Monthly Archives: June 2015

Some Tax-Motivated Couples Don’t Marry Under the Law, Even If They Are Bound In Their Hearts

The Supreme Court’s decision authorizing nationwide same-sex marriage further extends marital rights. But some extraordinarily-tax-motivated same-sex couples may make the same choice that some opposite-sex couples have made for years, to avoid marriage to take advantage of tax planning opportunities married couples cannot.

Marriage brings with it many tax benefits, especially under the federal income tax for families of all income levels with a single wage earner, and under the federal estate and gift tax, where even wealthy spouses are allowed unlimited tax-free transfers between themselves. But married couples are also treated as “related parties” under the Internal Revenue Code. Related party treatment prevents spouses from engaging in many tax motivated transactions that unmarried persons—even those who for all practical purposes function like a married couple—cannot.

For example, unmarried persons who co-own a corporation can more freely engage in redemption transactions in which their corporate share income tax basis offsets distribution income. Married couples are more restricted in this regard. Unmarried persons can buy and sell property between themselves free of related-party rules that re-characterize lower-tax long-term capital gain as higher-tax-rate ordinary income or prevent the purchaser from re-depreciating purchased assets. Members of unmarried couples can serve as counterparties in tax-deferred 1031 exchanges, whereas married couples are restricted in this regard.

The number of persons who would avoid marriage for tax reasons is limited. In our experience, however, some individuals—particularly those with substantial real estate holdings–take these tax planning opportunities into account when deciding whether to marry under the law, even if they are committed in their hearts. Those taxpayers turn Congressional policy on its head, causing tax laws intended to prevent abusive tax avoidance by closely connected individuals into an unintended deterrent to marriage.

E. John Wagner, II

Supreme Court Upholds the Affordable Care Act

The Supreme Court has issued its opinion in King v. Burwell, the much anticipated case regarding whether Affordable Care Act subsidies are available to purchasers of insurance on the Federal Exchange or whether the plain language of the Act restricted such subsidies to only those purchasing insurance through an “Exchange established by the State.” The Court, over strongly worded dissent, determined that the Act permitted payment of subsidies for insurance purchased through the Federal Exchange, leaving Obamacare, as it is known, intact. Had the court ruled as the dissent held, then millions of people would have effectively been exempted from the requirement to purchase health insurance (the “individual mandate”) because their health insurance cost, when not supplemented by a subsidy, would have exceeded 8% of income. The outcome of such a decision could have led to the “death spiral” for the Act, since the underlying financial assumptions that keep insurers in business are directly related to the effectiveness of the individual mandate.

The Court’s decision will provide certainty in the healthcare marketplace. King v. Burwell was widely seen as the last, and best, chance for opponents of the Act to obtain a judicial veto of the Act. Opponents of Obamacare now realize the Court will make every effort to uphold the Act in future cases.

Read Supreme Court Opinion here:  Supreme Court Opinion

 John L. Moore

Applicable Federal Rates for July 2015

The Internal Revenue Code prescribes minimum imputed interest rates and time-value-of-money factors applicable to certain loan transactions and estate planning techniques. These rates are tied formulaically to market interest rates. The Internal Revenue Service updates these rates monthly.

These are commonly applicable rates in effect for July 2015:

Short Term AFR (Loans with Terms <= 3 Years)                                          0.48%

Mid Term AFR (Loans with Terms > 3 Years and <= 9 Years)                     1.77%

Long Term AFR (Loans with Terms >9 Years)                                              2.74%

7520 Rate (Used in many estate planning vehicles)                                     2.2%

Here is a link to the complete list of rates:

E. John Wagner, II

Using your Rollover IRA to Buy Yourself a Job? Think Twice and Carefully!

A common retirement / employment technique that looks enticing is to rollover your substantial 401(k) account after terminating employment to an IRA and then use the IRA to purchase or start up a business for you to run.  What could be better?  A job for you, a profitable investment for your IRA that you control, and the investment funds remain tax deferred in the IRA.  What an excellent idea!  No, not so much!

While this business start-up technique may look like the perfect use of your accumulated retirement funds, there are a lot of technicalities that can cause the arrangement to blow up, triggering huge taxes and penalties.  The 8th Circuit Court of Appeals (in Ellis v. Commissioner) recently confirmed that such an arrangement done through an IRA disqualified the entire IRA (making the entire IRA taxable).  The taxpayer owed taxes and penalties amounting to more than 50% of the IRA’s value.

In the case reviewed by the court, the IRA owner caused the IRA to purchase 98% of a used car sales business and then used his control of the company to have the company pay him compensation for his services running the business. The court held that the IRA owner’s exercise of control over the company causing the company to pay him compensation violated the tax law’s prohibited transaction rules for the IRA.  The holding resulted in the IRA’s loss of tax deferred status as to all funds in the IRA.  The prohibited transaction rules that the court said were violated was direct or indirect use of the plan’s income or assets for the benefit of the IRA owner as well as dealing with the IRA’s income or asses for his own interest.

