The U.S. Tax Court is the court to use when the amount of federal taxes is in dispute and the taxpayer has not yet paid the bill. Several recent decisions from the Tax Court provide guidance for individuals and businesses in planning for future transactions.
Corporate services at cost
It is common practice for a business owner to use the services of his or her company for personal matters. The question that can arise is the extent to which this results in income to the owner.
In one recent case, the sole shareholder of a corporation in the construction business had his company build a lakefront vacation home for him. He had the corporation maintain a “cost plus” job account on its books to keep track of the materials for his home. He reimbursed the corporation for all of the materials, labor, and overhead costs related to his job. He acted as the general contractor, dealing with all of the subcontractors himself.
The IRS said that the profit that corporation would otherwise have made on its building activities for him of more than $48,000 was a constructive dividend. The Tax Court said that at-cost services do not result in a constructive dividend to an owner (Welle, 140 TC No. 19 (2013)). Normally the shareholder’s corporation would have charged customers a profit margin of 6% to 7%. However, the foregone profit was not a constructive dividend because it did not result in a distribution of current or accumulated earnings and profits (Code Sec. 316(a)). While an economic benefit received can amount to a constructive dividend, it only becomes a dividend if it is a distribution from earnings and profits without expectation of repayment. There is no automatic connection between a corporation’s decision not to make a profit on services provided to a shareholder and a corporation’s distribution of earnings and profits. A dividend results only when corporate assets are diverted to or for the benefit of a shareholder.
Planning pointer: A shareholder can have his or her corporation provide services for the owner’s benefit without triggering a constructive dividend as long as the corporation is reimbursed for its outlays.
IRAs and Personal Guarantees
An IRA can be a flexible investment vehicle, allowing for tax deferral of income and gains until distributions are taken. However, tax deferral is thwarted if the IRA is misused by engaging in a prohibited transaction. This causes the IRA to lose its exempt (tax-deferred) status, resulting in immediate taxation of all of the funds in the account (assuming the IRA was created with tax-deductible contributions).
One individual set up a corporation (Corporation A) and had his IRA buy its shares. Then Corporation A purchased another corporation (Corporation B) with cash and a note. The IRA owner personally guaranteed the note issued by Corporation A. After B’s stock had appreciated, he converted his IRA to a Roth IRA. Then B’s stock was sold for a considerable gain.
The IRS said that all of the gain was taxable to him and the Tax Court agreed (Peek, 140 TC No. 12 (2013)). His personal guarantee of the note issued by the corporation whose stock was in his IRA was an indirect extension of credit to the IRA, which is a prohibited transaction. This caused the IRA to lose its exempt status as of the date that the note was made (well before the conversion to a Roth IRA and well before the sale of B’s stock) (Code Secs. 408(e) and 4975(c)(1)(B)).
Planning pointer: Self-directed IRAs offer considerable opportunities for investment growth by savvy individuals. However, exercise care when using self-directed IRAs. Only certain types of investments are permissible. What’s more, any self-dealing can be viewed as a prohibited transaction.
Dependency exemptions for noncustodial parents
When parents get divorced, only one can claim a dependency exemption for their child. Under federal tax law, the exemption belongs to the custodial parent unless that parent waives the right to claim it. A waiver must be made in writing; Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, is used for this purpose.
Often, divorce courts specify which parent is the one to claim a dependency exemption. This direction may not align with federal tax law, as one parent found out. A divorce decree awarded physical custody of the couple’s three children to the mother. The dependency exemptions were to be divided between the parents, but the divorce decree did not require the mother to execute Form 8332 to release the claim to the exemptions. The father claimed a dependency exemption for two of the children, consistent with his understanding of the divorce decree, but he did not get his ex-wife to sign Form 8332. She claimed a dependency exemption for two children, so that each parent claimed the same child as a dependent on their returns.
The Tax Court concluded that tax law trumps state law on divorce matters when it comes to the dependency exemption (Shenk, 140 TC No. 10 (2013)). Simply put, because the mother did not sign a release of her right as custodial parent to claim the dependency exemptions, the father could not claim them despite the language in the divorce decree.
Planning pointer: A parent going through a divorce should make sure that an experienced tax advisor review documents related to settlements so he or she understands the consequences of the provisions in the documents.
Easements with strings
An individual who owns a building or land may be able to obtain a current tax deduction without losing the right to use the property. This is accomplished through a conservation easement (or a façade easement with respect to a certified historic structure) granted in perpetuity. To qualify, there must be a legally enforceable restriction on the use of the property so that it is exclusively for (Code Sec. 170(h)):
- Preservation of land areas for outdoor recreation by, or the education of, the general public.
- Protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem.
- Preservation of open space (including farmland and forest land).
- Preservation of a historically important land area or a certified historic structure.
The problem arises in how the donation of an easement is structured. In a recent decision, donors made gifts of cash and a façade easement of their property located in a historic preservation district in New York City to the National Architectural Trust (NAT) and claimed a charitable deduction. The easement was appraised at $990,000 (the easement apparently reduced the appraised value of the $9 million property by 11%); they also donated cash equal to 10% of the appraised easement value ($99,000). The IRS disallowed the deduction, maintaining that the gifts were “conditional.” Under the terms of a side letter with NAT (referred to by the donors as a “comfort letter”), the property would be returned to the donors if the IRS disallowed the deduction.
The Tax Court agreed with the IRS that the gift was conditional and not deductible (Graev, 140 TC No. 17 (2013)). The donors argued that the possibility that the condition would be triggered (i.e., that their donation would be disallowed) was so remote as to be negligible (Reg. Secs. 1.170A-1(e), 1.170A-7(a)(3)), and 1.170A-14(g)(3)). They said that under state law (New York in this case), the side letter was unenforceable because it was not part of the recorded deed, making it a nullity.
The court rejected the donors’ arguments. The facts showed that NAT was ready and willing to honor the letter. NAT kept the donors informed about Congressional developments concerning easements and gave them an opportunity to back out of the donation before the deed was recorded. Thus, the donors effectively reserved the right to have their easement and cash returned if certain events occurred, making the gift conditional and nondeductible.
Planning pointer: Donors making conservation easements should follow the rules carefully to avoid a disallowance of the deduction for their charitable donation. Retaining any rights or conditions can disqualify the donation. For more details, review the IRS’ Audit Technique Guide on Conservation Easements at www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Conservation-Easement-Audit-Techniques-Guide#_Toc113.
Conclusion
Tax Court decisions offer important guidance on key points in tax laws that serve to help in planning transactions in the future.
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