noted that for “over half a century the federal Internal Revenue Code has allowed “minister[s] of the gospel” (a term interpreted broadly enough to include cantors and rabbis) to exclude from gross income the rental value of their parsonages. In short, religious tax exemptions of the type the Court invalidates today permeate the state and federal codes, and have done so for many years. Justice Brennan shot back, however, that the “fact that such exemptions are of long standing cannot shield them from the strictures of the Establishment Clause and furthermore, no one acquires a vested or protected right in violation of the Constitution by long use, even when that span of time covers our entire national existence and indeed predates it.”

Moreover, Judge Crabb in her own Wisconsin Opinion in FFRF v Lew seems to have totally and completely embraced Justice Brennan’s Opinion in Texas Monthly, noting that because Section 107 does not include the limitations on the type or location of the housing that the private sector exclusion provides, Section 107 has no “secular purpose or effect and that a reasonable observer would view it as endorsing religion.” However the Good News is there is hope. Indeed, Judge Crabb states, that invalidation of the Allowance on Constitutional grounds does not mean that the government is powerless to enact tax exemptions that benefit religion. Thus, if Congress believes that there are important secular reasons for granting the Exclusion, Congress is free to rewrite the provision in accordance with the principles laid down in Texas Monthly so that it includes ministers as part of a larger group of beneficiaries.

In conclusion in my view, regardless of the outcome in the 7th Circuit, this case may be headed for the US Supreme Court for a final showdown. So be warned, if you live outside the 7th Circuit of Indiana Wisconsin and Illinois, be prepared for more challenges from the FFRF closer to hone. What does this mean for the Preachers of the Gospel out there? If you are a member of the Clergy and preach the Gospel, unless Congress acts soon, your housing allowance may be just a memory from the 20th Century. If the Allowance is important to you, make sure to let your elected representatives know how you feel.

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See you next time,
Kindest regards, Chris Moss CPA

IRS Material Participation Audit

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If you own multiple businesses you know all too well that start-ups generally lose money the first or second year. But did you know you can deduct these losses against current earnings, lower taxes and increase cash flow all at the same time you phase into rapid growth and expansion? Before you get too excited about having such a great tax strategy, turn around and make sure your tax professional has your back, for lurking in the dark at an IRS office near you is a Government agent getting ready for battle using a new and exciting weapon against you, the “material participation” rules of engagement. Long time business owners and start ups alike are increasingly at risk of losing all losses in the battle to comply with IRS regulations requiring at least 500 hours of material participation. Stay with me on TaxView as we head to US Tax Court to find out how to protect and armor up your business losses from adverse IRS audit consequences if the Government finds that you are not “materially participating” in your business activities.

Let’s start out with Iversen vs IRS a rather simple introduction to Section 469. Iversen owned various business interests included 100% ownership in Stirrup Ranch LLC, a 14,000 acre cattle and horse ranch in Fremont County Colorado. Martin Nergaard, attorney and CPA and former IRS employee prepared and filed Iversen’s 2005 and 2006 tax returns. Nergaard concluded Iversen qualified for material participation in that he worked the Ranch at least 500 hours. As a result Nergaard deducted almost $500,000 in losses on Iversen’s tax returns. Sure enough the IRS audited and disallowed all the losses claiming that Iversen did not materially participate in the Ranch. Iversen appealed to US Tax Court. In US Tax Court Judge Swift’s Opinion in Iversen vs IRS (2012) material participation is defined as involvement on a “regular, continuous and substantial basis”. Judge Swift says you can use “any reasonable means” to prove you materially participated, including calendars, appointment books, and narrative summaries citing 1.469-5T. Neither Iversen’s testimony nor his evidence was credited as sufficient to convince Judge Swift to allow Iversen’s losses. IRS wins Iversen loses.

Our next case Newell vs IRS decided in US Tax Court in February of 2010. Judge Marvel has somewhat different facts here than Swift did with Iversen. Newell owned 100% of a California Millworks business and owned a 33% interest in Pasaddra Country Club LLC. Newell deducted over $5 Million of losses on his 2001 2002 and 2003 income tax returns from these businesses. The IRS audited and disallowed all these losses citing 469(h)(2) claiming that Newell as a “limited partner” did not materially participate in the Country Club. The Court sided with Newell noting that only limited partners in a “partnership” not partners in an LLC are limited by 469(h)(2). Newell wins IRS loses.

