Monthly Archive: January 2015

1031 Sale and Leaseback

Welcome to TaxView with Chris Moss CPA

Are you soon coming out of a Section 1031 tax free exchange with a large gain? Have you thought about a 1031 sale leaseback (SL) as an alternative to a straight purchase to close out your 1031 this year? Why use an SL? Long term SLs qualify for tax free nonrecognition under Section 1031 and § 1.1031(a)-1(c) of the regulations. For those savvy enough to structure a 1031 SL correctly you can improve cash flow, reduce your risk, and free up credit for additional leveraged real estate purchases, all within the safety of a tax deferred Section 1031 exchange. But the IRS is watching these 1031 SL deals closely. So if you are interested in an SL and have a material gain coming out of a 1031 exchange stay tuned to TaxView, with Chris Moss CPA to find out why the IRS is so concerned about SLs and find out how to bullet proof your tax return from big IRS tax liability if your 1031 SL should get audited.

Why is the Government so concerned about SLs? It’s not about your 1031 and it’s not about your real estate SL. In fact, it’s not about you at all. It’s about bogus equipment deals set up by what appears to be unprincipled at best and worst dishonest tax advisors as in CMA v IRS US Tax Court (2005). This 128 page US Tax Court Opinion introduces us to “lease strips” and/or “rent strips” in a mind boggling series of worthless equipment leasing transactions that the Court concluded were without any substance or business purpose other than to evade tax. IRS wins big CMA loses. Here are just a few more abusive equipment deals which might explain why the IRS is cynical: Santulli v IRS US Tax Court (1995), Heide v IRS US Tax Court (1998), John Hancock Life Insurance v IRS US Tax Court (2013), Nicole Rose Corp v IRS US Tax Court (2001) and Andantech LLC and Wells Fargo Finance vs IRS US Tax Court (2002).

As a result of these abusive equipment leasing cases, the Government regularly audits SLs and sadly looks closely at even the most honest of Section 1031 SL transactions. How can you protect your 1031 SL? Have your tax attorney review with you Frank Lyon Co v IRS, US Supreme Court 435 US 561 (1978) the gold standard of legitimate SL cases. The facts are simple: Worthen Bank and Trust of Little Rock Ark in 1967 was unable to build a headquarters on land it owned due to the Federal Reserve rule at the time that the investment could not be in excess of 40% of its capital and surplus. As a work around in 1968, a privately held company Lyon was approved by the Federal Reserve as an acceptable borrower and New York Life as the acceptable lender. Worthen would sell the building to Lyon for $7 Million as it was constructed and Worthen would lease the completed building back for 25 years from Lyon for a rent of $14 Million. Finally, Lyon, the borrower would pay approximately the same amount of $14 Million back to the lender New York Life.

Lyon deducted interest, depreciation and other legal expenses in connection with the purchase on its 1969 income tax return. The IRS audited and disallowed the deductions claiming that Lyon was not the real owner of the building and that the sale-and-leaseback arrangement was a sham. Lyon paid the tax, and then sued in Federal District Court in Arkansas with the Court finding for Lyon. The Government appealed to the 8th Circuit Court of Appeals which reversed the District Court and ruled in favor of the Government. Lyon appealed to the US Supreme Court on a writ of certiorari which the Court granted in Lyon v US 435 US 561 (1978).

Justice Blackmun who wrote the majority 7-2 Opinion for the Supreme Court in 1978 notes that despite the fact that Worthen had agreed to pay rent and that this rent equaled the amounts due from Lyon to New York Life, Lyon was nevertheless primarily liable on the mortgage with the obligation on the notes squarely on Lyon. Lyon furthermore exposed its very business well-being to this real and substantial risk. “The fact that favorable tax consequences were taken into account by Lyon on entering into the transaction is no reason for disallowing those consequences. We cannot ignore the reality that the tax laws affect the shape of nearly every business transaction.” Lyon wins IRS loses.

Do you see the IRS trap? If you are coming out of a 1031 exchange make sure your tax attorney bullet proofs the sale leaseback so that your landlord—not you—has the risk of ownership. It is that simple. Everything else will fall into place with the right tax attorney and the right qualified intermediary. (QI)

What does this mean for us? First have your tax attorney, qualified intermediary, real estate agent and banker all telephone conference or better yet meet within the 180 day window with plenty of time to spare with the replacement property-the property you will be leasing back-identified within 45 days of the relinquished property sale if a forward exchange. For a reverse exchange please consult your trusted QI. Second, make sure your landlord, the party that will be leasing back to you bears all the risk of ownership. Third have your tax attorney write up the transaction for insertion into your tax return to bullet proof the lease payments deductions in year one and every year thereafter. Finally, perhaps purchase a new additional rental property with your line of credit that you never used on the 1031 SL deal. Keep in mind that cost segregation comes into play as a tax strategy for new construction. Your Section 1031 SL deal is now bullet proof from a stray audit that might just come your way soon. Happy 1031 to all and thank you for joining Chris Moss CPA on TaxView.

