12.20.09
Posted in Taxation Law at 10:09 by Administrator
A reduction, modification or cancellation of indebtedness can have significant consequences under federal tax law. Too often, however, debtors fail to take tax considerations into account when they restructure debt, especially when navigating their way through the process without legal counsel.
The tax rule that applies to cancellation of debt is fairly straightforward. Under section 61(a)(12) of the Internal Revenue Code, as amended, cancelled debt – COD – income generally is taxed as ordinary income. There are several statutory exceptions to this rule. But debtors may pay a price for those exceptions in the form of reductions in debtor “tax attributes” such as basis of assets and certain tax credits.
Foreclosures and Repossessions
Most debt workouts, however, don’t involve simple cancellation of debt. A creditor may agree to accept a voluntary conveyance of the loan collateral in complete satisfaction of the debt – for example, a house in the case of a mortgage – or the creditor can foreclose on, or repossess, the collateral.
Either of these actions, in effect, amounts to a sale of the property, so the debtor will have some mix of cancellation of debt income and capital gain under IRC section 1001. The mix of COD income and sale or exchange gain depends on whether the debt is recourse or nonrecourse.
In the case of a recourse debt – which allows the creditor to recover other debtor assets in addition to the original collateral – the conveyance of, or foreclosure on, the collateral is split between COD income and capital gain.
First, the transaction results in a capital gain or loss, which depends on the difference between the fair market value of the property and the debtor’s adjusted basis. If the fair market value of the property exceeds the amount of the debt, there is no COD income. If, however, the fair market value is less than the debt, then the debtor may realize COD income in the amount that the canceled debt which exceeds the fair market value – in addition to any capital gain or loss. The debtor can avoid COD income if the creditor accepts a deficiency note to cover any shortfall between the value of the property conveyed and the amount of the debt.
If there is an auction or foreclosure proceeding, the bid price is presumed to equal the fair market value of the property in the absence of clear and convincing evidence to the contrary. But a debtor should be wary of this presumption if a distressed sale yields very little, and should be prepared to rebut the presumption with an appraisal.
In the case of a nonrecourse debt – which bars a creditor from attaching assets of a debtor beyond the original collateral – cancellation of debt income is removed from the tax equation.
A voluntary conveyance or foreclosure of property in satisfaction of a nonrecourse debt is treated as a sale or exchange of the transferred property. The debtor simply realizes a capital gain or loss equal to the difference between the principal amount of the debt and the adjusted basis of the property.
Exclusions
COD income may be excluded from gross income if the debtor falls within certain exceptions enumerated in IRC § 108. Significant exclusions include bankruptcy, insolvency, and mortgage forgiveness debt relief.
COD income is not recognized for tax purposes if the discharge of the debt occurs in a federal bankruptcy proceeding pursuant to a plan approved by the court – whether under Chapter 7, 11 or 13. Under the bankruptcy exclusion, there is no limit on the amount of COD income that may be excluded.
The insolvency exclusion, however, applies only when, and to the extent, a debtor’s liabilities exceed the fair market value of assets, and income may only be excluded to the extent of the insolvency. Assets exempt from the claims of creditors must be counted in determining whether the debtor qualifies for the insolvency exclusion. This could be a factor as to whether the debtor seeks to use the insolvency exclusion or, instead, restructure in a formal bankruptcy proceeding.
The last significant exclusion is for mortgage forgiveness. Under the Mortgage Forgiveness Debt Relief Act of 2007, this exclusion applies only to the discharge of this kind of debt if it occurs on or after January 1, 2006, and before January 1, 2013. The indebtedness must be incurred to acquire, construct or substantially improve any qualified principal residence, and be secured by that property. The exclusion is limited to $2 million of COD income for a married couple filing jointly ($1 million for single filers and married persons filing separately), and it must be used to reduce the basis of the principal residence.
If the indebtedness exceeds the monetary limits, or if a portion is used for a nonqualified purpose, those portions of the indebtedness will be deemed to have been canceled first and must therefore be treated as COD income.
