Larry's Tax Law

While it is highly unlikely Santa’s little helpers will deliver to taxpayers a tax reform package by the end of 2014 that is acceptable to the Senate, the House of Representatives and the President, House Ways and Means Committee Chairman, Dave Camp, made one last attempt to move the ball forward.  On December 11, 2014, shortly before Chairman Camp’s expected retirement, he formally introduced a bill in the House to adopt into law the Tax Reform Act of 2014 which he authored and circulated in proposed form to lawmakers back in February.  Affixed with the label “Fixing Our Broken Tax Code So That It Works For American Families and Job Creators,” the proposal is now formally before Congress.

Whether we will see tax reform in this country anytime soon is debatable.  When and if we see it, whether IRC § 1031 will survive has been a subject of discussion.

House Ways and Means Committee Chairman David Camp issued a discussion draft of the Tax Reform Act of 2014 earlier this year.  The proposed legislation spans almost 1,000 pages.*  One of its provisions repeals IRC § 1031 and taxpayers’ ability to participate in tax-deferred exchanges.  The Obama Administration responded to Chairman Camp’s proposal.  It wants to retain IRC § 1031, but limit its application to $1,000,000 of tax deferral per taxpayer in any tax year.  Based upon the precise wording of the White House’s response to Chairman Camp’s proposal, it appears the $1,000,000 limitation would only apply to real property exchanges.  So, personal property exchanges would be spared from the proposed limitation.  Of course, there is always the possibility that lawmakers, if they take this approach, would expand the White House’s proposed limitation to apply to personal property exchanges.  Only time will tell.

When tax advisors fail to follow the rules, it tarnishes our profession.  The bad behavior may subject them to discipline by the body governing their practice, the Office of Professional Responsibility and/or the criminal justice system.

Discipline may come in many flavors, depending upon the severity of the misconduct.  Sanctions generally consist of censureship, suspension, disbarment, financial penalties and imprisonment.

The stakes are high.  Tax advisors and their firms need to know and follow the rules, and implement systems to ensure compliance by the members of their firms.

Background

Effective June 30, 2005, Treasury issued final regulations amending Circular 230 (“2005 Regulations”).  The 2005 Regulations were specifically aimed at two goals:

• • Deterring taxpayers from engaging in abusive transactions by limited or eliminating their ability to avoid penalties via inappropriate reliance on advice of tax advisors; and

• • Preventing unscrupulous tax advisors and promoters from marketing abusive transactions and tax products to taxpayers based upon opinions that failed to adequately consider the law and the facts.

After the 2005 Regulations were issued, Treasury continued tinkering with the regulations to refine its approach, keenly keeping focus on these two goals.  Accordingly, we have seen numerous refinements to Circular 230 in the past nine (9) years, including:

• • Amendments to the 2005 Regulations published on May 19, 2005;

• • Broadened authority granted by lawmakers to Treasury to expand standards relating to written advice on October 22, 2004, with the passage of the American Jobs Creation Act of 2004 (“AJCA”).  In addition, the AJCA gave Treasury authority to impose monetary penalties against tax advisors who violate Circular 230;

• • Amendments to Circular 230 published on February 6, 2006, in proposed form, adopting, among other things, monetary penalties for Circular 230 noncompliance.  These regulations were finalized, effective September 26, 2007; and

• • Amendments to the written advice provisions of Circular 230 published on October 1, 2012 in proposed form.  These amendments were finalized on June 14, 2014.

Until 2005, Circular 230 was untouched for almost two decades.  An enormous storm awoke Treasury from a deep sleep, causing a loud roar to permeate among lawmakers, the IRS, Treasury and the tax community.  The result was the adoption of rules aimed at achieving the two goals set forth above.

The ultimate cause of the storm was the broad sweeping allegations of fraud and deception in the accounting and law professions which we saw in the early part of this millennium, including scandals involving ENRON, Global Crossing, imClone, WorldCom, Qwest, Tyco, HealthSouth and Aldelphia.  Further feeding the storm were the black clouds created by the collapse of Arthur Andersen and the financial penalties assessed against and the practice limitations imposed upon KPMG.  Last, but certainly not least, the investigations and lawsuits against tax advisors (and their firms) for developing and marketing abusive tax shelters, including the investigations and lawsuits leading to the demise of the large law firm of Jenkens & Gilchrist (“Jenkens”), added to these dark times.

Treasury issues long-awaited amendments to Circular 230.  On June 9, 2014, Treasury published amendments to Circular 230 that we have been anticipating for the past several months.  It looks like the crazy email disclaimers, just like leisure suits, will be a thing of the past.  Among many changes to Circular 230, the final regulations eliminate or clarify the complex rules for written advice.  Based upon my first read of the regulations, it certainly appears Treasury has been listening to tax practitioners.

