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Parents and grandparents often lend money to their children or grandchildren to help with major expenditures like education, a wedding or the purchase of a new home.
Similarly, closely held businesses may lend money to shareholder-employees. And business owners sometimes lend money to the business to assist with expansion plans.
All of these transactions are examples of related-party loans.
Not surprisingly, the IRS requires that loans be structured in a business-like manner with terms that reflect current market conditions. If the loan terms are deemed too favorable, the IRS has the ability to recharacterize the loan – perhaps as a gift, additional compensation, or a corporate dividend or distribution – with all the tax implications that a recharacterization implies.
For no-interest or below-market interest loans, the IRS also has the right to reflect the current “market” interest rate for tax purposes by requiring that the lender take into income more interest than was actually received under the terms of the loan. The interest for tax purposes is calculated based on the Applicable Federal Rate (AFR).
The IRS publishes AFRs each month. They represent the minimum acceptable interest rates for most loans. If the interest rate on your loan at its inception is equal to or exceeds the relevant AFR, the IRS cannot challenge the appropriateness of the rate during the term of the loan.
AFRs include annual, semiannual, quarterly and monthly rates for short-term loans (terms of three years or less), mid-term loans (terms over three years but not exceeding nine years) and long-term loans (terms longer than nine years).
The recently published AFRs for May 2014 are as follows:
AFR Interest Compounding Period
Annual Semiannual Quarterly Monthly
Short-term 0.33% 0.33% 0.33% 0.33%
Mid-term 1.93% 1.92% 1.92% 1.91%
Long-term 3.27% 3.24% 3.23% 3.22%
To ensure that the IRS recognizes your transaction as a loan for tax purposes and does not recharacterize it as something else – a gift, additional compensation, or a corporate dividend or distribution, for example – you should have a written loan document or promissory note with an interest rate at least equal to the applicable AFR.
The borrower should sign and date the document, which should describe the terms of the loan, including loan amount, interest rate, payment schedule and any other terms. If your borrower is providing collateral, include a detailed description.
If the IRS determines that the interest rate for your loan is below the prescribed minimum established by the AFR, the loan is subject to the below-market loan rules. These rules generally require the lender and the borrower to recognize interest income and interest expense for federal tax purposes based on the relevant AFR rather than the loan’s actual interest rate.
For a demand loan, without a fixed loan term and end date, the Applicable Federal Rate used to calculate interest for tax purposes varies each month, based on fluctuations in the AFR. For a term loan, with a documented loan term and end date, the interest calculation is based on the relevant AFR as of the loan’s start date.
There is an exception to the below-market loan rules for a loan with a total amount outstanding between lender and borrower that does not exceed $10,000, if the loan is not for tax avoidance purposes.
If you create a new term loan now, when the AFR is near its all-time low, you can lock in a very favorable interest rate.
The tax rules governing below-market and related-party loans are complex with a number of exceptions. To understand all of the tax implications, consult your taxadviser before you enter into or renegotiate any loan.
©2014 CPAmerica International
A recent case demonstrates the difficulties involved in securing a tax deduction from transactions between related parties.
In 1990, Robert Alpert established two irrevocable trusts to fund his two sons’ educations. In 1996, he established a third trust for the benefit of his sons.
Between 1990 and 1996, Alpert transferred $1.1 million to the trusts. In January 1996, the trustee of each of the trusts signed a promissory note to Alpert. No funds were actually transferred in connection with the promissory notes.
Rather, the amounts stated as owed approximated the net funds Alpert had previously advanced to each trust. Subsequently, Alpert continued to transfer moneys to the trusts, but no additional promissory notes were executed.
In 2006, Alpert reported a $1.9 million nonbusiness bad debt deduction on account of worthless debts owed him by the 1990 trusts.
The IRS argued that Alpert was not entitled to the bad debt deduction because he did not establish that:
➜ The transfers to the trusts were bona fide debts;
➜ He was the debt holder in 2006; and
➜ The debts became worthless in 2006.
In concluding that the transfers were not bona fide debts, the court noted that:
➜ The beneficiaries of the trusts were Alpert’s sons.
