Accuracy Related Penalty IRC 6662(a): 5 Tips

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Philip Falco
Accuracy Related Penalty IRC 6662(a): 5 Tips

5 Tips by Tax Lawyer Philip Falco:

  1. Scan all of your receipts and email the questionable expenses to your CPA for review.
  2. Keep a mileage log and provide the actual log to your CPA.  Telling your CPA what your mileage was is not enough to avoid the IRC 6662(a) accuracy related penalty.
  3. Work with a CPA who has integrity and who will be willing to “fall on the knife” if he gave you incorrect tax advice.  Everyone makes mistakes, not everyone is willing to own up to them.
  4. Categorize your expenses all year long.  If you are not sure if something is a business expense, ask right away and properly categorize it.  It is up to the taxpayer to show the IRS you properly categorized an expense.  This seems simple but is subtly complex.  The IRS will willingly categorize an expense as personal unless taxpayer shows otherwise.
  5. Evidence is the name of the tax game.  In the digital age, there is no excuse for not archiving old receipts.  These documents can be critically important many years down the road.  Keep them, especially those pertaining to rental real estate (purchase, improvements) and business expenses.  Really any real estate evidence should be archived since an owner occupied real estate holding can be converted to a rental.  If so, adjusted basis (ex depreciation) becomes very important.

Accuracy Related Penalty IRC 6662(a)

Section 6662(a) imposes an accuracy-related penalty equal to 20% of the underpayment to which section 6662 applies. Section 6662 applies to the portion of any underpayment which is attributable to, among other things, negligence or disregard of rules or regulations. Sec. 6662(b)(1).  Underpayment of tax is typically attributable to negligence.

IRC Section 6662(c) provides that “[f]or purposes of section 6662, the term ‘negligence’ includes any failure to make a reasonable attempt to comply with the provisions of the Code, and the term ‘disregard’ includes any careless, reckless, or intentional disregard.”

Negligence also includes any failure to exercise ordinary and reasonable care in the preparation of a tax return or any failure to keep adequate books and records and to properly substantiate items. Sec. 1.6662-3(b)(1), Income Tax Regs.

Burden of Proof

Section 7491(c) provides that the Commissioner bears the “burden of production” with regard to penalties and must come forward with sufficient evidence indicating that it is appropriate to impose the penalty. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner meets his “burden of production”, however, the “burden of proof” remains with the taxpayer, including the burden of proving that the penalty is inappropriate because of reasonable cause under section 6664. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.

Exception: Reasonable Cause for Taxpayer’s Position

Section 6664(c)(1) provides that the penalty under section 6662(a) shall not apply to any portion of an underpayment if it is shown that there was reasonable cause for the taxpayer’s position and that the taxpayer acted in good faith with respect to that portion. See Higbee v. Commissioner, 116 T.C. at 448. The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Petitioners have the burden of proving that the penalty is inappropriate because of reasonable cause under section 6664. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.

Reasonable cause can be reliance on a CPA’s tax advice.  However, For reliance to be reasonable, “the taxpayer must prove by a preponderance of the evidence that the taxpayer meets each requirement of the following three prong test: (1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.” Neonatology Assocs., P.A. v. Commissioner, 115 T.C. at 99.

As an example, if a taxpayer tells his CPA about mileage without also giving the CPA a mileage log, this has been held to be not sufficient, and the accuracy related penalty was imposed.

It is up to the taxpayer to show that he provided his CPA with sufficient documentation of a deduction.

Practical Effect: Your CPA will have to write a letter to the IRS, be interviewed by the IRS, or testify in Tax Court (or US District Court) to adequately present this approach.

Meticulous bookkeeping is critical for taxpayers in the 21st Century.  Please feel free to ask us about our bookkeeping, accounting, and tax services.

Breaking News: IRS Changes to the Offshore Voluntary Disclosure Program (OVDP)

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Philip Falco

IRS Reduces OVDP Penalty to 5% in non-willful offshore compliance cases.

For eligible U.S. taxpayers residing in the United States, the only penalty will be a miscellaneous offshore penalty equal to 5 percent of the foreign financial assets that gave rise to the tax compliance issue.

