What is a “Willful” Failure to Disclose Offshore Bank Account

This is the central question as to whether a taxpayer enters Offshore Voluntary Disclosure or Streamline.  It also fixes potential penalties under 31 U.S.C. §5321.

31 U.S.C. 5314 is the statute that requires reporting of foreign bank accounts.  Pursuant to the statute, reporting is required by the following:

  1. a United States Citizen,
  2. a resident of the United States or
  3. a person in, and doing business in the United States.

Incidentally, the term “person” has broad meaning, which includes corporations.

Pursuant to 31 U.S.C. §5321, the amount of penalty shall not exceed $10,000 unless the case is “willful“.  In cases of willfulness, the maximum penalty increases to the greater of  $100,000 or 50 percent of the account balance.  It is also noteworthy that, pursuant to subsection (d), a criminal penalty may be stacked on top of this civil penalty.

A lot is riding on the meaning of “willful” so let’s turn our focus to it.  If you would like to read what is required of the Secretary of Treasure to prove an FBAR case, click here to read the 7 elements.

Legal standard and Burden of Proof

To affix the civil penalty under 31 U.S.C. §5321 the Secretary of Treasury must establish willfulness by the preponderance of the evidence.  This is a lower standard than beyond a reasonable doubt.  The Burden of Proof is on the United States Government.

Meaning of “Willful”

31 U.S.C. §5321 does not define “willful”.  In United States of America v. McBride, 908 F. Supp. 1186 (D.Utah 2012), The United State District Court analyzed the meaning of “willful” as it is used in 31 U.S.C. §5321.  The Court gave heavy weight to the fact that taxpayer signed the tax return.

Signature alone is sufficient proof of a taxpayer’s knowledge of the instructions contained in the tax return form and in other contexts, the Court stated.  This is an inference of “willful” conduct by mere signature alone. The Court went on to analyze the proposition that signature by itself does not prove knowledge, but knowledge may be inferred from the signature and the signature is prima facie evidence that the signer knows the contents of the return.

In either case, taxpayer’s signature shifts the burden of proof to taxpayer to prove non-willfulness.  The Court held that knowledge of the law, including knowledge of the FBAR, requirements, is imputed to taxpayer, which is sufficient to inform taxpayer of the requirement to file Form TD F 90-22.1.  The Court held that signature alone imputed knowledge to taxpayer of the FBAR requirement.

It is noteworthy that the Court analyzed taxpayer’s credibility in detail.  Taxpayer alleged that he did not know he had a legal duty to file FBAR’s, which is common and understandable assertion.  Rather than just dismiss this argument on the basis of his signature on tax return, the Court found taxpayer not credible because of prior testimonial inconsistencies.

Implicitly, there is a defense that taxpayer did not know of FBAR requirements despite signature on a tax return.  After all a signature is prima facie evidence of willfulness, not the end-all and be-all of willfulness.

In the end, “willfulness” is determined by the facts and circumstances of each case that must be analyzed in the context of that particular time period in question.


Blank Receipt – No Tax Deduction for Charitable Contributions

The U.S. Tax Court issued a decision concerning tax deductions of charitable contributions in Thad Deshawn Smith v. Commissioner of the Internal Revenue, October 2, 2014.  The case is a great way to discuss what the IRS and Tax Court require as far as documentation.

Mr. Deshawn attempted to deduct a whopping $27,277 in noncash charitable contributions in 2009.  He donated clothes, electronics, etc to AMVETS.  AMVETS wrote Mr. Deshawn blank “tax receipts”.  Have you ever noticed this practice when donating to Goodwill?  Goodwill just hands you a blank receipt.  Well that practice does not cut it.

The critical failure was that the receipts did not specify the items donated.  Mr. Deshawn made a valiant effort to document the donation by creating spreadsheets.  However, because there was no evidence that the spreadsheets were submitted (hint – signed) by AMVETS, no deduction was allowed.

Here is some technical background.

Contributions of $250 or More:

Section 170(f)(8)(A) provides that an individual may deduct a gift of $250 or more only if he substantiates the deduction with a contemporaneous written acknowledgment of the contribution by the donee organization. This acknowledgment must:

  1. include “a description (but not value) of any property other than cash contributed”;
  2. state whether the donee provided
    any goods or services in exchange for the gift; and
  3. if the donee did provide goods or services, include a description and good-faith estimate of their value. Sec. 170(f)(8)(B); sec. 1.170A-13(f)(2), Income Tax Regs.