Stay tuned, I will be posting a summary of the amended regulations soon.

The Internal Revenue Service (“IRS” or “Service”) has repeatedly stated that, while its crackdown on the failure of taxpayers to report foreign financial accounts has been strong, it is reasonable in the application of the law. At least one taxpayer, Mr. Carl R. Zwerner, would likely debate that pronouncement.

On June 9, 2014, Bloomberg BNA Daily Tax Report (No. 110) revealed that a long and hotly-contested battle between Mr. Zwerner and the United States government has come to an end. This highly-publicized case is frightening. It illustrates that the IRS may not always be reasonable in the application of the foreign financial account reporting (“FBAR”) laws.

Mr. Zwerner, an 87-year old retired specialty-glass importer, is a United States citizen who resides in Coral Gables, Florida. He had a financial account in Switzerland. The account balance never exceeded $1.7 million. It appears the account was opened by Mr. Zwerner during 2004 in the name of a foundation. In 2007, he closed the original account and transferred the account balance to another Swiss account. The new account was opened in the name of yet another foundation. Mr. Zwerner controlled these accounts; he was undisputedly the beneficial owner of the accounts.

On June 11, 2013, the battle commenced when Assistant Attorney General Kathryn Keneally instituted a lawsuit against Mr. Zwerner in the United States District Court for the Southern District of Florida, seeking to collect almost $3.5 million in penalties from him for violating the FBAR rules. The assessment which the government was pursuing against Mr. Zwerner amounted to more than double the highest account balance of his Swiss financial account.

Following up on my summary of Congressman Dave Camp's discussion draft of the Tax Reform Act of 2014, I had the opportunity to discuss the subject with Colin O'Keefe of LXBN. In the brief interview, I describe some of the proposed tax provisions that will impact individual taxpayers and corporate taxpayers.

According to an article published by Kristi Eaton of the Associated Press (“AP”) on February 20, 2014, NBA star Kevin Durant filed a lawsuit against his former accountant, Joel Lynn Elliott, CPA, for alleged mistakes made in the preparation of income tax returns.  As a result of the mistakes, Durant alleges he will have to amend certain income tax returns, pay additional taxes, and possibly be subjected to penalties.

 The lawsuit, filed in California, where CPA Elliott practices accounting, alleges that the accountant made numerous errors in the preparation of Kevin Durant’s income tax returns, including deducting as business expenses the costs of personal travel and the costs of a personal chef.  According to the AP, the complaint provides with respect to the travel expenses:  “In preparing a client’s tax returns, a reasonable prudent accountant would have conducted a basic inquiry and sought documentation to confirm that each travel expense for which a deduction was recorded was truly business related.” 

As a general proposition, if a tax return preparer gives a client incorrect advice about the deductibility of certain expenses or mistakenly includes non-deductible expenses on the client’s tax return, what are the client’s damages? The taxes, the interest on the underpayment of taxes, the penalties and/or the cost to amend the tax return?   If the client ends up engaging a new preparer to amend his or her tax return, and pays the tax, interest on the underpayment of taxes and penalties, it seems logical the preparer could be liable for the cost of amending the returns and the penalties.  The client owes the tax; nothing the preparer did likely changes that conclusion.  Unless the client would have refrained from incurring the non-deductible expenses in the first place had he or she been given a correct recitation of the tax laws, how can the preparer be liable for the tax?   Interest is a bit trickier.  Since the client got the use of the money (from the time the taxes were originally due until actually paid), one can argue the preparer is not liable for the interest.  Assuming the preparer gave incorrect advice or mistakenly included non-deductible expenses on the client’s tax return, he or she will likely be liable for the cost of amending the tax return and the penalties.  Obviously, there may be facts that would cause a court to rule differently.

House Ways and Means Committee Chairman Dave Camp (R-Michigan) issued a discussion draft of the “Tax Reform Act of 2014” last week.  The proposed legislation spans almost 1,000 pages and contains some interesting provisions, including, without limitation, the following:

Individual Taxpayer Provisions

• • Consolidation and simplification of individual income tax brackets.  The current seven tax brackets would be consolidated into three brackets—namely, a 10% bracket, a 25% bracket and a 35% bracket.  High-income taxpayers would be subject to a phase-out of the tax benefit of the 10% bracket.  In addition, the special rate structure for net capital gains would be repealed.  In its place, non-corporate taxpayers could claim an above-the-line deduction of 40% of adjusted net capital gain.

