Dawn Connolly, Author at Barnard Vogler & Company

The Tax Court determined in a recent case that, because an individual’s IRA owned the shares of his limited liability company, the payment of compensation to the individual for his services to the company was a prohibited transaction.

The prohibited transaction resulted in disqualification of the IRA and a deemed distribution of its assets.

In 2005, Terry Ellis organized a limited liability company (LLC), signing the operating agreement on behalf of the Terry Ellis IRA, an entity that did not yet exist. The IRA owned 98 percent of the membership units.

The LLC was formed to engage in the business of used car sales, with Ellis as the general manager. A month later, Ellis created the Terry Ellis IRA. He then transferred cash from his 401(k) account with a former employer to the IRA. The IRA transferred the funds to the LLC and received its membership units. The LLC elected to be treated as an association taxable as a corporation.

During 2005, the LLC paid Ellis $9,754 as compensation for his role as general manager and deducted that amount on its corporation tax return. Ellis’s 2005 return reported the $9,754 as taxable compensation. It also reported the distribution from the 401(k) account but did not report any portion of the distribution as taxable.

The IRS concluded that Ellis engaged in a prohibited transaction with his IRA either:

When he caused his IRA to engage in the sale and exchange of membership interests in the LLC; or
When he caused the LLC, an entity owned by his IRA, to pay him compensation.

The Tax Court concluded that the formation of the LLC did not involve any prohibited transaction. However, the compensation that the LLC paid to Ellis was a prohibited transaction.

The court agreed with Ellis that, at the time of its formation, the LLC was not a disqualified person with respect to the IRA because, at that point in time, the LLC had no owners or ownership interests. However, the court said that, by paying the compensation, Ellis engaged in a prohibited transaction.

Ellis argued that the payment of compensation was not a prohibited transaction because the amounts paid to him by the LLC did not consist of plan income or assets of his IRA. He saw the compensation as merely the income or assets of a company in which his IRA had invested.

Given the facts in this case, the court concluded that the LLC and the IRA were substantially the same entity.

As a result of the prohibited transaction, the full amount that Ellis transferred to the IRA from his old 401(k) account was deemed distributed to him on Jan. 1, 2005. That amount was therefore includible in his gross income.

The court also found that Ellis was subject to the 10 percent additional tax that applies to early distributions from qualified retirement accounts. Finally, the court found that Ellis was liable for the 20 percent accuracy-related penalty (Terry L. Ellis v. Commissioner, TC Memo 2013-245, Oct. 29, 2013).

The IRS has modified the “use-it-or-lose-it” rule for health flexible spending arrangements.

At the plan sponsor’s option, employees participating in a health flexible spending arrangement (health FSA) may be allowed to carry over to the next plan year up to $500 of unused amounts remaining at year-end, according to Notice 2013-71 and an accompanying fact sheet. Prior to this announcement, any amounts that were not used by year-end were forfeited.

Health FSAs are benefit plans established by employers to reimburse employees for healthcare expenses, such as deductibles and co-payments. These plans are usually funded by employees through salary reduction agreements, although employers may contribute as well. Qualifying contributions to, and withdrawals from, health FSAs are not subject to tax.

Unused health FSA contributions left over at the end of a plan year have historically been forfeited to the employer. A plan can, but is not required to, provide an optional grace period immediately following the end of each plan year. The grace period would extend the period for incurring expenses for qualified benefits to the 15th day of the third month after the end of the plan year (March 15 for a calendar-year plan).

For a health FSA to be a qualified benefit under a cafeteria plan, the maximum amount available for reimbursement of incurred medical expenses of an employee, the employee’s dependents and any other eligible beneficiaries with respect to the employee cannot exceed $2,500 per year. This maximum is effective for tax years beginning after Dec. 31, 2012.

The new notice provides that an employer, at its option, can amend its cafeteria plan document to provide for the carryover to the immediately following plan year of up to $500 of any amount in a health FSA remaining unused as of the end of the plan year. The notice also clarifies that the carryover does not count against or otherwise affect the next year’s salary reduction limit. Any unused amount in excess of $500 will be forfeited.

The notice provides that the plan sponsor can specify a lower amount as the permissible maximum carryover amount or can decide not to allow any carryover at all.

For a cafeteria plan offering a health FSA to adopt this new carryover provision, the plan must be amended on or before the last day of the plan year from which amounts may be carried over. The new provision may be effective retroactively to the first day of that plan year.