Other positive changes for taxpayers living in the United States:

  • Eliminating a requirement that the taxpayer have $1,500 or less of unpaid tax per year;
  • Eliminating the required risk questionnaire;
  • Requiring the taxpayer to certify that previous failures to comply were due to non-willful conduct.

The IRS increases its effort to make OVDP accessible to everyone.  This is a step in the right direction.  The goal is to get taxpayers in compliance.

Non-willful conduct is conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.

Other good news: If you made an OVDP submission prior to July 1, 2014 you may elect to have your case considered under Streamline so long as a closing agreement has not been executed.

We specialize in Offshore Account Compliance. We represent taxpayers entering the 2012 Offshore Voluntary Disclosure Initiative Program (OVDP)

See our page on OVDP / OVDI

Please contact Philip Falco, CPA, Juris Doctor – Honors to discuss these new measures and how they apply to you (303) 626-7000.

 

Offshore Voluntary Disclosure Initiative (OVDI) (OVDP) Program

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Philip Falco

The clock is ticking on this tax amnesty program provided by the IRS.

Countries from around the world have disclosed or are in the process of disclosing United States account holder information.  If a taxpayer is caught before entering OVDI / OVDP the penalties are draconian.  Penalties likely include criminal prosecution.

If the taxpayer has offshore accounts or properties, it is critical that the taxpayer speak with a tax attorney and not an accountant.  The accountant privilege does not apply to criminal proceedings.  However, the attorney-client privilege does apply to criminal proceedings.  The accountant could be subpoenaed to testify against the taxpayer at the criminal trial.

Philip Falco, CPA, Juris Doctor – Honors will work on your case to gain acceptance in OVDI / OVDP.

Quiet disclosures are not the answer.  This is where a taxpayer begins to file proper schedules on his or her tax return without entering OVDI / OVDP.  The IRS has specifically reserved the right to pursue criminal prosecution in these cases.

Because of the vast disclosures from foreign countries, participation in OVDI / OVDP is becoming more difficult every day.

The disclosures required for  OVDI / OVDP are massive and must be done precisely.  The worst fear would be accusation of a half-truth facing criminal prosecution.

We can prepare the required amendments to your returns and prepare the complete package to the IRS as required by OVDI / OVDP.

In the opinion of Philip Falco, CPA, Juris Doctor, the offshore initiative is the most significant tax development since the 1986 revisions to the internal revenue code that cracked down on tax shelters (revisions to passive activities and at-risk tax rules).

See our page on OVDP / OVDI

 

Blank Receipt – No Tax Deduction for Charitable Contributions

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Philip Falco
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

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Philip Falco
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

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Philip Falco
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

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Philip Falco
Partnership Basis in Contributed Promissory Notes and Guarantees: Tax Tips

Philip Falco, Attorney, CPA tracks inside and outside partnership basis, prepares 1065 Tax Returns and K1’s (303) 626-7000 phil@coloradolegal.com

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.

See also our page on the sale of a partnership

Nonresidents of Colorado Taxed on Colorado Real Estate

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Philip Falco
Nonresidents of Colorado Taxed on Colorado Real Estate

It is a little known fact that if a nonresident of Colorado owns real estate in Colorado, such as a ski condo, the nonresident must file a DR 104 and complete the 104PN Part-Year/Nonresident Computation Form upon sale or receipt of rent.

For example, a taxpayer who lives in California and owns a vacation ski condo in Aspen must file a Colorado State Income Tax Return DR 104 upon the sale of the condo or if taxpayer has rental income with respect to the ski condo.  As such, taxpayer would likely file two State tax returns: a California return and a Colorado return.

In addition to Colorado real estate, the following income sources are taxed:

  1. The ownership of any interest in real or tangible personal property in Colorado
  2. A business, trade, profession, or occupation carried on in Colorado
  3. The distributive share of partnership or limited liability company income, gain, loss, and deduction determined under CRS section 39-22-203
  4. The share of estate or trust income, gain, loss, and deduction determined under CRS section 39-22-404
  5. Income from intangible personal property, including annuities, dividends, interest, and gains from the disposition of intangible personal property to the extent that such income is from property employed in a business, trade, profession, or occupation carried on in Colorado. A nonresident, other than a dealer holding property primarily for sale to customers in the ordinary course of his trade or business, shall not be deemed to carry on a business, trade, profession, or occupation in Colorado solely by reason of the purchase and sale of property for his own account.
  6. His share of subchapter S corporation income, gain, loss, credit, and deduction allocable or apportionable to Colorado.