• • Expand the standard deduction (to $22,000 for joint filers and $11,000 for individuals) and modification of available itemized deductions, including:

• • Repeal of the 2% floor on itemized deductions and the overall limitation on itemized deductions.

• • Reduce the itemized deduction for home mortgage interest to $500,000.

• • Repeal of the deduction for personal casualty losses.

• • Repeal of the deduction for unreimbursed medical expenses.

• • Repeal of the deduction for state and local taxes not paid in connection with business or investment.

• • Simplification of the rules surrounding charitable deductions.

• • Repeal of the exclusion for employee achievement awards.

• • Repeal of the deduction for moving expenses.

• • Reinstating the former provision allowing the cost of over-the-counter medications to be reimbursed through tax-favored health accounts.

• • Consolidation and simplification of tax benefits for higher education.  A single educational tax credit of up to $2,500 annually would be made available that could be used for up to 4 years; however, the current deductions for educational expenses and interest on student loans would be repealed.

• • Elimination of the income limitations on Roth IRAs and prohibiting new contributions to traditional IRAs and non-deductible traditional IRAs—effectively forcing all new IRA contributions to be Roth contributions.

• • Repeal of the exception to the 10% early withdrawal penalty for withdrawals from retirement plans and IRAs used to pay first-time home buyer expenses (capped at $10,000).

• • Elimination of the deduction by the payor for the payment of alimony and elimination of the inclusion in income by the recipient.

• • Repeal of the individual AMT.

• • IRC Section 1031 would be repealed.  Consequently, tax deferral from like-kind exchanges would no longer be permitted.

• • Simplification of rules surrounding in-service distributions, hardship withdrawals and required minimum distributions from retirement plans.

• • Encouraging Roth contributions in 401(k) plans by requiring all 401(k) plans to offer Roth accounts and requiring larger plans to treat all employee contributions as Roth contributions once an employee had contributed one-half of the annual contribution limit.

I Won the Gold Medal in Sochi. Awesome! Do I Owe Taxes on the Value of My Prize? 

As a general rule, in accordance with IRC § 61, the value of any prize or award a taxpayer receives is subject to taxation.  IRC §§ 74 and 117 provide limited exceptions to this general rule.

IRC § 74 specifically excludes from the income of the recipient certain employee achievement awards and certain prizes or awards transferred to charitable organizations prior to receipt.  IRC § 117 specifically excludes from the income of the recipient “qualified scholarship” proceeds.  These exceptions are subject to rigid qualifications. 

The value of prizes and awards which do not come within the parameters of these limited exceptions are subject to taxation.  Consequently, as we know, the winning ticketholder of the lottery is taxed on his or her winnings.  The recipient of the Nobel Prize is subject to taxation on the cash prize he or she receives.  Likewise, the value of the ring received by each of the members of the Seattle Seahawks this year for winning the Super Bowl is subject to taxation.  Also, the value of the rings received by each member of the Miami Heat for winning the NBA championship in 2012 and 2013 is subject to taxation.

Is a full time gambler in the trade or business of gambling?  If the answer is yes, two results follow (one result which is good and one result which is not so good):  (1) the gambler is able to deduct under Section 162 of the Code all of the ordinary, necessary and reasonable expenses incurred in carrying on the business; and (2) the net income of the gambler, if any, is subject to self-employment tax under Section 1401 of the Code.

In 1987, the United States Supreme Court was presented with the issue of whether a full time gambler was engaged in the trade or business of gambling.  Commissioner v. Groetzinger, 480 US 23 (1987).  Justice Blackmun issued the court’s opinion.  The Supreme Court thoroughly reviewed the history of the phrase “trade or business” in the context of the Internal Revenue Code.  The court stated: “[T]o be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income profit.  A sporadic activity, a hobby, or an amusement diversion does not qualify.”   Whether a taxpayer is engaged in a trade or business is a question of facts and circumstances.

In Groetzinger, evidence revealed the taxpayer spent substantial amounts of time preparing for and actually gambling.  He had been gambling for a long period of time; the activity was not sporadic.  It was continuous.  Mr. Groetzinger had no other “profession or type of employment.”  He engaged in gambling with the intent to make a profit.  The court ultimately concluded, gambling may constitute a trade or business, and based upon the facts presented, Mr. Groetzinger was engaged in the trade or business of gambling.

Mr. Groetzinger won the battle in that his victory allowed him to deduct is ordinary, necessary and reasonable expenses associated with his gambling activities.  He lost the war in part because his net income (if any) would now be subjected to self employment taxes.  The result was likely unsuspected by the taxpayer.