Retirement and Charitable Remainder Trusts

I got a call from a potential client yesterday. Looking towards retirement he said "tax optimization" is his goal and he seems to believe that setting up a charitable remainder trust (CRT) is the way to achieve that. Unfortunately, he caught me off guard with some terminology from some online stuff he had been reading so I probably won't be gaining him as a client.

Also unfortunately, for him, based on his readings on the Internet he strongly believes that the distributions a donor receives from a charitable remainder trust are tax free. There are exceptions but having them apply is rare. In general, distributions from a CRT are taxable to the recipient. Technically, the nature of the income earned by the trust determines the taxability of the distribution. First, all the ordinary income (taxable at ordinary rates) is deemed to comprise the distribution, then any capital gains and finally any tax exempt income.

Example 1: Suppose a CRT starts with $100,000 of assets and earns a total of $9,000 during the year composed of $4,000 of ordinary income, $3,000 of long term capital gains and $2,000 of tax exempt interest. Let's assume the distributions are $5,000 per year. The ordinary income is deemed to be distributed first, then the long term capital gains, then the exempt interest. So our donor/taxpayer has $4,000 of ordinary income, $1,000 of long term capital gains and $0 of tax exempt interest.

Example 2: The CRT starts with $100,000 of assets and somehow manages to earn $5,000 of tax exempt interest. Now the $5,000 distribution is tax exempt to the recipient.

A problem is, in today's economy, it's somewhere between difficult and impossible to earn 5% or more on an investment in state and local bonds (the securities that generate tax exempt interest income) without taking extraordinary risks. On top of that, the trustee will be attempting to maximize the remainder interest (for the benefit of the charity) which is not conducive to investments in low interest bonds. Remember, the CRT isn't paying income taxes so the trustee has zero incentive to make investments that generate tax exempt income.

I regret not making a better impression on my caller for two reasons. First, I'm almost certainly not getting him as a client. Second, he's liable to make an irreversible decision based on his misinformation, something that would be avoided if he had me as his CPA.

Takeaway for me: Be ready for anything, particularly jargon created for use in sales pitches.

Takeaway for you: Don't believe everything you read on the Internet, especially about finances and taxes.

Caveat: The rules regarding charitable remainder trusts are way more complex and arcane than covered in this post. Don't even think about creating one for your favorite charitable organization until you've consulted with a tax professional, ONE WHO DOESN"T CARE WHETHER YOU CREATE A CRT OR NOT.

If you have questions about charitable remainder trusts or retirement planning or anything else related to income taxes, email me at bill@hollandbrowncpa.com. I promise I know more about this stuff than yesterday's caller probably believes.

Don't Ignore Your CPA's Advice!

Amit Chandel, a CPA in Orange County, California, made this post in the CPA Sole Practitioners and CPA Small Firms group on LinkedIn. In it, he provides an excellent example that supports  the imperative that is the subject of both his post and mine.

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A California couple, Madhu and Tara Singhal, recently learned that lesson the hard way. In late October, the Tax Court upheld the IRS's imposition of an accuracy-related penalty under section 6662(a). The decision was a summary opinion by Judge Carolyn Chiechi.

Madhu Singhal an electrical engineer and also a member of the California bar, a fact noted by Chiechi,. In 2009 the Singhals formed a limited liability company (MMIT) as a vehicle to sell one of Singhal's inventions. In 2010 MMIT sold the invention for a long-term capital gain of $553,750.

Madhu Singhal engaged a CPA, Paul Gray, to prepare the 2010 Form 1065, "U.S. Return of Partnership Income," for MMIT. On September 15, 2011, Gray sent the completed return for MMIT, including Schedules K-1, to the Singhals. The Schedules K-1 showed their distributive shares, which included the long-term capital gain of $553,750. Gray also sent a separate letter to the Singhals advising that their distributive shares were the amounts to be reported on their 2010 individual tax return and that those shares may not correspond to their actual distributions. It was this latter advice that was the focus of the Tax Court opinion.

The Singhals filed their return on November 6, 2011. Singhal prepared the Form 1040; Gray did not. Their tax return did not reflect the long-term capital gain of $553,750 from MMIT. Instead, they reported a much lower amount.