However, a plan may be amended to adopt the carryover provision for a plan year that begins in 2013 at any time on or before the last day of the plan year that begins in 2014. As a result, some plans may be able to put the carryover option into effect for 2013.

As you are cleaning house before the relatives come to visit, you may come across a number of items that you no longer need or want but could brighten someone else’s holiday season.

Many charities are looking for toys your children have outgrown or usable clothing that has gone out of style. Here are some tips for making someone else’s holidays a little brighter, while saving some tax dollars for you at the same time:

1. Only donations to qualified charitable organizations are tax deductible. Providing help directly to a family in need may fill you with the holiday spirit, but it will not secure a tax deduction for you. Maybe you can find a local church, temple, synagogue or mosque to act as a go-between.

➤ You must itemize your deductions to claim charitable contributions on your return.

2. If you receive a benefit because of your contribution, such as event tickets or a discount at a local restaurant, then you can deduct only the value of your contribution that exceeds the value of the benefit received.

3. Cash contributions, regardless of amount, must be substantiated by a bank record, like a canceled check or credit card receipt, showing the name of the charity and the amount of the gift. A written acknowledgment from the charity showing the date and amount of the gift will also suffice. Dropping a check in the kettle or asking the bell-ringer for a receipt takes some of the luster off the gift, but it’s a requirement if you want the tax deduction.

➤ The rules for a deduction of monetary donations do not change the requirement that you obtain an acknowledgment from a charity for each deductible donation – either money or property – of $250 or more. However, one statement containing all of the required information may meet both requirements.

4. If you have money taken out of your paycheck for charity, keep a pay stub, a Form W-2 or other document furnished by your employer showing the total amount withheld for charity, along with the pledge card showing the name of the charity.

5. For 2013 only (unless Congress extends it again), an IRA owner who has reached the age of 70½ or older can make a direct transfer of up to $100,000 per year to an eligible charity, tax free. This means that amounts directly transferred to the charity from your IRA are counted in determining whether you have met the IRA’s required minimum distribution, but they will not be considered a taxable withdrawal. Some restrictions apply: Distributions from employer-sponsored retirement plans, including SIMPLE IRAs and simplified employee pension (SEP) plans, are not eligible.

6. If you donate a noncash item, you can generally deduct the item’s fair market value – what the item would sell for in its current condition. Keep notes on how you determined the value. A picture of the item may also help if your tax return is audited.

➤ If the items you donate include used clothing and household items, there is an additional requirement that the deduction be allowed only if the item is in good used condition or better.

➤ On the other hand, if the item is worth more than $500, even if it is in less than “good” condition, you may still be able to claim the deduction if you go through the effort of obtaining an appraisal.

7. The rules for the donation of a car, truck, other motor vehicle, boat or airplane are a little different. Rather than using the fair market value of the donation, you generally are limited to deducting the gross proceeds the charity receives from its sale if the value of the item is more than $500. You must obtain a Form 1098-C, Contributions of Motor Vehicles, Boats and Airplanes, or a similar statement, from the charity and attach it to your tax return. Other rules apply if the charity doesn’t sell your donation within a specified time period.

8. If the total of all your noncash contributions is over $500, your tax return must also include a Form 8283, Noncash Charitable Contributions.

9. Special rules apply to donations of appreciated goods, like stock or jewelry, or difficult-to-value items, such as artwork. If you plan to make these kinds of donations, check with your tax adviser.

Contributions are deductible in the year made, so be sure to get those gifts in by Dec. 31. Credit card charges made before the end of the year are deductible even if you pay the credit card bill next year. Similarly, checks written and mailed by the end of the year are deductible this year even if they are cashed in 2014.

You can also take some time out of your busy schedule to volunteer at a shelter, deliver a meal to a shut-in or shovel snow for an elderly neighbor. You won’t get a tax deduction for the value of your time, but you will brighten someone’s day – maybe even your own. ■

The Tax Court has once again ruled that regular commuting expenses are nondeductible personal expenses, no matter what the mitigating circumstances might be.

William Cor was an engineer living in Las Vegas. He worked at a remote test site in the desert. There was no direct public transportation to the job site.

Cor commuted by car and calculated that he drove approximately 160 miles round-trip, four days a week. Although he kept no records of his commuting expenses, he claimed $50 an hour, or $150 per day, for a daily commute of three hours. The amount works out to almost $1 per mile, which is about double the standard mileage allowance the IRS generally allows for travel deduction purposes – but not for commuting expenses.

