Hurricane Sandy: Tax Deductions For Casualty Losses

My last post talked about when we can trash tax and other important records. Well, Hurricane Sandy brought a whole new meaning to the concept of trashing records and a whole lot more.  

Experts estimate that Hurricane Sandy has caused $50 billion of damage.  Eqecat Inc., a financial advisory firm out of Oakland, California predicts that insurance will cover $10 to $20 billion of such losses.  Storm victims will be on the hook for the other $30 billion of losses. 

A couple of points to keep in mind before talking about the casualty loss tax implications:

• If your house is damaged from this disaster, contact local building authorities to see if the home is inhabitable,
• Establish an insurance claim, but don’t settle immediately,
• Make temporary repairs and take other remedial action to prevent further damage to homes and belongings, and
• Take photos of the damages.

With so many lives in complete turmoil, many of us on the East coast  crushed by Sandy’s wrath are not thinking of  claiming a casualty loss for tax purposes. However, knowing about how taxpayers can claim tax deductions under casualty loss provisions of the Internal Revenue Code is essential in dealing with insurance companies.  While memories are fresh and evidence is still available, now is the time to develop, document and support such casualty losses.

To aid those affected by this devastation readers should look at my article entitled Casualty Losses For Hurricane Sandy.  This article details  the tax qualification rules for being eligible for casualty losses.  It is a must read for anyone devastated by Sandy.

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Can I Trash It Now? Tax Record Retention Guidelines

Papers, papers and still more papers.  When can I destroy these documents?

There are no hard and fast rules in this area.  The following offers some general guidance to carefully consider when determining any destruction of documents.

Against the urge to purge, remember that maintaining documents and records is often essential if a tax audit by the IRS, state or local taxing authority occurs.  Be aware that it is the burden of the taxpayer to provide sufficient proof and support for any tax position taken on a tax return.  Prematurely disposing of relevant documentation and proof supporting a tax deduction or tax position could have a disastrous tax impact.

Tax rules offer some guidance as to minimum document retention periods. It is imperative to keep records such as receipts, canceled checks, and other documents that support an item of income or a deduction, or a credit appearing on a return until the statute of limitations expires for that return. Here are some of the key statute of limitation rules for federal tax returns:

• For most returns the statute of limitations is 3 years from the date you filed the return. However, the following are some very important exceptions to this 3 year statute of limitation.
• There is no period of limitations to assess tax when a return is fraudulent or when no return is filed.
• If income that you should have reported is not reported, and it is more than 25% of the gross income shown on the return, the time to assess is 6 years from when the return is filed.
• For filing a claim for credit or refund, the period to make the claim generally is 3 years from the date the original return was filed, or 2 years from the date the tax was paid, whichever is later.
• For filing a claim for a loss from worthless securities the time to make the claim is 7 years from the date the return was due.
• If you are an employer, you must keep all of your employment tax records for at least 4 years after the tax becomes due or is paid, whichever is later.

Additionally, it is often imperative to check state and local statute of limitation rules before destroying files and records.

Keep in mind that documents may need to be retained and preserved for legal reasons other than taxation, such as, insurance claims or facilitating the transfer of  assets in the case of deceased family member.  Documents like death certificates, estate tax closing letters should be kept indefinitely.

For more detailed guidance on how long to keep specific documents and other document retention considerations and safeguards, please read my article Record Retention For Individuals .

For more detailed guidelines for record retention rules and other protective housekeeping measures for businesses see Record Retention Guidance For Business: A Conservative and Basic Approach.

A discussion with your tax attorney and tax accountant may be a prudent and conservative course of action before destroying any documents or files.

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IRS Slams Taxpayers: Attention to Tax Details Matter

Taxpayers found out the hard way that the documentation rules imposed by the IRS better be followed exactly and to the letter.  In Durden, TC Memo, 2012-140, taxpayers claimed a $22,517 charitable contribution for 2007.  The IRS disallowed this deduction and the United States Tax Court agreed.

The taxpayers had canceled checks and a letter dated January 10, 2008 from the church confirming this contribution.  Seems like that would be enough.  Wrong!

The IRS did not accept the church’s acknowledgement because it lacked certain language as required under IRS rules.  For a charitable contribution deduction, Section 170(f)(8) of the Internal Revenue Code requires that a monetary contribution of $250 or more must be substantiated by:

1. A contemporaneous written acknowledgment,
2. That indicates the amount paid by the taxpayer, and
3. Whether the organization provided any goods and services in consideration (or in exchange) for the contribution, and if so, a good faith estimate of the value of such goods and services.