See you next time on TaxView,

Kindest regards,

Chris Moss CPA

IRS Disguised Sales Trap

Welcome to TaxView with Chris Moss CPA.

For any of you out there owning a partnership interest that restructures from an S Corp to an LLC or perhaps borrows funds and takes partnership or shareholder distributions, watch out for the IRS Disguised Sale Trap (DST). Or perhaps you own some land or stock with a very low or even negative basis and are told by tax advisors that you can borrow money on those assets without every having to pay back the loan tax free. Watch out for the IRS DST. What exactly is a DST? A DST is simply cash you received that the Government says is a taxable sale resulted from you selling your equipment, partnership interest, real estate or land that you claimed on your tax return was nontaxable proceeds from a loan. If you are snared by this trap you will be viewed by the IRS as if you sold your interest. When that happens be prepared to pay a large tax to the Government or be forced to appeal to the US Tax Court for relief. The US Tax Court will be looking for evidence unique to your case which when applied to the case law will support your position that your distribution was not a disguised sale. Just how to do this is where we are headed on TaxView with Chris Moss CPA. So stay with us here on TaxView to protect your partnership interest from IRS DST traps and save you taxes.

We are going to start with a very simple concept: If it’s too good to be true it isn’t, as was the case of United Circuits vs IRS US Tax Court (1995). Frank Schubert and Gary Jump owned United Circuits (United) a company that ensured that waste products from manufacturing were in compliance with EPA standards. United would purchase various equipment each year which would be depreciated in accordance with IRS regulations. Equitable Lomas Leasing contacted United offering an alternative one year leasing program from 1989 and 1990 with a $1 dollar buy out after one year allowing United to deduct all their depreciable equipment in one year. United deducted the entire one year lease expense on both years tax returns. The IRS audited and disallowed all deductions. United appealed to US Tax Court in United Circuits vs IRS US Tax Court (1995). If you saw this case as a DST in reverse you are right. The Court easily found for the IRS. IRS Wins United Loses.

Moving to a much more complex set of facts we move to Virginia Historic Tax Credit vs IRS US Tax Court (2009) in which an investment fund (the Fund) was issuing tax credits to investors. The IRS disallowed the allocations of tax credits and increased income of the partnership claiming that in fact these tax credit allocations were disguised sales to the investors. By the way, do you see the DST in this case? Was the sole reason for joining the partnership to obtain a tax credit? The Government is going to see this as a disguised sale of tax credits with the investors being nothing more than buyers.

The Fund appealed to US Tax Court in Virginia Historic Tax Credit v IRS US Tax Court (2009). The Court concludes based on all the evidence presented, including a detailed review of the operating agreements, the investors were not purchasers but investor partners who genuinely wanted to support historic rehabilitation. The Court looked closely at the executed multiple documents creating the partnerships signed by each investor. The partnerships operating agreements indicated the purpose of the partnership was to help rehabilitate historic property and to receive State tax credits in return. Investors who testified at trial all testified credibly and accurately. Finally Judge Kroupa points to Congressional intent to encourage State historic rehabilitation programs and supports individuals involved in these programs citing the National Historic Preservation Act (1966). Fund wins, IRS loses.

Be careful though. If it’s too good to be true it isn’t. In Superior Trading LLC v IRS, 728 F.3d 676 (7th Cir. 2013) dozens of complex partnerships were formed around noncollectable receivables and bogus promissory notes in attempt to create a tax shelter scheme that was too good to be true. 7th Circuit Chief Judge Easterbrook, Posner and Williams chides Superior Trading, noting a genuine partnership is a business jointly owned by two or more persons (or firms) and created for the purpose of earning money through business activities. If the only aim and effect are to beat taxes, the partnership is disregarded for tax purposes. Which is exactly what the Court did in ensnaring Superior in the DST. IRS wins, Superior Trading Loses.

Our final case, Gateway Hotel v IRS US Tax Court (2014), involves the former Statler and Lennox Hotels of St Louis Missouri which were being renovated by Gateway Hotel Partners (Gateway).