The IRS issued a deficiency notice to the Singhals regarding their return. The Service determined that the long-term capital gain from MMIT was $553,750, the amount reported on MMIT's Form 1065. The deficiency notice determined an underpayment of $60,687 under section 6651(a)(1) and an accuracy-related penalty under section 6662(a) of 20 percent of the underpayment, or $12,137.

Before trial, the Singhals conceded the underpayment determination by the IRS but contested the accuracy-related penalty. There are two alternative prongs to the section 6662(a) penalty. Under section 6662(b)(1), the penalty is applicable if attributable to the taxpayer's negligence. Under section 6662(b)(2), the penalty is applicable if it amounts to a substantial understatement. As an objective metric, the substantial underpayment prong obviously provides an easier path for the IRS.

A taxpayer can defend against the accuracy-related penalty under section 6662(a) if he can demonstrate reasonable cause and that he acted in good faith under section 6662(c). The IRS carried its burden of proof of a substantial underpayment under section 6662(b)(2) simply by referencing the numbers reported on the Singhals' Form 1040. The taxpayers therefore had the burden of proving reasonable cause.

Their principal argument was that they believed the proper amount to be reported was the amount of distributions received from MMIT. It was that belief, the taxpayers argued, that demonstrated they acted in good faith when underreporting the long-term capital gain.

Chiechi quickly rejected the reasonable cause argument. She noted that the reasonable cause defense is a facts and circumstances determination, which includes an analysis of the taxpayers' "efforts to assess (their) proper tax liability" and their "reliance on the advice of a professional, such as an accountant."

In making her determination, Chiechi focused on the CPA's letter, which specifically advised the taxpayers that the proper amount reportable on their Form 1040 may not correspond to the amount of the distributions from MMIT. At some point during the trial, Chiechi took over the trial's proceedings to ask Singhal a critical question. What, she asked, was his understanding of the letter? Singhal's response must have made his fellow attorneys wince. He said he never read the letter. That answer was clearly the clincher for Chiechi. She said a reasonable person would not have ignored his CPA's advice in preparing the Form 1040. "A reasonable person would have read" the letter, she wrote.
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Mr. Chandel's original post is here (LinkedIn membership required). The Tax Court ruling is here (PDF format).

All the code section numbers aside, the taxpayers erroneously did not include almost $554,000 capital gain on their own tax return. Besides additional tax $61,000, the taxpayers owed an accuracy related penalty (of called the negligence penalty) of more than $12,000. One fact that often helps some taxpayers to avoid this penalty is to assert they were following the advice of a tax professional. Unfortunately for the taxpayers in this case, their CPA advised them to do the exact opposite of what they actually did.

As the subject line urges, DON'T IGNORE YOUR CPA'S ADVICE!

Myths Regarding the Flat Tax

A flat tax on income would tax all individual income at the same rate. At a 15% rate, a person making $10,000 would pay $1,500 in taxes and a person making $100,000 would pay $15,000. Current proposals would eliminate income taxes on capital gains and dividends (so it isn't really the same tax rate on ALL income).

It is more fair than the current system - only if you agree that tax burden should be shifted from the wealthiest 10% or so of taxpayers to everyone else. Of the taxpayers who paid tax in 2012, those with AGI under $50,000 (90,812,022 returns) had 1.8% of total net taxable gains while those with AGI of a $1,000,000 or more (392,850 returns) had 73.5% of those gains. The flat tax would have eliminated taxes on almost $455 billion of capital gains realized by the very wealthy (about $1,158 per tax return and on $11.4 billion of capital gains on the under $50,000 taxpayers (about 12 cents per return). The division of taxable dividends is not quite as extreme: About 7.8% were received by taxpayers with AGI between $1 and $50,000 while 52.0% were received by taxpayers with AGI of a $1,000,000 or more.

Here are some other comparisons. 28.9% of the educator expense deductions were taken on tax returns with AGI of under $50,000 while almost none were taken by those with AGI of $1,000,000 or more. 58.2% of the total student loan interest deductions were taken by taxpayers with AGI under $50,000 while those over $1,000,000 deducted nothing (due to the AGI related phase out).

It is simpler than the current system - because it eliminates tax breaks such as home mortgage interest and real estate tax deductions, charitable contribution deduction, education credits and deductions, dependent care and child credits, and more. I've seen no suggestion that businesses would lose all their deductions and credits therefore that part of the tax code, with all its complexities, would remain.