The problem for the taxpayers was that the church failed to include part 3 in their January 10, 2008 letter to the taxpayers.  They then went back to the church and got a second letter dated January 21, 2009 that revised the first letter by containing the required language under part 3 of this test.

But now the problem was that the revised letter was too late so it could not be considered contemporaneous by the IRS.  To be contemporaneous under Section 170(f)(8)(C) of the Internal Revenue Code it must be obtained by the due date of the tax return (here April 15, 2008) plus any extensions or, if earlier, the date the taxpayer files the return.  So now the taxpayers flunked part 1 of the test!

You might think that this is pretty harsh since the taxpayer’s really came close here.  So did the taxpayers.  The taxpayers argued that since they substantially complied they should still get the deduction.  The substantial compliance test has been successfully argued where a taxpayer can show that despite strict compliance they have met the essential statutory purpose of such requirement.  The court pointed out that the essential statutory purpose of the acknowledgement rules are  two-fold:

1. Assist taxpayers in determining their deduction, and
2. To aid the IRS in processing returns.

The court determined that without a statement from the church that no goods and services were provided,  neither of these two essential statutory purposes can be met.

This is a pretty harsh result for the taxpayers, especially since it was clearly the church that failed to provide the requisite language.  But the object lessons here are clear.

First, when dealing with charitable contributions you better make sure this language is present, especially in cases where large gifts are involved.

Second, when it comes to taxes attention to details is essential.

Third and finally, complying with the various federal, state and local income taxes is complicated.  Having an attention-to-detail minded tax attorney, or tax accountant is greatly recommended and probably essential.  With the loss of this large charitable deduction and the cost to bring this matter before the United States Tax Court, the Durdens definitely found this out the hard way.

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New Tax Alert: Employers Playing Tax Games with Workers: IRS Offers Way to Come Clean

The IRS has just introduced a new Voluntary Worker Classification Settlement Program offering past payroll tax relief when the employer agrees to reclassify workers as employees.  For the details and discussion of this VCSP program please see my just published article at my website at the following link: http://www.sjfpc.com/IRS_Payroll_Taxes_VCSP.html at my website (www.sjfpc.com).

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Hidden Offshore Bank Accounts: IRS Offers A Second Chance To Come Forward

The Internal Revenue Service announced on February 8, 2011 a special voluntary disclosure initiative designed to bring offshore money back into the U.S. tax system and help people with undisclosed income from hidden offshore accounts get current with their taxes.  Here are some of the basic provisions of this program.

 

1. Deadline To Come Forward: August 31, 2011

This second new voluntary disclosure initiative will be available to taxpayers through Aug. 31, 2011.

2. 2011 Offshore Voluntary Disclosure Initiative Makes Raises Penalty Charges and Makes Other Changes to the 2009 OVDP

The new IRS program is called the 2011 Offshore Voluntary Disclosure Initiative (OVDI). It includes several changes from the 2009 Offshore Voluntary Disclosure Program (OVDP). The overall penalty structure for 2011 is higher, meaning that people who did not come in through the 2009 voluntary disclosure program will not be rewarded for waiting.

3. New Penalty Framework

For the 2011 initiative, there is a new penalty framework that requires individuals to pay a penalty of 25 percent of the amount in the foreign bank accounts in the year with the highest aggregate account balance covering the 2003 to 2010 time period. Some taxpayers will be eligible for 12.5 or 5 percent penalties instead of the 25% penalty. Please see the discussion below for such exceptions.

4. Back Taxes Must Be Paid

Participants also must pay back-taxes and interest for up to eight years.

5. Additional and Usual Penalties Imposed

Taxpayers must pay accuracy-related penalties. No reasonable cause arguments can be made to avoid the such penalties. The IRS will also assert failure to file and failure to pay penalties.

6. Returns To Be Filed By August 31 Deadline

Taxpayers participating in the new initiative must file all original and amended tax returns and include payment for taxes, interest and accuracy-related penalties by the Aug. 31 deadline.

7. Special 12.5% Category Instead of 25% Penalty

The IRS also created a new penalty category of 12.5 percent for treating smaller offshore accounts. People whose offshore accounts or assets did not surpass $75,000 in any calendar year covered by the 2011 initiative will qualify for this lower rate.