Attribute Reduction
As mentioned earlier, the price for excluding COD income is that certain specified tax attributes of the debtor then must be reduced. When COD income is excluded by a debtor in conjunction with bankruptcy or insolvency, the debtor’s tax attributes must be reduced in the following order: (1) net operating losses; (2) general business credits; (3) alternative minimum tax credits; (4) capital loss carryovers; (5) basis of assets; (6) passive activity loss and credit carryovers; and (7) foreign tax credit carryovers. The credits are reduced at the rate of 33 cents for each dollar of excluded COD income. The other attributes are reduced on a dollar-for-dollar basis.
The reduction in attributes is made after the determination of taxes for the taxable year of the debt discharge. That means attributes arising in or carried to the year of the discharge may be used to reduce income or tax for the year of the discharge, and the remaining attributes themselves are reduced for the following year.
Flexibility in the rules for reducing attributes allow a debtor, with careful planning, to apply the rules to best advantage. Instead of reducing attributes in the order prescribed above, the debtor may elect, pursuant to IRC section 1017, to first reduce the basis of its depreciable property. In that way, the debtor may choose to preserve net operating losses for future years.
The exclusions from COD income for qualified principal residence debt specifically provide for a reduction in the basis of the property securing the debt instead of following the ordering rules for attribute reductions.
Modification of Debt
A creditor may agree to modify the terms of a loan or other debt, usually by reducing the interest rate or extending the maturity date. The tax consequences of such a modification depend on whether it is defined as “significant” under Treasury regulation section 1.1001-3.
Generally, a modification is significant only if, based on all the facts and circumstances, the legal rights or obligations are altered in an economic manner and to a degree that changes the character of the debt in a major way.
A modification that changes the timing of payments, for instance, is significant if it results in the “material” deferral of scheduled payments. A deferral will be material if it extends a payment period more than five years, or more than half of the original term of the loan, whichever is less. Other significant modifications in a debt may include changes in its yield to the creditor; the substitution of a new obligor replacing the original debtor on a recourse debt; a change in the collateral or guarantee on a nonrecourse debt; or changing the debt instrument from recourse to nonrecourse, or vice versa.
If a debt modification is not significant under the definition of the Treasury regulations, or if it was contemplated or provided for in the original debt instrument, then it generally has no tax consequences.
If the modification is significant, however, the debt is deemed to be exchanged for new debt in a taxable exchange under IRC section 1001. In that case, the debtor will generally be treated as having satisfied the old debt with an amount of money equal to the issue price of the new debt.
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11.22.09
Posted in Real Estate Law, Taxation Law at 19:31 by Administrator
Real estate investors have various “tools” in their investment “toolboxes” which can be used to increase both the net value and diversity of a real estate portfolio. One powerful “tool” is the Like-Kind Exchange, also known as Section 1031 of the Internal Revenue Code or the “1031 Exchange”.
Tax obligations are a major obstacle to the creation and retention of wealth, as most real estate transactions have tax consequences. The Internal Revenue Code (IRC) requires a taxpayer to pay tax on a real estate transaction where the fair market value (FMV) of property received (e.g., cash) is greater than the adjusted basis of a property given up (i.e., investment real property). In other words, if a real estate investor sells an investment property for an amount greater than its adjusted basis, the difference between the sale price of the property and the property’s adjusted basis will be subject to capital gains tax. (The “basis” of an asset is generally its cost. However, basis may be adjusted over the course of time due to various events. The basis of property must be increased by capital expenditures and decreased by capital returns. Increases in basis have the effect of reducing the amount of gain realized or increasing the amount of realized loss. Decreases in basis have the effect of increasing the amount of realized gain or decreasing the amount of loss.)
Although the general rule is that a real estate investor must recognize a capital gain on the sale of investment real property where the FMV of the property sold is greater than the property’s adjusted basis, IRC section 1031 provides taxpayers with a mechanism to defer recognition of the gain to the extent that the investment property which is given up is exchanged for a property of “like-kind”.
Like-kind property is alike in nature or character, but not necessarily in grade or quality. Real property is of like-kind to all other real property, except for foreign real property. Examples include single family residence for apartment building, or commercial building for parking lot. A lease of real property for 30 or more years is treated as real property.
“Boot” is all property which does not qualify for Section 1031 treatment. Boot includes cash received, net liability (e.g., mortgage) relief, and the FMV of other non-qualified property received.