The facts are complex so hold on to your tax-belts and enjoy the ride: The Court notes that Gateway had two members, Washington Avenue Historic Developer, managing partner, (WHAD), and Housing Horizons (HH), with profits split 1% to WAHD and 99% to HH. WAHD was substantially owned and controlled by an S Corporation Historic Restoration (HR). HH on the other hand was owned and controlled by Kimberly Clark Corporation (KC) and was just a passive investor with a 70% membership in Gateway,. Gateway ultimately would get funding from investors interested in the partnerships Missouri Historic Preservation Tax Credits (MHTCs) that investors would be entitled to. However, Gateway needed interim financing until they could offer the MHTCs to investors. The Missouri Development Finance Board (MDFB) in December 2000 agreed to make an $18 Million bridge loan to fill the Gap. The loan was made to HRI, who signed the bridge loan agreement on behalf of WAHD and GHP. The MDFB intended HRI to be the sole borrower and be solely liable for repayment of the bridge loan in the event of default. HRI agreed to make a capital contribution of the bridge loan proceeds to WAHD (HRI contribution) concurrently with the funding of the bridge loan, and WAHD was in turn required to contribute those proceeds to Gateway.

The bridge loan was repaid in 2002 with proceeds from the transfer of MHTCs to various investors. Gateway filed Form 1065 for 2002 and did not reflect the distribution of MHTCs in any amount to WAHD nor did it report it had income from transfers of MHTCs to various investors. The IRS audited Gateway for 2002 and 2003 and determined that Gateway failed to report $18 million of income from its transfers or what the Government claimed were disguised sales of the MHTCs. Gateway filed an appeal with US Tax Court in Gateway Hotel v IRS US Tax Court (2014).

Judge Goeke notes under Section 1.707-3 rules are providing for identifying disguised sales based on the facts and circumstances of each case. Section 1.707-3(b)(2) specifically provides a non-exhaustive list of 10 factors to prove the existence of a disguised sale. The Court looked very closely at all parties operating agreements and reviewed all 10 factors, comparing each factor to the facts of the case. The Court found only 2 of the 10 factors supporting a disguised sale. Gateway wins, IRS loses.

What can all of us do with much less complex business facts and circumstances to avoid DSTs? First and most important have your tax attorney annually review with you all K-1 distributions from partnerships and proceeds from loans as they pertain to Section 1.707-3(b)(2). Make sure cash or property you receive are put through the 10 factor scrutiny for analysis by your tax attorney. Second review all your operating agreements and financing arrangements with your attorney. Amend agreements as necessary to make certain you are ready for any DSTs coming your way. As you can see in Gateway, Courts look very closely at operating agreements and apply them to Section 1.707-3(b)(2) to your unique tax facts. Finally, if you receive any distribution in cash from loans or partnerships be sure you receive a written tax opinion from your tax attorney that this money is a “nontaxable distribution” and not a disguised sale. Insert that written tax opinion in your tax return before your file. When you get DST audited years later you will be glad you did. Thanks for joining Chris Moss CPA on TaxView.

See you next time on TaxView

Kindest regards

Chris Moss CPA

501(c)(3) Private Foundation Basics

Welcome to TaxView with Chris Moss CPA

If you have given a large donation to an IRS designated 501(c)(3) public charity this year you all know that you get to itemize that contribution as a tax deduction on Schedule A of your Form 1040. But there is also another option: the charitable tax-exempt 501(c)(3) Family Private Foundation or PF. While the super-rich have always had PFs, Bill and Melinda Gates Foundation for example, many more American taxpayers are giving PFs a try. Your family gets significant control over the types of “grants” they make as well as substantial income and estate tax benefits. Not to mention a permanent legacy for your family for generations to come. But watch out: there are many IRS Government placed PF traps that can cause your PF to cost you more than its worth in penalty excise taxes. So if you have any interest in forming a Private Foundation, stay with us here on TaxView with Chris Moss CPA to learn the steps in properly operating a PF so that you stay clear of IRS imposed excise taxes during a routine PF audit.

The legislative history of the PF is to say the least fascinating. One of the first PFs in the early 20th century was the Rockefeller Foundation formed in 1913. Did the newly enacted income tax enacted that same year and the estate tax three years later in 1916 have anything to do with this? What do you think?

Over a 100 years and thousands of private foundations later Congress addressed the wide spread abuse of the tax exempt status of private foundations. A leading 7th Circuit case, Quarrie Charitable Fund v IRS, 603 F.2d 1274 (7th Cir US Court of Appeals 1979) and the House Ways and Means 2005 Report rewinds us back to the Tax Reform Act of 1969. The Act imposed PF excise taxes on self-dealing between the founding family and the PF and a small 2% tax on investment income. Even with these excise taxes, PFs continue to be extremely popular with many taxpayers and have evolved into Grant-Making Private Foundations (GPFs), Private Operating Foundations (POFs) and Exempt Private Operating Foundations (EPOFs’) which are relatively easy to set up and operate—that is as long as you know where the IRS traps are.