8. Special 5% Category Instead of the 25% Penalty

If a taxpayer meets all four of the following conditions, then the offshore penalty is reduced to 5%:

 (A) did not open or cause the account to be opened (unless the bank required that a new account be opened, rather than allowing a change in ownership of an existing account, upon the death of the owner of the account);

(B) has exercised minimal, infrequent contact with the account, for example, to request the account balance, or update accountholder information such as a change in address, contact person, or email address;

(C) has, except for a withdrawal closing the account and transferring the funds to an account in the United States, not withdrawn more than $1,000 from the account in any year covered by the voluntary disclosure; and

(D) can establish that all applicable U.S. taxes have been paid on funds deposited to the account (only account earnings have escaped U.S. taxation).

9. Special 5% Category for Foreign Resident

If a taxpayer is a foreign resident who was unaware that he or she was a U.S. citizen, then the offshore penalty is reduced to 5%.

10. Benefits of 2011 Initiative: Avoid Higher Penalties and Possible Criminal Prosecution

The 2011 initiative offers clear benefits to encourage taxpayers to come in now rather than risk IRS detection. Taxpayers hiding assets offshore who do not come forward will face far higher penalty scenarios as well as the possibility of criminal prosecution.

Copyright © 2011, Steven J. Fromm.  All rights reserved. No part of this article may be reproduced or used in any form or fashion without the written permission of Steven J. Fromm.

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Failing To Update Retirement Plans: How to Avoid IRS Plan Disqualification & Penalties by Using VCP

In our fast paced world, many retirement plans are drafted and then often neglected.  In extreme cases, plans are put aside without ever being updated.  Some plan sponsors have failed to restate their plans for years or even decades.  For many individuals, retirement plan accounts represent the largest portion of their wealth.  As the following discussion will illustrate, the failure to protect this most valuable and important asset by keeping the retirement plan in full compliance with applicable retirement plan laws could result in some very nasty, costly and unforeseen financial repercussions.

The retirement plan laws have always required that plans be updated for tax law changes.  Before 2003, the IRS allowed plans to be periodically restated for tax law changes that occurred over many years.  This resulted in large, periodic major plan restatements.  However, since 2003 the IRS has required amendments to retirement plans for each new tax law resulting in more frequent “interim amendments.”  [For those of you interested in a more detailed discussion of these required interim amendments since 2003, please go to my questions answered at my Linked-In profile.]  For many plans, the deadlines for many of these plan restatements or interim amendments have now expired.  Current rules provide that plans that have not been redrafted to comply with required prior restatements or interim amendments cease to be qualified as of their applicable deadlines.

In the worst case scenario, the IRS may demand that the plan be retroactively disqualified.  If the IRS is successful in disqualifying the plan, the plan sponsor’s tax deductions for contributions taken in the year of disqualification and in later years would be disallowed.  The taxes owed by the plan sponsor due to the disallowance of previously claimed retirement plan deductions plus applicable interest and penalties could be enormous.  In addition, participants of the plan would have to treat as taxable income the value of their plan account as of the date of such disqualification.  The taxes, interest and penalties to the participants from the date of plan disqualification could be equally exorbitant. This would be a truly disastrous and harsh result for both the employer plan sponsor and participants in the disqualified plan.

However, in most cases, the current policy of the IRS is to impose monetary penalties instead of the more severe penalty of plan disqualification.  Even so, when the IRS raises these failures as the result of an audit the penalties can be quite severe.   Penalties can range from $2,500 to $80,000 depending on the failures involved and the size of the plan.  It is worth noting that in recent years, the IRS has increased its auditing of retirement plans.

 Here is Good News: How to Solve This Looming Problem 

The IRS has a voluntary remedial program called the VCP (voluntary compliance program) to correct these plan document deficiencies.  The IRS position is that retirement plans may be re-qualified only by having the plan sponsor voluntarily come forward before an IRS audit by submitting the newly drafted delinquent restatements and/or interim amendments to the IRS in accordance with some very detailed procedures and documentation pursuant to Revenue Procedure 2008-50.  Once the IRS reviews and hopefully approves the application and the newly drafted required documentation, the plan is deemed to be in full compliance with applicable law and such plan is retroactively tax qualified.

Instead of paying a steep monetary penalty, the VCP submission results in the paying of a filing fee to the IRS.  Sometimes, if the violation is quite limited the filing fee can be as low as $375.  (Remember, you will still need to pay for documentation services associated with plan restatements and interim amendments.  However, these costs would have been incurred in any event to keep your plan in full compliance with the law.)  The important point here is that the use of the VCP program avoids the risk of plan disqualification or the imposition of a large monetary penalty.

 How We Can Help:

Numerous VCP program applications under the applicable Revenue Procedure 2008-50 have been submitted by this office.  This application along with the needed plan restatements and interim amendments must be carefully drafted to ensure efficient negotiations and a successful outcome with the IRS.