We now come to our final case which involves real estate businesses. Fasten your seat belts on this ride because real estate passive activity road map requires acceleration at dizzying speeds sometimes causing taxpayers to faint into disastrous head on collisions with the IRS into the walls of US Tax Court in Washington DC. Frank Aragona Trust vs IRS decided in US Tax Court in March of 2014 Aragona is a trustee which manages rental real estate properties. Real estate activities, even with material participation, are considered passive under 469(c)(2). For those of you in real estate please take a look at these excellent articles on real estate passive losses. See Journal of Accountancy 469(c)(2). Also see the Tax Advisor Section 469. Aragona deducted on the trust tax return from 2003-2006 millions of dollars of losses. When the IRS audited these years all losses were disallowed and almost $600,000 of tax was assessed. Aragona appealed to US Tax Court. The question presented before the Court: Whether 469(c)(7) applies to a trust as it does for all other business entities.

Before we find out the exciting conclusion of the Court, I suggest we rewind history to the Tax Reform Act of 1986 as championed by President Reagan. The 1986 Reform Act had generally disallowed all Real Estate losses from offsetting ordinary income in order to fight back against abusive tax shelters in that era. However after years of lobbying by the Real Estate industry, Section 469(c)(7) was enacted in the 1993 during the Clinton Administration to give “Real Estate Professionals” a chance to deduct their legitimate losses. For those of you with multiple businesses you need to jump through two high, but with proper structure planning and record keeping, not impossible hoops: 1)More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates; and 2) The taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.

Fast forward please back to Aragon Trust. The IRS agreed that the trust had adequately documented its records to prove material participation. However, the IRS said a “trust” was not capable of performing personal service since the trust was not a person. The Court rejected this IRS argument and concluded that a trust is “capable of performing personal services and therefore can satisfy the section 469(c)(7) exception. The Court opined that indeed, if Congress had wanted to exclude trusts from the section 469(c)(7) exception, it could have done so explicitly by limiting the exception to “any natural person”. Aragon wins IRS Losses; a big victory for trusts and taxpayers nationally.

In conclusion if you do not all feel 100% protected from a possible IRS material participation attack on your business activities ask your tax professionals to document your time in each business in the actual tax returns they file for you. If you have multiple businesses, and you feel you need even more protection, please consult your tax advisors and make sure you are extemporaneously and contemporaneously keeping track of your participation in each business. Perhaps you wish to disclose summary participation data in attachments to your annual income tax returns before you file? Finally subscribe as I do to the “now or later” ancient philosophy of tax audits: Consult tax attorney now, protect you from IRS audit later.

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IRS Offer-In-Compromise

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

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

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

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

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

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

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

Submitted by Chris Moss CPA

Estate Tax Business Valuation: Goodwill

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

Goodwill brings us smack into the walls of the US Tax Court where just a few weeks ago Judge Paris decided the case of T.C. Memo. 2014-155 ADELL vs IRS. Franklin Adell founded STN.Com’s, a cable uplinking company, with his Son Kevin. STN.COM sole business purpose was to broadcast an urban religious program channel named “The Word Network” (The Word). When Adell died in 2006 his estate included the entire ownership of STN.Com and numerous other assets. Adell‘s estate valued STN.Com, with a reported date-of-death value of $9.3 million in the Form 706 Estate Tax return filed in late 2007. Estate tax was owed of approximately $15 Million on STN and all the other assets. The STN.Com stock’s reported value was based on a valuation report prepared by and certified by J Stout Risius Ross, Inc. (Ross).

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

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

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

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

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

Kindest regards Chris Moss CPA

Family LLC Member Discounts

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

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

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

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

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

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

Submitted by Chris Moss CPA

IRS Criminal Investigation Divison

Submitted by Chris Moss CPA

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

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

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

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

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

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

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

Thank you for joining Chris Moss CPA on TaxView

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Kindest regards
Chris Moss CPA