➜ There was no written agreement with respect to the majority of the transfers.
➜ There was no evident plan of repayment.
The court then said that, even if the transfers represented bona fide indebtedness, Alpert failed to establish that he was the creditor in 2006. Finally, the court found that Alpert failed to show that the debts became wholly worthless in 2006, particularly since the trusts were not insolvent.
Alpert was the founder of Aviation Sales Co. (AVS), a publicly traded company. He also had trading authority over his mother’s brokerage accounts.
Acting without his mother’s knowledge, Alpert purchased AVS shares for her at a cost of $2 million. The share price of AVS declined precipitously, and when Mrs. Alpert learned of the purchases, she threatened to sue.
Alpert orally promised his mother that he would cover any losses she incurred if she sold the AVS shares at a loss. In exchange, she agreed that he would share in half of any profits if the shares were sold at a gain. Those promises were later memorialized in a letter.
In 2006, Alpert reported a loss, which he identified as “Indemnification Payment to G. Alpert.” Alpert contended that he was entitled to a loss for his indemnification payments because:
➜ His trade or business involved acquiring majority ownership positions in distressed companies, improving their operations and profitability, and taking them public;
➜ In so doing, he sought out and enlisted other investors for the purpose of acquiring these companies; and
➜ The indemnification agreement with his mother was part of that business process.
In rejecting Alpert’s argument, the court said that the indemnification agreement and the losses stemming from it were not incurred in his business activities. The court said that it was clear from the letter agreement between Alpert and his mother that he was trying to protect himself from liability for mismanagement of his mother’s assets, not from his business activities. (Robert Alpert v. Commissioner, TC Memo 2014-70, April 17, 2014) .
©2014 CPAmerica International
The Tax Court recently concluded that, when the taxpayers in the case asserted that they had reasonable cause and acted in good faith as a defense to penalties assessed by the IRS, they forfeited their privilege protecting attorney-client
communications.
In this case (Ad Investment 2000 Fund, LLC, et.al. v. Commissioner, 142 TC No. 13, April 16, 2014), the IRS asserted that the taxpayers engaged in transactions designed to create artificial tax losses. The IRS also assessed penalties attributable to:
➜ A substantial understatement of income tax;
➜ A gross valuation misstatement; and/or
➜ Negligence or disregard of rules and regulations.
Anticipating the taxpayers’ argument that the penalties should not apply because they acted with reasonable cause and in good faith, the IRS asked the court to compel production of six tax opinion letters the taxpayers had obtained from their law firm.
The taxpayers objected to the disclosure on the grounds that the letters were privileged attorney-client communications. The IRS argued that the taxpayers waived any privilege under the common-law doctrine of implied waiver by relying on affirmative defenses to the penalties that turn on the taxpayers’ beliefs or state of mind. The taxpayers contended that they had developed their reasonable belief by analyzing the pertinent facts and authorities and not by any reliance on advice from their attorneys.
The court concluded that, by putting the taxpayers’ legal knowledge and understanding into contention to establish good-faith and state-of-mind defenses, the taxpayers forfeited the privilege protecting attorney-client communications relevant to the content and formation of their legal knowledge, understanding and beliefs.
The court reasoned that the taxpayers must show that they analyzed the pertinent facts and legal authorities and, in reliance upon that analysis, reasonably concluded in good faith that there was a greater than 50 percent likelihood that the tax treatment would be upheld if challenged. This put into contention their knowledge of the pertinent legal authorities, their understanding of those legal authorities and their application of the legal authorities to the facts.
The court noted that the taxpayers received the opinions well before their tax returns were due and they did not claim that they ignored the opinions. If the opinions formed the basis for the taxpayers’ beliefs, the court concluded that it is only fair to allow the IRS to review those opinions.
©2014 CPAmerica International
The IRS has released a draft of a shorter, less burdensome version of the regular Form 1023 – Form 1023-EZ – for organizations that plan to apply for tax-exempt status. It is not currently available for use.