The overwhelming majority of the complexity affecting individual tax returns provide tax savings; because of phase outs based on AGI, much of that savings is enjoyed by taxpayers with AGI under $100,000 or so.

Anyone who thinks a flat tax would remain simple needs a reality check. Just look at what Congress has done with the current income tax law during the last 2 or 3 decades. A flat tax might not even begin very simple because of the lobbying efforts of those negatively affected by elimination of home mortgage interest and real estate tax deductions, charitable contribution deduction, education credits and deductions, dependent care and child credits, and more.

The IRS would be eliminated - not true. It might be renamed but a tax collection agency would continue to exist. Those parts of the IRS needed to enforce business related parts of the Internal Revenue Code would remain unchanged.

It would reduce fraud - Ha! Crooks are crooks. Crooks will still cheat on their taxes. Most of the dollar cost of income tax fraud today comes from failing to report taxable income. Phony deductions and credits pale in comparison.

A flat tax would stimulate the economy here like it did in Eastern Europe - Some former members of the Soviet Union, primarily Baltic countries, did adopt a flat tax and did enjoy initial economic growth. Whether that growth was a result of a flat tax regime or because of suddenly having a free more capitalistic economy is open to debate. In any event, those countries’ economies are now no better, perhaps worse, than other countries.

In short, the benefits claimed for a flat tax are unlikely to occur, certainly for no significant length of time. The costs include the significant economic dislocation (job migration and price fluctuations are two examples) that would accompany any significant change in a tax regime. All the costs of having a flat income tax easily outweigh the mostly non-existent benefits.

Income tax information came from the IRS at http://www.irs.gov/uac/SOI-Tax-Stats-Individual-Income-Tax-Return-Form-1040-Statistics.

Costs and Benefits - the IRS Budget

I know I'm frustrated with long wait times when calling the IRS on behalf of a client. I'm confident that my colleagues in the tax preparation industry are as well. John Koskinen, Commissioner of the Internal Revenue Service has a suggestion for us and anyone else who has waited on hold for 2 or 3 or more hours to get a question answered or an issue resolved. Accounting Today says that advice is "to call their member of Congress."

As noted by the Commish, a 1% decline in tax compliance costs $30 billion in revenue. The IRS budget is $11 billion. Congress continually piles on the IRS work load (not just the ACA but every new complexity to the tax law) while cutting the IRS budget. Koskinen was also quoted in the Washington Post stating that every additional $1 budgeted for tax enforcement yields $4 of additional revenue.

Poorer service and decreased tax revenues causes the phrase "penny wise and pound foolish" to come to mind.

I agree with Commissioner Koskinen's advice. If you don't like incredibly long telephone wait times or if you don't like tax cheats getting away with their lawlessness, then call or write your Representative in Congress.

Tax Implications of Bitcoins

Back on March 25 the IRS issued IR-2014-36 entitled “IRS Virtual Currency Guidance : Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply.”  
The title pretty much says it all. Virtual currency, of which Bitcoins are a well-known example, is treated like regular currency although not legal tender in the U.S.
“General tax principles that apply to property transactions apply to transactions using virtual currency.  Among other things, this means that:

• Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes.
• Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules generally apply.  Normally, payers must issue Form 1099.
• The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
• A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.”

Payments described in the first two bullet items are reported at the fair market value of the virtual currency on the date of the payment. Reporting requirements mentioned in the last bullet item also use fair market value on the transaction date to determine whether the need for a report is triggered.
If you invest in a virtual currency, like Bitcoins, when you sell that investment you will have a capital gain or loss.
The full text of Notice 2014-36 is available as a PDF file here.
If you have questions about this or any other tax issue, give me a call (804-745-7157) or send me an email (bill@hollandbrowncpa.com).

Travel & Entertainment: Maximizing Tax Benefits

Tax law allows you to deduct two types of travel expenses related to your business, local and what the IRS calls "away from home."

1. First, local travel expenses. You can deduct local transportation expenses incurred for business purposes such as the cost of getting from one location to another via public transportation, rental car, or your own automobile. Meals and incidentals are not deductible as travel expenses, but you can deduct meals as an entertainment expense as long as certain conditions are met (see below).
2. Second, you can deduct away from home travel expenses-including meals and incidentals, but if your employer reimburses your travel expenses your deductions are limited.