The Bottom Line:

Plan sponsors should immediately and voluntarily move to correct plan deficiencies pursuant to the more taxpayer friendly and cheaper VCP program before the IRS audits your plan.  Once the IRS commences an audit, the VCP submission strategy is no longer an option and your plan is exposed to disqualification and/or severe monetary penalties.

Looking forward, you must establish a program with your plan adviser to ensure that your plan is kept in compliance with the laws concerning plan restatements, interim amendments and the changing IRS submission requirements and deadlines.  This will avoid having to deal with all of these problems again in the future.  In fact, the Revenue Procedure requires a disclosure in the VCP application as to what new procedures the plan sponsors will use to avoid this problem in the future.

 Do Not Wait

Do not wait for the IRS to audit your retirement plan as it then will be too late to get the cheaper and less painful VCP deal.  For a free initial consult to assess your retirement plan situation, please do not hesitate to call me, Steven J. Fromm, Esquire at 215-735-2336.  All consultations are confidential and covered by attorney-client privilege.

Copyright © 2009, Steven J. Fromm

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THE SILVER LINING OF A BAD ECONOMY: GIFTING OF SHARES OF STOCK IN A CLOSELY HELD BUSINESS

As with most things in life, when things are bad, there usually is something good that can come out of it.  Our current economic troubles have resulted in many closely held or small businesses being worth far less then they used to be.  This is not a good situation for businesses that are hanging on to survive or have to be sold for various reasons.  However, for people wanting to minimize estate and gift taxes and have been putting off taking a cold hard look at their estate plan, now may be the perfect time to explore the gifting of shares in their businesses.

For example, some businesses have senior family members who own all or most of the shares of the outstanding stock of their corporation.  With the value of the business being down right now, more shares could be gifted to younger family members involved in the business.

Example:  Mr. Senior owns 80% of Deflated, Inc., while his two sons who work in the business own 10% each.  Deflated was worth $3,000,000 in 2007.  By the end of 2008, it was worth $2,500,000.  Mr. Senior talks to tax counsel and after exploring the tax strategies and planning tools discussed below decides to gift 20% of his shares worth $500,000 to each of his sons, leaving him with a 40% stock interest.

The tax advantages are as follows:

1.  The stock gifted to each son was previously worth $600,000. The current market value of such stock to each son is now only $500,000.  If Deflated, Inc. goes back to its value once the economy recovers, then Mr. Senior has just transferred $200,000 ($100,000 to each son) to his sons estate and gift tax free.  At a current marginal estate tax rate of 45%, Mr. Senior’s family can save $90,000 (45%*$200,000).

2.  The gifts to each son are gifts of a minority interest in Deflated, Inc. and such gifts lack marketability due to the limited market for such shares.  Estate and gift tax rules allow discounts for these factors that reduce the value of assets transferred.  (Caveat: There are some legislative proposals being floated in Washington seeking to limit this tax strategy. Stay tuned.) These discounts for minority interests and lack of marketability conservatively can be 25%, sometimes more.   With such discounts the gift of each $500,000 is reduced by $125,000. At a current marginal estate tax rate of 45%, Mr. Senior’s family can save another $112,500 (45%*$250,000).

3.  Outright gifts of stock are eligible for the annual donee exclusion of $13,000.  In addition, Mr. Senior has a spouse who will join in this gift, which will allow for a second $13,000 exclusion.  So the taxable gift to each son is now reduced by $26,000 (Mr. Senior’s annual exclusion of  $13,000 and his spousal joinder of another $13,000).  Additional savings to the family is $23,400 (45%*26,000*2 sons).

4.  If Mr. Senior makes no further gifts and dies with his reduced ownership interest of 40%,  his estate can claim the minority interest and lack of marketability discounts against his remaining shares.  If Mr. Senior dies in 2014, when deflated is worth $4,000,000, his family can take a 25% lack of marketability/minority interest discount, saving his family another $180,000 (45%*$400,000 marketability/minority interest discount[$1,600,000 forty-percent interest*25%]).

Bottom Line:  Mr. Senior can take advantage of the lousy economy, the lack of marketability and minority interest discounts and the annual donee exclusions with a spousal joinder to save his family a tremendous amount of future estate and inheritance taxes.

Caveat:  Remember that this type of planning depends on the particular factual setting of each client.  One difference in the facts can change the outcome.  Also, be aware that state inheritance taxes have not been considered in the above example.  Finally, the above should not be considered as legal advice.  Please consult with tax counsel to discuss your particular factual situation.

Copyright © 2009, Steven J. Fromm.

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