When finalized, the two-page Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, may be used if an organization meets specific criteria. Organizations that would normally file Form 1023 will be able to file Form 1023-EZ if they meet all of the following requirements:
Some organizations may be considered tax-exempt under Section 501(c)(3) even if they do not file Form 1023 or 1023-EZ. These include churches, synagogues, temples and mosques, integrated auxiliaries of churches and conventions or associations of churches, and any organization that has gross receipts in each tax year of normally not more than $5,000. However, the IRS cautions that, even though these organizations are not required to file Form 1023 or 1023-EZ to be tax-exempt, they may be liable for annual filing requirements.
If an organization files Form 1023-EZ within 27 months after the end of the month in which it was legally formed, and the IRS approves the application, the legal date of formation will be the effective date of its exempt status. If it did not file Form 1023-EZ within 27 months of formation, the effective date of its exempt status will be the postmark date when it filed Form 1023-EZ.
If an organization did not file Form 1023-EZ within 27 months of formation, and it believes it qualifies for an earlier effective date than the postmark date, it must file Form 8940 after it receives exemption to request the earlier date. Alternatively, it could complete Form 1023 in its entirety instead of completing Form 1023-EZ.
©2014 CPAmerica International
With April 15 behind us, most taxpayers have filed their income tax returns. If for some reason, people have yet to file their 2013 return, they may owe interest and penalties when the return is ultimately filed.
It is important to note that interest and penalties are charged only if taxes are owed. If the return shows a refund, no interest or penalties apply, even if the return is filed late.
Here are eight points you should know about interest and late penalties:
©2014 CPAmerica International
I can’t believe how much homes in Reno are going for nowadays! Lately I have been helping a friend look for a home and it appears now close to $300,000 must be spent to afford a starter home (even though the experts say the average price is closer to $250,000, I find this hard to believe). 
In my recent home viewing experience $300,000 affords a regular 1,900 square foot home, with a small yard and neighbors overlooking this yard. In running the numbers, a purchase price of $300,000 for this starter home equates to a monthly payment of $1,520, which would include putting 20% down or $60,000 at a very low interest rate. I find it hard to believe people who can only afford starter homes can afford this large of a down payment. With a more realistic 5% down, the monthly mortgage payment would be $1,920. According to the industry experts, 30% of gross income is the maximum amount that should be spent on mortgage. At 20%, this would imply a gross income of a minimum of $61,000, and with 5% down an income of $77,000 per year. This is by far in excess of the average household income in Reno of approximately $50,000.
I’m not implying that there is a bubble forming as happened last decade and home prices are going to crash. I just worry that home prices might have increased a bit too much with the 25% gain from just a year ago and closer to 50% from the bottom. I’m waiting for the days when these historically low interest rates go back to levels of those of last decade, which were still historically low. With a rate increase of 1.5% to 5.5% this hypothetical mortgage payment goes from $1,920 to $2,168 which would allow less people to afford the home, if it ever gets sold again. So all I’m saying to my friend is be careful.
The IRS has provided a safe harbor that applies to the treatment of indebtedness secured by 100 percent of the ownership interest in a disregarded entity that holds real property.
The safe harbor will treat such indebtedness as indebtedness secured by real property for purposes of the income exclusion available under the cancellation of indebtedness rules.
Generally, a solvent taxpayer – other than a C corporation – whose qualified real property business indebtedness is discharged outside of a bankruptcy proceeding can elect to exclude some or all of the discharged amount from income. The excluded amount must be applied to reduce the basis of the taxpayer’s depreciable real property.
Qualified real property business indebtedness (QRPBI) is indebtedness that:
➤ Is incurred or assumed in connection with real property used in a trade or business and secured by such real property;
➤ Is considered “qualified acquisition indebtedness” if incurred or assumed by the taxpayer after 1992; and
➤ The taxpayer elects to treat as QRPBI.
QRPBI also includes indebtedness incurred to refinance qualified real property business indebtedness – but only to the extent it does not exceed the amount of the indebtedness being refinanced.