DR 0107 Colorado Nonresident Partner or Shareholder Agreement is the form used to establish jurisdiction over the nonresident partner (1065) or nonresident S Corporation (1120S) shareholder.  This formed is signed by the partner/shareholder and then filed by the partnership/s corp.  By signing this form the partner or shareholder promises to file a DR 104 as a nonresident of Colorado and report the income from the resident partnership or s corp.  In this way, the State of Colorado extends its jurisdiction to nonresident partners and shareholders thereby defeating state tax evasion techniques.

Consequently, if you receive a K1 from a Colorado partnership or Colorado S Corp, be ready to file a DR 104.

Federal Taxation of Marijuana

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Philip Falco

The legalization of marijuana in Colorado poses fascinating federal tax challenges.  I will help the industry manage this challenge.

The problem lies in a short provision in the United States Tax Code.  As States, such as Colorado, legalize substances that are illegal under federal law, this section in the tax code provides a formidable barrier to business operations.  This section was enacted in 1982 when Ronald Reagan declared the “War on Drugs”.  As unambiguous as that war was so to it is this section of the internal revenue code.

Sidebar: I have always taken interest in the Tenth Amendment to the United States Constitution.  The Tenth Amendment is beyond the scope of this post.  In general, the Tenth Amendment is used by States as a legal mechanism to exert legal authority in its own right and thereby limit legal authority of the federal government.  The argument would go that if a State, such as Colorado, chooses to legalize a substance that is illegal under federal law, Colorado law prevails and preempts federal law.

Sidebar to the Sidebar: As a Coloradoan for the past 20 years, having first hand witness of the evolution of this business, it is headed in the right direction.  I base this solely on observation.  It has helped commercial real estate.  It does seem that it stimulated the commercial real estate market during the great recession.  Now that Colorado is regulating the industry, especially the City & County Denver, the industry appears more reasoned and is in its second stage. I would say it is very much in the growth cycle.

Taxation

I focus on the taxation of profits and business models.  A business model would not be sustainable if it were taxed 100% on revenue without the ability to take deductions.  Internal Revenue Code §280E does just that.

IRC §280E is a subsection to Part IX of the internal revenue code entitled Items Not Deductible .

IRC §280E provides:

“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”

Marijuana is a schedule I controlled substance under federal law. As such no deductions or credits are allowed pursuant to IRC §280E.  Article XVIII, Section 16 of the Colorado Constitution legalizes marijuana for recreational use for individuals over 21 and regulation thereof.  Article XVIII, Section 14 of the Colorado Constitution legalizes marijuana for medicinal use.  Therein lies the rub.

Tax Court to the Rescue

Thank goodness for the separation of powers and level-headed judges.

Federal Taxation of Medical Marijuana / Caregiver Business Model

In a caregiver tax case, pursuant to IRC §280E the IRS disallowed all of Taxpayers deductions related to the provisioning of marijuana and deductions related to caregiving services.  The Tax Court disagreed.

The tax court allowed for Taxpayer to classify its business as two separate business models: provisioning of marijuana, and caregiver.  In the end, the tax court permitted most of taxpayer’s deductions.  The court permitted deductions related to caregiving such as rent, salaries, and so on.  The court allocated 10% of rent to provisioning of marijuana, which was disallowed.

What is interesting to note about this case is the IRS position of business-model pollution, as I describe it.  The IRS took the position that because Taxpayer was in a business concerning a controlled substance that business polluted the deductions of the legitimate business.  This concept of business-model pollution must be heeded as it applies to recreational marijuana.

Cost of Goods Sold

In a more recent tax court case, the court permitted the cost of good sold (COGS) deduction.  This is a huge win for the marijuana industry.