The first trap is easy to avoid, but apparently not to Todd v IRS US Tax Court (2002). In 1994 Todd formed the Todd Family Foundation and transferred 6,350 shares of Union Colony Bancorp to the PF. Todd took a $500,000 charity deduction on Schedule A of his 1994 Form 1040 using form 8283 Noncash Charitable Contributions as substantiation for the deduction. The IRS audited and disallowed all deductions including carryforwards to 1995-1997 arguing that there had been no qualified appraisal of the stock. Todd appealed to US Tax Court in Todd V IRS US Tax Court (2002). Judge Halpern easily finds for the Government citing IRS regulation 1.170A-13 that a qualified appraisal must be made no earlier than 60 days prior to the date of contribution, be prepared and signed by a qualified appraiser and must have been included in the tax return along with Form 8283. IRS Wins Todd Loses.

The next two traps of control and self-dealing are more complex as discussed by the IRS themselves in their article Developments in the Private Foundation Area (1990). Unlike public charities, PFs are most likely controlled by the founding family, as in Bell v IRS US Tax Court (2009). Bell owned the Bell Family Foundation and numerous other profitable business entities. Bell contributed stock in Northeast Investors Trust to the Bell Foundation and properly deducted a charitable deduction with a signed appraisal on his 1996 tax return. There were in addition subsequent charitable carryforwards to years 1997-2000. The IRS audited and disallowed all Bell’s donations to the Bell Foundation for all years claiming that Bell still controlled the stock because Bell controlled the Foundation. Since Bell still controlled the stock there was never a charitable donation to deduct because no charitable gift had ever been transferred. The Bells appealed to US Tax Court in Bell v IRS US Tax Court (2009). The Court noted that although the PF is controlled by the Bells, control alone is not sufficient to defeat the charity deduction by the Bells. Judge Wells further argues that the IRS had not cited any authority in support of their contention that merely having control over the foundation disqualifies the Bells from claiming the charitable contribution deductions for the contribution of the shares of Northeast Investors Trust to the Foundation. Indeed the Court opines, the “Self-dealing” trap is more likely to trip up PFs as per IRS Code Section 4940 through Section 4945. IRS loses, Bell Wins.

Which brings us to the trap of self-dealing. “Self-dealing’ includes the furnishing of goods, services or facilities between a PF and a disqualified person as per Section 4941(d)(1)(C). There is one exception: Section 4941(d)(2)(E) allows “self-dealing” to family members if their service was of a professional nature and their compensation was not excessive. But what about for example a janitorial service?

In Madden v IRS US Tax Court (1997), Madden’s PF, the Museum of Outdoor Arts contracted with Madden’s Maintenance Company to perform maintenance, janitorial and custodial work. The IRS audited six years’ worth of Madden’s tax returns from 1983-1989 and charged him self-dealing excise tax on all years. Madden appealed to US Tax Court in Madden v IRS US Tax Court (1997). Judge Fay reviews the legislative history involving the “personal service” exception of Section 4941(d)(2)(E) noting that in order to prevent PFs from being used by their Founders for personal gain, Congress established a set of arm’s length standards for dealings between the foundation and the Founder members or “disqualified individuals”. H. Rept. 91-413 (Part 1), at 21(1969). The Court notes that while the IRS regulations do not define the term “personal service” they offer several examples such as legal services, investment management services and general banking services. The Court therefore concluded that janitorial service was not “personal service” and that Madden was subject to the “self-dealing” excise tax under Section 4941(a)(1). IRS Wins Madden Loses.

So what can you do to set up your PF right now? First, choose what area you want to make a difference in the world. One family can change the world with the properly structured PF. Look at Water Missions and see how this one family is changing the world working through the power of the Holy Spirit to provide fresh water to nations in need. Next make sure to consult with your tax attorney. She can set up your PF, including State entity formation, IRS EIN number, application to the IRS for tax exemption Form 1023 and can act as your PF in house legal counsel as well. Third transfer assets to the Foundation either in cash, stock and/or real estate and begin the journey to create your legacy. As a secondary yet important benefit your transferred assets are removed from your taxable estate saving you and your family estate tax upon your passing. Last but not least is the annual income tax savings you receive as you deduct one very large charitable donation on Schedule A of your personal tax return. All said and done, not a bad way to change the world. Hope your PF goes well in 2015. Thanks for joining us on TaxView, with Chris Moss CPA.

See you next time on TaxView,

Kindest regards and Happy New Year 2015

Chris Moss CPA