Although the court agreed that Cor endured a more costly and much longer commute than average in both mileage and time, the drive to the job was still a personal commute between home and work. The expenses of the commute were not deductible, regardless of the distance traveled or the lack of housing near the job site (William Cor v. Commissioner, TC Memo 2013-240, Oct. 22, 2013).

Since the commuting expenses were personal, any reimbursement by an employer to defray those expenses would be subject to income and employment taxes, as would any increase in salary to induce employment. Cor was also liable for a 20 percent negligence penalty.

The estate tax law generally provides that an executor may elect to value farmland considering its actual use, rather than its highest and best use, if certain conditions are met.

The tax basis of inherited property is usually its fair market value at the date of death. However, when a special-use valuation is elected for estate tax purposes, the tax basis of the property is its special-use value instead of its fair market value.

The Tax Court determined in a recent case (Brett Van Alen v. Commissioner, TC Memo 2013-235, Oct. 21, 2013) that two beneficiaries of a trust that sold an easement in farmland specially valued in their father’s estate were bound by a duty of consistency to use the special-use value as their tax basis for calculating their gain on the sale.

In 1994, Joseph Van Alen died. His will created a testamentary trust for the benefit of two of his children. Property going into the trust included Van Alen’s interest in a ranch, which had a fair market value of $1.963 million at the date of his death.

The estate elected special-use valuation. It ultimately reported the special-use value at $98,735, which the IRS accepted.

In 2007, the California Rangeland Trust bought a conservation easement on the ranch, paying the testamentary trust $910,000 as its share of the proceeds. A series of returns and amended returns eventually led to a beneficiary claiming a gain of less than $25,000 from his 50 percent share of the trust’s gain.

Both the IRS and the Van Alen children agreed that the trust received $910,000 in proceeds from the sale of the easement. However, they disagreed on the amount of capital gain the siblings should report from those proceeds.

The children argued that the special-use valuation did not bind the trust. They said that the $1.963 million appraised value of the ranch interest provided clear and convincing evidence that someone – but not the children – made a mistake when reporting the special-use value at less than $100,000.

They asked the court to redetermine the special-use valuation, not to increase their father’s taxable estate, but only to recalculate the trust’s tax basis in the ranch interest.

The court noted that both the IRS and the children agreed that Van Alen’s estate met all the requirements to elect the special-use valuation. It also noted that, when special use is elected, the tax basis of the property is its special-use value. After accounting for trust-level deductions and the distributions made by the trust to its beneficiaries, that basis would result in a long-term capital gain of nearly $360,000 to each of the children.

The court said that, if it allowed the children to revise the special-use election, it would be allowing them to whipsaw, or defeat in two ways, the IRS. The estate could escape the burden of an additional estate tax because the statute of limitations had expired. Meanwhile, the trust – and the children as its sole beneficiaries – would be given additional tax basis to offset amounts realized from the conservation easement sale, as well as future sales of the ranch interest.

The court found that the duty of consistency required the children to use the reported special-use value as their tax basis. In addition, the children were liable for the negligence and substantial understatement penalties.

The IRS has granted a one-year reprieve, available in parts of 38 states, for farmers and ranchers who previously were forced to sell livestock due to drought and now must replace those livestock to avoid a tax liability.

Farmers and ranchers who sell more livestock than they normally would because of drought may defer tax on the extra gains from those sales. To qualify, the livestock generally must be replaced within a four-year period. However, the IRS is authorized to extend the four-year period if the drought continues.

In Notice 2013-62, the IRS announced that a one-year extension of the replacement period generally applies to capital gains realized by eligible farmers and ranchers on sales of livestock held for draft, dairy or breeding purposes. Sales of other livestock, such as poultry and livestock raised for slaughter or held for sporting purposes, are not eligible.

The IRS is providing this relief to any farm located in a county, parish, city, borough, census area or district listed as suffering exceptional, extreme or severe drought conditions by the National Drought Mitigation Center (NDMC). These conditions must have been experienced during any weekly period between Sept. 1, 2012, and Aug. 31, 2013. Any county contiguous to a county listed by the NDMC also qualifies for the relief.

Farmers and ranchers in these areas whose drought sale replacement period was scheduled to expire on Dec. 31, 2013, will now have until the end of their next tax year. This extension immediately impacts drought sales that occurred during 2009.

However, because of previous drought-related extensions affecting some of these localities, the replacement periods for some drought sales before 2009 are also affected. In addition, the IRS announced that it may grant more extensions if severe drought conditions persist.