The 8th Circuit case involved investment in the business start-up by the taxpayer’s IRA.  Similar techniques are offered through C corporation business start-ups.

While it is clear that an IRA investment of this nature is extremely dangerous, often destroying the tax deferred status of the IRA, the same technique can be successful if done in a C corporation using the corporation’s qualified plan instead of the IRA.  But there are significant expenses and dangers involved. Individuals should not consider this technique unless the investment funds involved are large enough to justify the expense and risk, and the individual has a high tolerance for details and complications.

To use the this business start-up technique in a C corporation, the typical approach is first transfer the rollover funds into a qualified plan established by the new start-up business and then have the qualified plan purchase stock in the business that is sponsoring the qualified retirement plan.  The IRS and DOL calls these types of transactions “ROBS” for “rollover business startup”.  While we do not assist clients in creating ROBS arrangements we routinely assist clients in understanding the risks and rewards inherent in the arrangements.

Carol L. Myers

Changing Investment Structures for Foreign-Owned US Real Property has Many Traps for the Unwary

There are various ways to structure a foreign investment in US real property and each has its own advantages and disadvantages (see below for a link to a previous blog post on this topic). A frequently chosen structure is a pass-through or fiscally transparent structure which, very generally, has income tax advantages (especially upon a disposition of the property), but US estate tax disadvantages. Over time, however, clients age and their plans change, and so we are sometimes called upon to convert a pass-through structure to a structure with US estate tax advantages (i.e., typically by inserting a foreign corporation into the structure), but which has income tax disadvantages. Converting such structures can at first blush seem relatively simple, but there are several traps for the unwary. A common approach to converting such structures is for the foreign client to contribute their ownership interests in the US pass-through entity (such as a partnership or LLC taxed as a partnership or disregarded for federal income tax purposes) to a foreign corporation. Normally, such a transaction would be tax-free under IRC section 351 as a contribution to the capital of a corporation. However, FIRPTA complicates the picture. Specifically, FIRPTA rules add additional requirements in order for this transaction to be tax-free, including that the ownership interest in the US pass-through entity (which is considered a US real estate property interest (“USRPI”) for FIRPTA purposes), be exchanged for another USRPI. Stock of a foreign corporation is generally not a USRPI, and therefore the contribution of the ownership interests in the pass-through entity to the foreign corporation would be considered a taxable sale. There are at least two planning techniques to avoid this issue that involve the use of a US corporation or having the foreign corporation elect to be treated as a US corporation for federal income tax purposes, but both techniques have their own set of advantages and disadvantages that must be carefully considered.

A previous blog post on structuring options for foreign investment in US real estate can be found here:

Michael J. Wilson

Real Estate Investor Forced to Recognize Ordinary Business Income Instead of Capital Gain, Despite Holding Property Without Physical Improvement For Over a Decade

Sometimes it’s what you say, not what you do, that matters. A taxpayer learned that the hard way in a recent United States Tax Court decision.

There are numerous court decisions in which a taxpayer acquired property, incurred “soft costs” to entitle the property for future development, and then recognized capital gain (not higher-tax ordinary income) on the sale of the property. In these cases, the taxpayer did not physically improve the property, and the taxpayer by resolution, agreement, prior tax reporting, or other independent means expressed an intent to sell the property before physical improvement occurred. Amongst other factors, the combination of an expressed non-development intent with the actual lack of physical improvement was sufficient to preserve capital gain treatment, and to prevent the taxpayer’s activities from becoming a more active “business” subject to higher ordinary income tax rates. This sometimes has been true even when the taxpayer sells the property to another company with common ownership, which then develops the property.

The recent Tax Court decision emphasizes that the expression of intent is essential to preserving capital gain qualification, even if property is never developed or improved. In the case, the taxpayer originally intended to develop the property. The taxpayer incurred soft costs to prepare the property for development, but then held the property for over a decade without physically improving it. The taxpayer rented and occupied the property as office space, uses usually considered capital gain-qualifying activities. The Tax Court nevertheless held that the absence of evidence the taxpayer abandoned its initial development intent was sufficient to distinguish the case from others in which taxpayers engaged in the same activities, but specifically expressed non-development investment intent to third parties.

While the decision seems harsh, it is a reminder that the characterization of a taxpayer’s activities in partnership or operating agreements, resolutions, business coding on tax returns, and other third-party pronouncements is essential to protecting capital gain qualification, even if a taxpayer never physically develops property.

Here is a link to the United States Tax Court decision in Fargo v. Commissioner:

E. John Wagner, II