The acknowledgment is “contemporaneous” if the taxpayer obtains it from the donee on or before the earlier of:

  1. the date the taxpayer files a return for the year of contribution; or
  2. the due date, including extensions, for filing that return. Sec. 170(f)(8)(C).

Contributions exceeding $500

For noncash contributions in excess of $500, taxpayers are required to maintain reliable written records with respect to each item of donated property. Sec. 1.170A-13(b)(2) and (3), Income Tax Regs.

These records must include, among other things:

  1. the approximate date the property was acquired and the manner of its acquisition;
  2. a description of the property in detail reasonable under the circumstances;
  3. the cost or other basis of the property;
  4. the fair market value of the property at the time it was contributed; and
  5. the method used in determining its fair market value. Sec. 1.170A-13(b)(2)(ii)(C) and (D), (3)(i)(A) and (B), Income Tax Regs. The taxpayer must include with his return “a description of such property and such other information as the Secretary may require.” Sec. 170(f)(11)(B).

Contributions Exceeding $5,000

For contributions of property (other than publicly traded securities) or similar items of property valued in excess of $5,000, the taxpayer must generally satisfy the substantiation requirements discussed previously and must also:

  1. obtain a “qualified appraisal” of the items; and
  2. attach to his tax return a fully completed appraisal summary. Sec. 170(f)(11)(C); sec. 1.170A-13(c)(2), Income Tax Regs.;

Interest Deductible Even On Non-Taxpayer’s Mortgage

I came across this today in passing while working on a tax case.

Most homeowners deduct home mortgage interest on Schedule A of their 1040.  Actually, this is usually a taxpayer’s largest deduction.  Well, what if the taxpayer is not liable for the mortgage can taxpayer still take the deduction?

For example, taxpayer’s parents transferred title of a home to taxpayer.   The mortgage remained the obligation of parents.  Taxpayer does not refinance.  Taxpayer pays mortgage.  May taxpayer deduct the interest paid on schedule A?  I have to admit that the IRS is pretty generous on this one.  The IRS permits taxpayer to take the deduction on schedule A.  Thank you IRS!

What follows is the background and legal support.

1.163-1(b), Income Tax Regs., provides: “Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness.”

However, “title” to the real estate is required.  Real estate title can include legal, equitable, and beneficial title. Hynes v. Commissioner, 74 T.C. 1266, 1288 (1980); Song v. Commissioner, T.C. Memo. 1995-446; Bonkowski v. Commissioner, T.C. Memo. 1970-340, affd. 458 F.2d 709 (7th Cir. 1972). This is where it can get complicated and you would need to seek a tax pro, such as myself, on this point.

I will point out that the 1098 will not be in your name but the IRS has spoken: deduct, deduct, deduct!

Taxation of Artists: Business or Hobby Losses – Tax Tips

Artists typically have financial challenges while they build a market for their artwork.  During the many years of likely tax losses, the IRS might re-characterize losses as nondeductible hobby losses.  So if an artist is an employee while also building a business as an artist, the IRS might disallow the losses to be deducted against employment income.  This can be very unfair since the artist could be in genuine pursuit of a business.

Tax Background: Business

Section 162(a) allows as a deduction “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” To be entitled to deductions under this section, the taxpayer must show that she engaged in the activity with an actual and honest objective of making a profit. Hulter v. Commissioner, 91 T.C. 371, 392 (1988).

However, “a reasonable expectation of profit is not required.” Sec. 1.183-2(a), Income Tax Regs. The Tax Coiurt determines whether the taxpayer has the requisite intent to earn a profit on the basis of all surrounding facts and circumstances. Golanty v. Commissioner, 72 T.C. 411, 426 (1979), aff’d without published opinion, 647 F.2d 170 (9th Cir. [*24] 1981); sec. 1.183-2(b), Income Tax Regs. In making this determination, greater weight is accorded to objective facts than to the taxpayer’s subjective statement of intent. Keanini v. Commissioner, 94 T.C. 41, 46 (1990); sec. 1.183-2(a), Income Tax Regs.;

Tax Background: Hobby

If an activity is not engaged in for profit, no deduction attributable to it is allowed except to the extent of gross income derived therefrom (reduced by deductions allowable without regard to whether the activity was engaged in for profit). Sec. 183(b). Thus, losses are not
allowable for an activity that a taxpayer carries on primarily for sport, as a hobby, or for recreation. Sec. 1.183-2(a), Income Tax Regs.