The basis in property acquired in a like-kind exchange is equal to: adjusted basis of property given + gain recognized + boot given (cash, liability incurred, other property) – boot received (cash, liability relief, other property).
An exchange of like-kind properties must be completed within the earlier of 180 days after the transfer of the exchanged property or the due date (including extensions) of the transferor’s tax return for the taxable year in which the exchange occurred. Also, the replacement property must be identified as such not later than 45 days after the date on which the transferor transfers the property. The identification of multiple replacement properties is permitted. Special rules apply to exchanges between “related” parties.
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Posted in Litigation, Taxation Law at 19:28 by Administrator
Every year, the Internal Revenue Service (IRS) sends millions of letters and notices to taxpayers. Many of these letter and notices are sent during the late summer and fall. Here are eight things you should know about IRS notices – just in case one shows up in your mailbox.
1. Don’t panic. Many of these letters can be handled with relative simplicity.
2. There are number of reasons the IRS sends notices to taxpayers. Notices may request payment of taxes, notify you of a change to your account, or request additional information. The notice you receive normally covers a very specific issue about your account or tax return.
3. Each letter or notice contains specific instructions on what the IRS would like you to do to satisfy the inquiry.
4. If you receive a correction notice, you should review the correspondence and compare it with the information on your return.
5. If you agree with the correction to your account, usually no reply is necessary unless a payment is due.
6. If you do not agree with a correction made by the IRS, it is important to respond to the letter or notice.
7. The IRS has lawyers and other tax professionals which represent it in collections matters; you should have a professional representing you, too.
8. If you receive a letter or notice from the IRS with which you disagree, call Earle Law Offices for a free attorney-client privileged telephone consultation.
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Posted in Business Law, Taxation Law at 19:27 by Administrator
If you own a small business, whether your business hires workers as independent contractors or as employees will determine how the financial resources the business has available to it for labor are apportioned.
Following are eight considerations for business owners who must decide whether to classify workers as independent contractors or as employees.
1. The three characteristics used by the IRS to determine the relationship between businesses and workers are: Behavioral Control, Financial Control, and the Type of Relationship.
2. “Behavioral Control” refers to facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.
3. “Financial Control” refers to facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job.
4. “Type of Relationship” refers to how the workers and the business owner perceive their relationship.
5. If your business has the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees.
6. If your business can direct or control only the result of the work done – and not the means and methods of accomplishing the result – then your workers may be independent contractors.
7. Employers who mis-classify workers as independent contractors can end up with substantial tax bills, penalties for failing to pay employment taxes and file required returns, as well as non-tax penalties, such as those imposed pursuant to the California Labor Code and liability which mae arise from the failure to provide workers’ compensation coverage.
8. Employers can become the subject of an IRS inquiry following a request by a worker for a determination of whether the worker should by classified as an employee or as an independent contractor. More likely, however, workers indirectly seek such a determination by filing a claim for unemployment compensation benefits or a complaint with the California Labor Board.
Please contact Earle Law Offices today if you are an employer who needs legal advice or representation concerning the classification of a worker.
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Posted in Real Estate Law, Taxation Law at 19:21 by Administrator
The Internal Revenue Service (IRS) announced on July 29, 2009, its first successful prosecution related to fraud involving the first-time homebuyer credit and warned taxpayers to beware of this type of scheme.
On Thursday July 23, 2009, a Jacksonville, Florida tax preparer, James Otto Price III, pled guilty to falsely claiming the first-time homebuyer credit on a client’s federal tax return. Price faces the possibility of up to three years in jail, a fine of as much as $250,000, or both.
To date, the IRS has executed seven search warrants and currently has 24 open criminal investigations in pursuit of potential instances of fraud involving the credit. The agency has a number of sophisticated computer screening tools to quickly identify returns that may contain fraudulent claims for the first-time homebuyer credit.
“We will vigorously pursue anyone who falsely tries to claim this or any other tax credit or deduction,” said Eileen Mayer, Chief, IRS Criminal Investigation. “The penalties for tax fraud are steep. Taxpayers should be wary of anyone who promises to get them a big refund.”
Whether a taxpayer prepares his or her own return or uses the services of a paid preparer, it is the taxpayer who is ultimately responsible for the accuracy of the return. Fraudulent returns may result not only in the required payment of back taxes but also in penalties and interest.