Local Transportation Costs

The cost of local business transportation includes rail fare and bus fare, as well as costs associated with use and maintenance of an automobile used for business purposes. If your main place of business is your personal residence, then business trips from your home office and back are considered deductible transportation and not non-deductible commuting.

You generally cannot deduct lodging and meals unless you stay away from home overnight. Meals may be partially deductible as an entertainment expense.

Away From-Home Travel Expenses

You can deduct one-half of the cost of meals (50 percent) and all of the expenses of lodging incurred while traveling away from home. The IRS also allows you to deduct 100 percent of your transportation expenses--as long as business is the primary reason for your trip.

Here's a list of some deductible away-from-home travel expenses:

• Meals (limited to 50 percent) and lodging while traveling or once you get to your away-from-home business destination.
• The cost of having your clothes cleaned and pressed away from home.
• Costs for telephone, fax or modem usage.
• Costs for secretarial services away-from-home.
• The costs of transportation between job sites or to and from hotels and terminals.
• Airfare, bus fare, rail fare, and charges related to shipping baggage or taking it with you.
• The cost of bringing or sending samples or displays, and of renting sample display rooms.
• The costs of keeping and operating a car, including garaging costs.
• The cost of keeping and operating an airplane, including hangar costs.
• Transportation costs between "temporary" job sites and hotels and restaurants.
• Incidentals, including computer rentals, stenographers' fees.
• Tips related to the above.

Entertainment Expenses

There are limits and restrictions on deducting meal and entertainment expenses. Most are deductible at 50 percent, but there are a few exceptions. Meals and entertainment must be "ordinary and necessary" and not "lavish or extravagant" and directly related to or associated with your business. They must also be substantiated (see below).

Your home is considered a place conducive to business. As such, entertaining at home may be deductible providing there was business intent and business was discussed. The amount of time that business was discussed does not matter.

Reasonable costs for food and refreshments for year-end parties for employees, as well as sales seminars and presentations held at your home are 100 percent deductible.

If you rent a skybox or other private luxury box for more than one event, say for the season, at the same sports arena, you generally cannot deduct more than the price of a non-luxury box seat ticket. Count each game or other performance as one event. Deduction for those seats is then subject to the 50 percent entertainment expense limit.

If expenses for food and beverages are separately stated, you can deduct these expenses in addition to the amounts allowable for the skybox, subject to the requirements and limits that apply. The amounts separately stated for food and beverages must be reasonable.

Deductions are disallowed for depreciation and upkeep of "entertainment facilities" such as yachts, hunting lodges, fishing camps, swimming pools, and tennis courts. Costs of entertainment provided at such facilities are deductible, subject to entertainment expense limitations.

Dues paid to country clubs or to social or golf and athletic clubs however, are not deductible. Dues that you pay to professional and civic organizations are deductible as long as your membership has a business purpose. Such organizations include business leagues, trade associations, chambers of commerce, boards of trade, and real estate boards.

Tip: To avoid problems qualifying for a deduction for dues paid to professional or civic organizations, document the business reasons for the membership, the contacts you make and any income generated from the membership.

Entertainment costs, taxes, tips, cover charges, room rentals, maids and waiters are all subject to the 50 percent limit on entertainment deductions.

How Do You Prove Expenses Are Directly Related?

Expenses are directly related if you can show:

• There was more than a general expectation of gaining some business benefit other than goodwill.
• You conducted business during the entertainment.
• Active conduct of business was your main purpose.

Record-keeping and Substantiation Requirements

Tax law requires you to keep records that will prove the business purpose and amounts of your business travel, entertainment, and local transportation costs. For example, each expense for lodging away from home that is $75 or more must be supported by receipts. The receipt must show the amount, date, place, and type of the expense.

The most frequent reason that the IRS disallows travel and entertainment expenses is failure to show the place and business purpose of an item. Therefore, pay special attention to these aspects of your record-keeping.

Keeping a diary or log book--and recording your business-related activities at or close to the time the expense is incurred--is one of the best ways to document your business expenses.

If you need help documenting business travel and entertainment expenses, don't hesitate to call us. We'll help you set up a system that works for you--and satisfies IRS record-keeping requirements.

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Email: bill@hollandbrowncpa.com

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