Intent to Earn a Profit

The regulations set forth a nonexclusive list of nine factors relevant in ascertaining whether the taxpayer conducted an activity with the intent to earn a profit. They are:

  1. the manner in which the taxpayer conducts the activity;
  2. the expertise of the taxpayer or her advisers;
  3. the time and effort spent by the taxpayer
    in carrying on the activity;
  4. the expectation that assets used in the activity may appreciate in value;
  5. the success of the taxpayer in carrying on other similar or dissimilar activities;
  6. the taxpayer’s history of income or losses with respect to the activity;
  7. the amount of occasional profits, if any;
  8. the financial status of the taxpayer; and
  9. elements of personal pleasure or recreation. Sec. 1.183-2(b), Income Tax Regs.

No factor or group of factors is controlling, nor is it necessary that a majority of factors point to one outcome. See Keating v. Commissioner, 544 F.3d 900, 904 (8th Cir. 2008), aff’g T.C. Memo. 2007-309; Engdahl v. Commissioner, 72 T.C. 659, 666 (1979) (taxpayer’s profit motive must be ascertained “not on the basis of any one factor but on the basis of all the facts and circumstances”); sec. 1.183-2(b), Income Tax Regs. Certain factors may be accorded more weight in a particular case because they have greater salience or persuasive value as applied to
its facts. See Vitale v. Commissioner, T.C. Memo. 1999-131, 77 T.C.M. (CCH) 1869, 1874, aff’d without published opinion, 217 F.3d 843 (4th Cir. 2000); Green v. Commissioner, T.C. Memo. 1989-436, 57 T.C.M. (CCH) 1333, 1343 (noting that all nine factors do not necessarily apply in every case).

1. Manner in Which Activity is Conducted

Conducting an activity in a businesslike manner may show that the taxpayer intends to earn a profit from it. Sec. 1.183-2(b)(1), Income Tax Regs. Facts evidencing a businesslike manner include (among other things) the taxpayer’s maintenance of complete and accurate books and records; the taxpayer’s conduct of the activity in a manner resembling that in which successful practitioners conduct similar business activities; and the taxpayer’s change of operating procedures, adoption of new techniques, or abandonment of unprofitable activities in a manner consistent with a desire to improve profitability. Giles v. Commissioner, T.C. Memo. 2006-15; sec. 1.183-2(b)(1), Income Tax Regs.

In order to demonstrate a profit motive, a taxpayer need not keep records of the sort maintained by a Fortune 500 company. In many situations, informal recordkeeping is sufficient. See, e.g., Burrus v. Commissioner, T.C. Memo. 2003-285, 86 T.C.M. (CCH) 429, 435-437 (cattle activity); Fields v. Commissioner, T.C. Memo. 1981-550, 42 T.C.M. (CCH) 1220, 1225 (same); Edge v. Commissioner, T.C. Memo. 1973-274, 32 T.C.M. (CCH) 1291, 1298 (farming); [*30] Farrell v. Commissioner, T.C. Memo. 1983-542, 46 T.C.M. (CCH) 1290, 1295 (same); Harrison v. Commissioner, T .C. Memo. 1996-509, 72 T.C.M. (CCH) 1258, 1262 (gold mining and treasure salvaging activity). For creative artists in particular, our precedents indicate that the recordkeeping required to evidence a profit motive is not rigorous.

In Churchman v. Commissioner, 68 T.C. 696 (1977), the Tax Court held that a taxpayer who had been involved in art activities for 20 years had a profit motive. The taxpayer kept all receipts of her art-related expenses and kept a journal recording what works she had sold and to whom. The Court found that her record keeping was sufficient to show that she conducted her art activity in a businesslike manner even though she “did not keep a complete set of books pertaining to her artistic activities.” Id. at 702.4.

2. Expertise of the Taxpayer and Her Advisors

A taxpayer’s expertise, research, and study of the accepted practices in an industry, as well as her consultation with experts, may indicate a profit motive. Sec. 1.183-2(b)(2), Income Tax Regs. In cases involving artists, the Tax court has considered (among other things) the taxpayer’s education, teaching activities, public recognition, and skills.

In Churchman, 68 T.C. at 702, the Tax Court found that the taxpayer had the requisite expertise as an artist where she studied art for 2½ years, taught art at the college level, had her works shown in commercial galleries at least once a year, and was the subject of articles and critical reviews in newspapers and magazines. In Waitzkin, 63 T.C.M. (CCH) at 2745, the Tax Court found that the taxpayer had the requisite expertise as an artist where she devoted most of her time to producing artwork, promoted her art to collectors and museums, and sold art for many years through galleries and otherwise.