Gross income, as defined in IRC §61, does not include COGS.  Historically, accountants perform separate measurements of income.  At the very outset a measurement is calculated to determine gross revenues less COGS.  Tax law inherited this practice.  Tax law considers COGS an exclusion. When one studies accounting, as I have, he undertakes the study of Cost Accounting, which is in itself the science of COGS.

In this more recent case, the tax court implemented the notion of business-model pollution against Taxpayer that had the affect of disallowing deductions that otherwise would have been allowed.

Tax Planning

COGS provides a considerable tax planning strategy especially as it relates to the recreational industry.  Minimizing business-model pollution is critical to fortify the profit models of separate businesses as it possibly relates to grow and retail.

Published: July 16, 2014.

By: Philip Falco, Attorney, CPA

Tax Preparation and Planning for Entrepreneurs and High Net Worth Individuals

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Philip Falco

Tax Preparation and Planning for Entrepreneurs and High Net Worth Individuals

During Tax season, we perform the most sophisticated tax preparation for you. We optimize shareholder and member basis, losses, gains, carryovers and carrybacks.  We ensure that you receive your deductions

Because we are vertically integrated, we provide you with simulated tax returns

If we find an error in your tax plan implementation, we bring it to your attention and provide our tax opinion.

We are vertically integrated.  To us this means that we start with the pieces that compose your tax return all the way up to strategic planning, legal planning, and integrate both for you.

After Tax Season
Tax season isn’t the only time to think about taxes. Nearly every business decision you make has a tax consequence, and we believe working with a tax professional year-round can help you make informed decisions to minimize tax liabilities and take advantage of every possible incentive.

It’s absolutely necessary to gain a thorough understanding of your company’s operations, tax elections and methods, not only to prepare an accurate, complete set of returns, but also to find the most effective means to save additional tax dollars and meet your financial objectives.

From implementing tax-saving strategies and reviewing new legislation to evaluating current elections and amending returns, our staff works tirelessly throughout the entire year to find the most effective ways to save you tax dollars and keep more of your hard-earned profits.

We are working on strategies to minimize the new Healthcare (ObamaCare) 3.8% Tax on Net Investment Income.  This tax is targeted at high income individuals (married filing jointly in excess of $250,000).

Click here to visit our Tax Preparation Page: Tax Preparation

Email us for a free consultation Phil@ColoradoLegal.com

Or call (303) 626-7000.

Commercial Real Estate holding entity

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Philip Falco

Colorado Corporate entity selection is very important.

Setting off on the correct course at the very beginning is worth the investment.  It can save taxes, owner liability and headaches.

There are various types of entities under Colorado statute Title 7. Colorado was one of the first States to enact a Limited Liability Company (LLC) statute.  In fact, the author’s corporation class studied the Colorado LLC statute in 1993.

A Colorado LLC is the most popular Colorado entity and for good reason.

Its purpose is to provide limited liability to members.  Limited liability has dwindled somewhat by way of Colorado Case Law.  There are measures to take to ensure protection.

What is Limited Liability?  This refers to personal liability of a member for entity liabilities.  Entity liability could include liability from third-party personal injury.

There is the Limited Liability Partnership (LLP).

Under Colorado statute, there are several varieties of LLP.  Historically, an LLP was required to have at least one general partner.  An entity can now chose to be a Limited Liability Limited Partnership (LLLP).

There is the Colorado Corporation.

A Colorado Corporation is formed pursuant to C.R.S. §7-90-101, et. seq.  A great advantage of a corporation is its simplicity.

Taxation

Generally, an entity can be taxed as a partnership, a C-Corp (Double Tax), or an S-Corp (flow through).

A Real Estate holding entity usually would chose partnership taxation because of its flexibility.  Other entities chose S-Corp because S-Corps provide more clarity on payroll, and they do, which is very important for tax compliance.

Under the Check The Box regulations, an entity, such as an LLC, can chose the following tax classifications: C-Corp, S-Corp, Partnership.  Under certain rules, an entity is considered a disregarded entity for tax purposes, in which case, taxation is according to Sole Proprietorship rules.

Partners who are Married.

If there are only two partners and they are married, they might very well be considered a disregarded entity by the IRS.  This could throw a wrench in your tax paradigm, so check with a professional to be sure.