Revenue Procedure 2014-20 provides a safe harbor under which the IRS will treat indebtedness secured by 100 percent of the ownership interest in a disregarded entity holding real property as indebtedness secured by real property. If the indebtedness meets the other requirements, it will be QRPBI. Accordingly, any income from the discharge of indebtedness is eligible for the exclusion and basis reduction rules.
To qualify for the safe harbor, all of the following must be met:
Failure to meet the requirements of this safe harbor does not preclude the taxpayer from arguing, based on facts and circumstances, that its debt nonetheless qualifies for exclusion/basis reduction.
The safe harbor is effective for elections made on or after Feb. 5, 2014. ■
©2014 CPAmerica International
The Tax Court concluded in a recent case that a developer of a planned residential community did not have to recognize income under the completed contract method of accounting until the common improvements were completed.
Shea Homes and its related entities developed large planned residential communities. Shea contended that final completion and acceptance under the completed contract method of accounting did not occur until the last road was paved and the final performance bond required by state and municipal law was released.
The IRS contended that the subject matter of Shea’s contracts consisted only of the houses and the lots upon which the houses were built. Under its interpretation, the contract for each home met the final completion and acceptance test upon the close of escrow for the sale of each home. The IRS also contended that contracts entered into and closed within the same tax year were not long-term contracts eligible for the completed contract method of accounting.
The court determined that Shea was permitted to use the completed contract method of accounting. Further, the court held that the subject matter of the contracts consisted of the home and the larger development, including amenities and other common improvements (Shea Homes, Inc. v. Commissioner, 142 TC No. 3, Feb. 12, 2014).
The court reasoned that the primary subject matter of the contracts included the house, the lot, improvements to the lot and common improvements to the development.
The amenities of the development were of great importance to, and a crucial aspect of, the taxpayers’ sales effort, the attainment of governmental approval of the development and the buyers’ purchase decision. Accordingly, the amenities were an essential element of the home purchase and sale contract.
©2014 CPAmerica International
The IRS has concluded that amounts that a manufacturer paid to retailers to offset the cost of constructing display areas for the manufacturer’s products did not have to be capitalized.
Under the facts presented in Chief Counsel Advice (CCA) 201405014, the manufacturer enters into an agreement to pay the retailers to maintain retail space that conforms to the manufacturer’s design requirements. The agreement provides that the retailers must repay the manufacturer if, within 15 years, the retailer no longer conforms to the requirements of the display area, no longer sells and maintains a full line of the manufacturer’s products or no longer provides servicing. The agreement does not obligate the retailers to purchase any specific quantity of products.
The CCA concluded that the manufacturer did not have to capitalize its payments to the retailer because the manufacturer did not own the retail space and the payments did not create or enhance a separate and distinct intangible asset.
The retailers were required to sell and maintain a full line of products and to provide servicing on site. However, the retailers were not required to purchase any specific amount of products during the term of the agreement, and the price of the product was not fixed. The manufacturer did not have the right to provide any specific quantity of products to the retailers.
© 2014 CPAmerica International
Most of us would be happy if the IRS never knew who we are or where we live.
But sometimes it’s a good idea to keep the government informed.
If you or one of your dependents had a name change last year, you should notify the Social Security Administration (SSA) before you file your federal income tax return. Otherwise, the name on your tax return will not match SSA records, which will likely result in a letter from the IRS inquiring about the mismatch.
If you overpaid your taxes, your refund could be delayed until the discrepancy is resolved.
Be sure to contact SSA if:
Your return must list the Social Security number of every dependent. If you have not obtained a Social Security number for a newborn child, you should process the necessary paperwork before you file your 2013 return.
You can effect a name change by filing Form SS-5, Application for a Social Security Card, with the SSA. It is also a good idea to let the IRS know about a change in address by filing Form 8822, Change of Address.
For individual, gift, estate or generation-skipping transfer tax returns, file Form 8822 or Form 8822-B, Change of Address or Responsible Party – Business, for your business. Note that Form 8822-B should be filed no later than 60 days after a change or by March 1 if the change occurred in 2013 and was not previously reported to the IRS.