The term “advisors” means advisors relevant to the field of art, such as galleries not necessarily financial advisors..

3. Taxpayer’s Time and Effort

The fact that a taxpayer devotes considerable time and effort to an activity may indicate a profit objective. Giles v. Commissioner, T.C. Memo. 2006-15. Having another job does not necessarily detract from this conclusion–in section 183 cases, this is likely the rule rather than the exception–because a taxpayer may engage in more than one trade or business simultaneously. See Gestrich v.Commissioner, 74 T.C. 525, 529 (1980), aff’d without published opinion, 681 F.2d 805 (3d Cir. 1982); Sherman v. Commissioner, 16 T.C. 332, 337 (1951). In Churchman, 68 T.C. at 697, we noted that the taxpayer taught art classes at two [*37] colleges and had “given numerous workshops independently of any institution.” The Tax Court regarded this as a positive factor in concluding that she was engaged in the trade or business of art. Id. at 702.

4. Expectation of Appreciation in Value

An expectation that assets used in the activity will appreciate in value may indicate a profit motive. Sec. 1.183-2(b)(4), Income Tax Regs. Even if the taxpayer derives no profit from current operations, she may reasonably entertain an expectation of overall profit when asset appreciation is factored in. Ibid. The expectation of appreciation becomes less speculative when a taxpayer shows actual success in an endeavor that could plausibly lead to appreciation. Cf. Tinnell v. Commissioner, T.C. Memo. 2001-106; Hoyle v. Commissioner, T.C. Memo. 1994-592.

In Waitzkin, 63 T.C.M. (CCH) at 2745, where the artist likewise had a large inventory, the Tax Court found that she had the potential to “enjoy greater financial benefits from her work” as it gained recognition and that “at any moment, [she] might become even more commercially
successful.” Cf. Allen v. Commissioner, 72 T.C. 28, 36 (1979) (finding ski lodge to be a trade or business where lodge had appreciated in value and taxpayers reasonably expected the value of their assets to continue increasing).

5. Taxpayer’s Success in Other Activities

A track record of success in other business ventures may indicate that the taxpayer has the entrepreneurial skills and determination to succeed in subsequent endeavors. This in turn may imply that the taxpayer, when embarking on these endeavors, does so with the expectation of making a profit. Sec. 1.183-2(b)(5), Income Tax Regs. On the other hand, the absence of prior business experience creates no inference that the taxpayer lacks a profit motive when undertaking a new venture. See Arwood v. Commissioner, T.C. Memo. 1993-352.

In a typical section 183 case, the taxpayer achieves considerable success in a business activity and later embarks on a new activity that the IRS regards as a hobby or sport.

6. History of Income or Losses

The fact that a taxpayer incurs a series of losses beyond an activity’s startup years may imply the absence of a profit objective. Sec. 1.183-2(b)(6), Income Tax Regs. This inference may not arise where losses are due to “customary business risks or reverses” or to “unforeseen or fortuitous circumstances which are beyond the control of the taxpayer.” Ibid. This inference may also be weaker in some fields of activity than in others. As we early recognized: “If losses, or even repeated losses, were the only criterion by which farming is to be judged a business, then a large proportion of the farmers of the country would be outside the pale. It is the expectation of gain, and not gain itself which is one of the factors which enter into the determination of the question.” Riker v. Commissioner, 6 B.T.A. 890, 893 (1927).

Because it often takes many years to achieve economic success in the creative arts, we have found that “a history of losses is less persuasive in the art field than it might be in other fields.” Churchman, 68 T.C. at 701-702. In Waitzkin, 63 T.C.M. (CCH) at 2745, the taxpayer was a “nationally recognized artist whose work ha[d] been shown and exhibited in many well-known galleries and famous museums.” We held that she was engaged in the trade or business of art even though she had never made a profit.

7. Amount of Occasional Profits

The fact that a taxpayer derives some profits from an otherwise money-losing venture may support the existence of a profit motive. See sec. 1.183-2(b)(7), Income Tax Regs. Moreover, “an opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are actually generated.” Ibid. The regulations cite a wildcat oil drilling venture as an example of an activity in which an honest profit motive may be founded on “a small chance that * * * [the taxpayer] will make a large profit.” Sec. 1.183-2(c), Example (5), Income Tax Regs.