The itemized deduction for state and local sales and use taxes is scheduled to expire at the end of this year. While Congress may still act to extend the deduction into future years, there is no guarantee the extension will be approved.

For 2013, the sales tax deduction is available as an alternative to the itemized deduction for state and local income taxes. So the primary beneficiaries of the sales tax deduction tend to be individuals who live in one of the states that do not have a state income tax. However, if you are considering the purchase of a big-ticket item, such as a car or a boat, it may be advantageous to consider completing the purchase in 2013 if you can benefit from the sales tax deduction.

If you live in a state without an income tax: Consider completing a major taxable purchase during 2013 if the sales tax deduction will push your itemized deductions over the standard deduction threshold. The standard deduction threshold is $12,200 for married couples, $8,950 for heads of household and $6,100 for unmarried taxpayers or married couples filing separately.

Even if you live in a state with an income tax: Some people may not have a significant income tax obligation. For example, a retiree may owe no state income tax because her pension and Social Security benefits are exempt from state tax and she has little other income. At the same time, she may itemize her deductions because she pays real estate taxes, has deductible medical expenses, pays mortgage interest and/or makes charitable contributions.

If your sales tax already exceeds your state income tax or is only slightly less than your state income tax, accelerating big-ticket purchases into 2013 may be advantageous.

In a private letter ruling, the IRS has refused to waive the requirement to roll over IRA distributions within 60 days for an individual whose bank failed to advise her of the deadline.

The IRS determined that the taxpayer did not qualify for relief because she did not show that the bank had a duty to inform her of the 60-day requirement. The overall facts also indicated that the ability to redeposit the amount was within her reasonable control during the time period in question (PLR201339002).

Normally, there is no immediate tax if distributions from an IRA are rolled over to an IRA or other eligible retirement plan. For the rollover to be tax-free, the amount distributed from the IRA generally must be re-contributed to the IRA or other eligible retirement plan no later than 60 days after the date that the taxpayer received the withdrawal from the IRA.

A distribution rolled over after the 60-day period generally will be taxed and may be subject to a 10 percent premature withdrawal penalty tax. Only one tax-free IRA-to-IRA rollover per IRA account can be made within a one-year period.

The IRS may waive the 60-day rule if an individual suffers a casualty, disaster or other event beyond that person’s reasonable control and if not waiving the 60-day rule would be against equity or good conscience (i.e., hardship waiver).

The IRS will consider several factors in determining whether to waive the 60-day rollover requirement. These factors may include, for example, the time elapsed since the distribution; the inability to complete the rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error; and errors committed by a financial institution.

In the new private ruling, an individual withdrew money from three IRAs maintained at a bank (Bank A) with the intent of depositing these funds at a later time into another IRA that would yield a better rate of return. The individual opened a rollover IRA at Bank B 68 days later but was informed that the intended deposit could not be accepted as a rollover contribution because the 60-day period had expired.

The IRS declined to waive the 60-day requirement. Although one of the factors on which relief can be based is whether errors were committed by the relevant financial institutions, the taxpayer did not demonstrate that Bank A had a duty to inform her of the 60-day rollover requirement.

Instead, the IRS found that the ability to timely redeposit the money into a rollover IRA was within the reasonable control of the taxpayer. Although the bank did not tell her that she needed to redeposit the funds within 60 days, she had the ability to do so.

When it comes to the tax law, not knowing about the rules generally is an insufficient excuse for not complying with them.

In a recent case, the Tax Court allowed a music professor and self-employed musician an itemized deduction as an unreimbursed employee business expense for the travel costs associated with his musical performances.

Consider whether some of the circumstances may apply to your travel costs, even though you may be in a different profession.

Joseph Scully is a jazz musician and music professor for the City Colleges of Chicago who plays with various ensembles and travels throughout the United States to participate in jazz conferences. Scully was also pursuing a doctorate in music.

Scully traveled to rehearsals and performances – “performance activities” – to stay abreast of developments in the music profession. He claimed deductions for driving miles in relation to his performance activities both as Schedule C business expenses and as Schedule A unreimbursed employee expenses.

Scully tracked his miles by logging the date, location visited and activity at each location. He maintained a mileage log for each of the years covered by the case.

But a flood destroyed the logs for the years 2002, 2003 and 2004. The mileage log for 2006 was not destroyed. Scully used his 2006 log to reconstruct the driving logs for his 2002, 2003 and 2004 tax years.