First-Time Homebuyer Credit: The First-Time Homebuyer Credit, originally passed in 2008 and modified in 2009, provides up to $8,000 for first-time homebuyers. The purchaser, however, must qualify as a first-time homebuyer, which for purposes of this credit means someone who has not owned a primary residence in the past three years. If the taxpayer is married, this requirement also applies to the taxpayer’s spouse. The home purchase must close before Dec. 1, 2009, to qualify, and the credit may not be claimed on the purchaser’s tax return until after the taxpayer closes and has purchased the home.
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Posted in Litigation, Taxation Law at 17:45 by Administrator
“ “ ‘[A] party who chooses to litigate an issue against the Government is not only representing his or her own vested interest, but is also refining and formulating public policy.’ ” INS v. Jean, 496 U.S. 154, 165 n. 14 (quoting H.R. Rep. No. 96-1418, at 10 (1980). For this reason, our legal system has adapted to ensure that, in certain circumstances, every citizen is able to defend himself against unjustified government action, free from the financial disincentives associated with litigation. [26 U.S.C. § 7430] provides such assurance to taxpayers.” Morrison v. Commissioner of Internal Revenue, 2009 WL 1312855 (C.A.9).
“The U.S. Tax Code permits a discretionary award of litigation costs, including attorneys’ fees, to the prevailing party in any civil tax proceeding brought by or against the United States. 26 U.S .C. § 7430(a). A ‘prevailing party’ is a party that ‘has substantially prevailed with respect to the amount in controversy’ or ‘with respect to the most significant issue or set of issues presented.’ § 7430(c)(4)(A)(i).” Id.
Section 7430 reads, in relevant part: “In any administrative or court proceeding which is brought by or against the United States in connection with the determination, collection, or refund of any tax, interest, or penalty under this title, the prevailing party may be awarded a judgment or a settlement for . . . reasonable litigation costs incurred in connection with such court proceeding.”
The issue in Morrison was whether a taxpayer may recover attorney fees after successfully challenging an IRS audit where a third party, instead of the taxpayer, advanced the taxpayer’s attorney fees to litigate against the IRS.
The fee controversy in Morrison arose after Morrison, a shareholder and officer in Caspian, a corporation, sold his interest in Caspian to Nariman Teymourian, another Caspian shareholder. Before Morrison resigned as an officer of Caspian, the IRS initiated audits of Morrison, Caspian, and Teymourian.
The IRS issued Notices of Deficiency to Morrison, Caspian and Teymourian. Morrison and Caspian each petitioned the United States Tax Court for redetermination; their tax court cases were consolidated and both parties retained the same law firm to represent them. After Morrison and Caspian both prevailed on their Tax Court petitions, both filed section 7430 motions seeking an award of attorney fees.
The Tax Court denied Morrison’s fee request on the ground that Morrison had not actually paid or “incurred” such fees, as Caspian had advanced Morrison’s fees under an agreement requiring Morrison to reimburse Caspian in the event Morrison was successful in obtaining a fee order against the IRS.
The IRS argued that Morrison had not “incurred” any attorney fees within the meaning of section 7430, arguing that a contrary interpretation of the term “incurred” would give rise to the so-called “stand-in” litigant problem. A stand-in litigant is one who seeks an award of attorney fees and then passes those fees on to an ineligible litigant.
Morrison, on the other hand, argued that the problems associated with a stand-in litigant, although perhaps a justified concern in the context of fee motions under other statutes, are not present in section 7430 cases because, unlike other cases litigated against the Government, it is the IRS who, at least in the first instance, initiates tax cases through audit and Notice of Deficiency. Additionally, Morrison argued, denying fee motions in tax cases where a third party paid the taxpayer’s attorney fees would provide the government with an incentive to deny meritorious claims, thereby requiring a taxpayer to litigate. Thus, the government could act unreasonably not only in its initial administrative proceedings, but also during litigation of the appeal, confident in the knowledge that it will not be ordered to pay the taxpayer’s attorney fees.