8. Taxpayer’s Financial Status

The fact that a taxpayer lacks substantial income or capital from sources other than the activity may indicate that she engages in the activity for profit. Sec. 1.183-2(b)(8), Income Tax Regs. An activity that produces losses, if recognized as a trade or business, will normally generate tax benefits for a taxpayer with other income. The receipt of such tax benefits, standing alone, does not establish that the taxpayer lacks a profit motive for the activity. See Engdahl, 72 T.C. at 670; McKeever v. Commissioner, T.C. Memo. 2000-288.

9. Elements of Personal Pleasure

The fact that a taxpayer derives personal pleasure from an activity, or finds it recreational, may suggest that she engages in it for reasons other than making a profit. Sec. 1.183-2(b)(9), Income Tax Regs. The derivation of personal pleasure, however, “is not sufficient to cause the activity to be classified as not engaged in for profit if the activity is in fact engaged in for profit as evidenced by other factors.” Ibid. “Success in business is largely obtained by pleasurable interest therein.”
Wilson v. Eisner, 282 F. 38, 42 (2d Cir.1922). Thus, “a business will not be turned into a hobby merely because the owner finds it pleasurable; suffering has never been made a prerequisite to deductibility.” Jackson v. Commissioner, 59 T.C. 312, 317 (1972); Giles v. Commissioner, T.C. Memo. 2006-15.

In Churchman, 68 T.C. at 702, the Court acknowledged that the taxpayer’s art activities “involved recreational and personal elements.” We nevertheless concluded that she conducted this activity with the intent to make a profit, noting that “her work did not stop at the creative stage but went into the marketing phase of the art business where the recreational element is minimal.” Ibid. These less pleasurable activities included maintaining a mailing list, sending out announcements, seeking representation from galleries, keeping receipts of business expenses, and maintaining records of sales and customers. Ibid.

Tax Tips

  1. Pursue your talent, first and foremost, while also running it as a business.
  2. Keep adequate tax records such as receipts from the purchase of materials and receipts from the sale of your artwork.
  3. Document relationships with galleries by archiving emails and contracts.
  4. Try to record the amount of time devoted to your art business: the more time the better for tax deductibility.

Partnership Basis in Contributed Promissory Notes and Guarantees: Tax Tips

Partners of a partnership sometimes contribute promissory notes to the partnership.  As an example, a partner drafts a note payable to the partnership promising to pay the partnership a sum of money.  The question then becomes whether the partner has an increase in partner basis for this.  The other question is what is the partnership’s basis in the promissory note.

Another related scenario is where a partner guarantees a partnership debt owed to a third party.  The question is whether this guarantee increases the basis of the partner in the partnership.

Partnerships don’t pay income tax, but they do file  information returns, and partners are supposed to use the numbers from those returns on their own individual returns. See IRC secs. 701, 6031, 6222(a).  Partnership basis is important because it determines where a distribution such as cash is taxed or not.  It also determines the amount of taxable gain or loss upon sale. An increase in a partner’s basis is desirable.  We provide legal and tax services to partnerships.

The value of what a partner contributes to his partnership can be tricky when he contributes something other than cash–like promissory notes or guarantees. a partnership’s basis in property contributed by a partner is the adjusted basis of that property in the hands of the contributing partner at the time of the contribution. IRC sec. 723.

The Tax Court has held that the contribution of a partner’s own note to his partnership isn’t the equivalent of a contribution of cash, and without more, it will not increase his basis in his partnership interest. See Dakotah Hills Offices Ltd. P’ship v. Commissioner, T.C. Memo. 1998-134, 75 T.C.M. (CCH) 2122.

As such, the partner’s basis does not increase and the partnership’s basis in the notes is zero.

However, a guarantee of a partnership debt to a third party does increase a partner’s basis.

For example, in Gefen v. Commissioner, 87 T.C. 1471 (1986) a partner executed a limited guaranty as a condition of her acquisition of an interest in a limited partnership. Under its terms, she assumed personal liability to the partnership’s existing creditor for her pro rata share of the partnership’s recourse indebtedness to that creditor. She also agreed that the partnership could
call on her to contribute to the partnership an amount equal to the partnership’s outstanding debt.  The Tax Court upheld the partner’s increase in basis for her limited guarantee.

This can be a tricky area.  However, here are tax tips:

  1. Consider guaranteeing a preexisting third party debt rather than contributing a promissory note to the partnership.
  2. Document that the partner is providing personal credit to partnership vendors.
  3. The partner should be obliged to make additional contributions under the guarantee.
  4. The guarantee must create a liability to a third party, not the partnership.

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