The IRS allowed certain travel expense deductions for music events on the Schedules C but did not allow any travel expenses as unreimbursed employee expense deductions on the Schedules A.

The Tax Court determined that Scully’s claimed vehicle expense deductions were for performance activities, and most of the trips were around the Chicago area. Scully did not claim the miles he drove from home to the City Colleges of Chicago where he taught. Therefore, the court determined that Scully was not trying to deduct personal commuting expenses but only expenses that he considered to be connected with his professional activities.

The court noted that the regulations permit a deduction for education expenses that:

➤ Maintain or improve skills required in employment, or

➤ Meet the express requirements of the employer.

However, expenses that fall into either of these categories would not be deductible if the education:

➤ Is required to meet the minimum education requirements for qualification in the taxpayer’s employment, or

➤ Qualifies the taxpayer for a new trade or business.

The court observed that Scully could have claimed his mileage as deductible business expenses or as deductible unreimbursed employee expenses. The court inferred from Scully’s reporting these expenses on Schedule A that he considered the expenses to be in furtherance of his trade or business as a college professor pursuing an advanced music degree, not as expenses incurred in the trade or business of a musician.

As a result, the court required Scully to show that the expenses were directly and proximately related to the skills required in his business as a college professor. The court then determined that Scully’s performance activities were related to his skill as a professor because he translated his specific experiences as a performer into classroom lessons. Scully showed a direct correlation between the costs expended to learn more about music and teaching music to students.

The court also noted that the deduction for educational expenses is not limited to formal or institutional education. Fees for refresher courses and courses dealing with current developments are deductible if not otherwise disqualified.

Instead of solely relying on structured classes and seminars, Scully stayed abreast of new developments in his profession through active participation, which is analogous to courses dealing with current developments.

The IRS had contended that Scully’s unreimbursed employee expenses were not ordinary and necessary to his employment as a music professor because (1) he generally enjoyed performing, and (2) performance activities were not in his job description. The court pointed out that the tax law doesn’t require activities resulting in business expenses to be unenjoyable, only that they be ordinary and necessary. It stated that Scully “should not be denied deductions because he likes his job.”

The court found that the tax law does not require that the expenses be explicitly connected with activities enumerated in a job description. In other words, there is not a direct connection between formally listing the activities in a job description and the deductibility of expenses incurred while performing those activities.

In addition, the court found that Scully testified credibly that he contemporaneously created mileage logs during the 2002, 2003 and 2004 tax years but those records were later destroyed when his basement flooded. Therefore, the court allowed him to substantiate the claimed deductions by making reasonable reconstructions of the expenditures (Joseph D. Scully, Jr. v. Commissioner, TC Memo 2013-229, Sept. 30, 2013).

Most businesses assume that compensation is deductible when it is paid. However, a recent statement by the IRS raises the question of whether some upfront “signing bonuses” paid to employees who sign a multi-year employment contract must be amortized over the term of the contract, rather than deducted when paid to the employee.

Signing bonuses paid by a minor league baseball team to its players must be amortized over the term of the player contracts, according to an IRS Legal Advice Issued by Field Attorneys.

Based on its experience, the taxpayer who operates the minor league baseball team and was the subject of the Legal Advice (FAA20133901F) wanted to amortize the signing bonus over a shorter period, which historically was shorter than the term provided in the contracts.

Except when the contract’s termination clause comes into effect, the contract stipulates that the player is required to provide services to the team for seven separate baseball seasons. At the end of this seven-year term, if the player has not entered into another contract with the team, he becomes a free agent.

Under the termination clause, the player can terminate his contract only if the team is in default on its contractual obligations for more than 15 days. The team can terminate the contract for several reasons, including if the player signs a major league contract, the player is traded, the player becomes disabled, or the team judges that the player has failed to play well enough.

The team compiled a report that showed the average life of all of its minor league player contracts over a period of years and sought to amortize the signing bonuses over that average number of years.

The IRS has previously ruled (Rev Rul. 67-379) that a signing bonus paid to a player is required to be capitalized and amortized over the useful life of the player’s contract. To the IRS, the useful life for a baseball player’s contract generally is the period over which the team controls the player’s ability to sign a contract with another team.

In the Legal Advice, the IRS concluded that, because the team controls the player for the term of the contract, the useful life of the player contract is that term – seven years – and that the player bonus is amortizable over the seven-year right of the team to receive services from the player.