On appeal, the Ninth Circuit Court of Appeals found Morrison’s argument more consistent with legislative intent than the position advanced by the IRS, and held that a taxpayer can “incur” attorneys fees if the taxpayer assumes either: (1) a noncontingent obligation to repay the fees advanced on his behalf at some later time; or (2) a contingent obligation to repay the fees in the event of their eventual recovery. Id., at 3.
Because the Tax Court took the view that a litigant can never “incur” fees if the fees are first paid by a third party, the Tax Court did not reach the issue of whether the agreement between Caspian and Morrison would support an award of attorney fees in this case. Accordingly, the Ninth Circuit remanded the case to the Tax Court for further proceedings.
Please contact Earle Law Offices immediately to obtain ethical, aggressive tax controversy representation if you become the target of an IRS examination. Depending on the facts of your case, it may be possible to use section 7430 to obtain a fee award against the IRS. If Earle Law Offices prepared the return which is being audited, your attorney fees for tax controversy representation were included in the fee for the preparation of your return.
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Posted in Litigation, Taxation Law at 17:32 by Administrator
The IRS has an appeals system for people who do not agree with the results of an examination (audit) of their tax returns or with other adjustments to their tax liability. Here are the top five things to know when it comes to your IRS appeal rights.
1. When the IRS makes an adjustment to your tax return, they will send you a report or a letter explaining the proposed adjustments. This letter will alert you of your right to request a conference with an Appeals office and how to put in a request for such a conference.
2. In addition to examinations, many other things can be appealed. You can also appeal penalties, interest, trust fund recovery penalties, offers in compromise, liens and levies.
3. If you request an Appeals conference, be prepared with records and documentation to support your position.
4. Appeals conferences are informal meetings. You may represent yourself or have someone else represent you. Those allowed to represent taxpayers include attorneys, accountants or individual enrolled to practice before the IRS.
5. If you do not reach agreement with IRS Appeals or if you do not wish to appeal within the IRS, you may appeal certain actions through the courts.
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Posted in Taxation Law at 17:29 by Administrator
The Internal Revenue Service announced on Thursday, March 5, 2009, that it will not renew contracts, which expire Friday, with two private debt collection agencies.
“After a thorough review of this program, I have decided not to renew the contracts,” IRS Commissioner Doug Shulman said. “I believe this work is best done by IRS employees, and I believe we have strong support from the Administration and the Congress for increased IRS enforcement resources going forward.”
Shulman also noted that the IRS anticipates hiring over 1,000 new collection personnel in FY 2009. These new employees would give the IRS the flexibility to make assignments based on the areas of greatest need rather than filtering which cases can be worked using contractor resources.
Shulman cited the results of a cost-effectiveness study of the private debt collection program.
The study – supported by an independent review – showed that it is reasonable to conclude that when working similar inventory, IRS collection is more cost effective than the contractors.
IRS employees have a range of options available to them in attempting to resolve difficult collection cases that, by law, the private contractors do not have.
Translation: The IRS has what it takes to take what you have; the IRS, supported by the Obama Administration, intends to use the full coercive powers of the Federal Government to collect taxes more effectively and efficiently than private collection agencies, which cannot use all the oppressive collection techniques which are available to the government.
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Posted in Real Estate Law, Taxation Law at 17:20 by Administrator
The Internal Revenue Service (IRS) recently announced an expedited process that will make it easier for financially distressed homeowners to avoid having a federal tax lien prevent the refinancing of mortgages or the sale of homes.
The filing of a Notice of Federal Tax Lien is a formal process by which the IRS makes a legal claim to property as security or payment for a tax debt. A lien serves as a public notice to other creditors that the IRS has a claim on the property.
In some cases, a federal tax lien can be made secondary to another lien, such as a lending institution’s lien, if the IRS determines that taking a secondary position ultimately will help with collection of the tax debt. That process is called subordination. Without lien subordination, taxpayers may be unable to refinance their home loans or reduce their home loan payments. Lending institutions generally want their lien to have priority on the home being used as collateral.
According to the IRS, the lien subordination or discharge process usually takes approximately 30 days from the date on which a proper request has been submitted.
Currently, there are more than 1,000,000 federal tax liens outstanding against both real and personal property. The IRS issues more than 600,000 federal tax lien notices annually.
Please call Earle Law Offices today if you need assistance in resolving a tax lien or other tax controversy.
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