New Jersey Couple Scores a Victory Against Bernie Madoff and the Division of Taxation

The New Jersey Tax Court recently held that a married couple was entitled to recover the Gross Income Tax (GIT) paid on dividends and capital gains reported as earned through their investments with Bernie Madoff. The taxpayers filed a claim for refund of gross income taxes paid by them for the tax years 2005, 2006 and 2007 with respect to capital gains and dividend income reported as earned through their investments with Madoff. They learned in 2008, that, in fact there had been no earnings, and that Madoff’s report to them of various security transactions and income earned from those transactions were fictitious. The Division of Taxation denied their refund claims.

The Division refused to stipulate to the facts surrounding the operation of the Madoff Ponzi scheme, however, the Director implicitly accepted the factual underpinnings of the plaintiff’s case in his official pronouncements with respect to the Madoff scheme; the court concluded that those facts constituted stipulated facts.

The taxpayers argued that they were entitled to refund of taxes paid on their factitious income. They also argued that their election to treat the loss as a theft loss on their federal income tax return did not preclude them from claiming refunds under the GIT Act. The Division of Taxation contended that the dividends and capital gains income were taxable because the taxpayers constructively received the income. They also argued that pursuant to its April 15, 2010 notice, victims of the Madoff fraud may only report a capital loss in 2008, the year in which the fraud was discovered and in accordance with the federal procedures for theft losses.

The Tax Court held that the taxpayers were entitled to income tax refunds because the dividends and capital gain income reported on their tax returns simply did not exist. The Tax Court found that there was never any sale, exchange or other disposition of property because the transactions reported by Madoff sent to the taxpayers never took place. The court then held that the Division of Taxation’s position that the only relief available to the taxpayers was to claim a capital loss in accordance with federal procedures was unreasonable. It found that there was no principal reason why the taxpayer should be required to use a federal procedure that relies upon federal tax code concepts that are not recognized by the Gross Income Tax Act. The court then found in favor of the taxpayers allowing the theft losses against the taxpayers gross income tax.

IS THE $5 MILLION GIFT TAX EXEMPTION ABOUT TO END?

The Tax Relief Act of 2010 made significant changes to the gift, estate and generation-skipping transfer tax regimes by increasing the amount each individual can give without incurring tax from $1 million to $5 million.  The increase was not permanent however, and rumor has it that it may be in jeopardy.  To avoid any risk, those who have decided to use their full exemptions should do so no later than December 31, 2011, and, if feasible, November 22.

The Rumors

Rumors circulating recently within the financial and estate-planning communities have suggested the $5 million exemptions may be in immediate jeopardy.  Democratic staff on the U.S. House Committee on Ways and Means recently proposed decreasing the $5 million gift, generation-skipping transfer tax and estate tax exemptions to $3.5 million, effective January 1, 2012.  There also are rumors the Joint Select Committee on Deficit Reduction (the Super Committee) may recommend a drop down in the gift tax exemption to $1 million, effective at year end, or possibly as early as November 23, 2011, when its recommendations are scheduled to be released, though there is no confirmation this rumor is true.

As we all know "everything" is on the table before the super-committee (although they would not admit it), I would caution you to advise your clients of these developments and act sooner rather than later.

Unlike the Federal Tax Treatment of Bad Debts, New Jersey Taxpayers Are Not Entitled to a Bad Debt Deduction

The New Jersey Appellate Division in Waksal v. Director, Division Of Taxation determined that a New Jersey couple could not report losses to offset capital gains on their New Jersey income tax return.

In January 2002, Harlan W. Waksal loaned $14,769,320 to his brother, who signed a promissory note and agreed to repay the loan on or before January 31, 2004. His brother then defaulted on the loan. Subsequently, plaintiffs filed a 2004 Federal Individual Income Tax Return and reported a short term capital loss of $14,769,320. They also filed a 2004 New Jersey Gross Income Tax Return and reported the same amount as a loss from the "sale, exchange or other disposition of property," pursuant to N.J.S.A. 54A:5-1(c). After using the loss to offset capital gains, they reported $6,644,022 as a net gain in their New Jersey tax return.

The New Jersey Appellate Court affirmed the summary judgment granted to the Director, Division of Taxation. The Waksals argue primarily that their nonbusiness bad debt was "a sale, exchange or other disposition of property" under N.J.S.A. 54A:5-1(c), and, as a result, they are allowed to report the loss on their New Jersey Gross Income Tax Return and offset capital gains. Because the New Jersey Gross Income Tax Act (the Act), N.J.S.A. 54A:1-1 to -10, does not permit such a deduction, the trial court’s decision was affirmed.

The trial court relied in part on Walsh v. Director, Division of Taxation, 15 N.J. Tax 180 (App. Div. 1995), and King v. Director, Division of Taxation, 22 N.J. Tax 627 (App. Div. 2005), which held that a loss from a nonbusiness bad debt could not be used to offset gains "derived from the sale, exchange, or other disposition of property" under N.J.S.A. 54A:5-1(c). The trial judge indicated that "net gains or income from disposition of property" is considered taxable income under N.J.S.A. 54A:5-1(c), which provides in part that New Jersey gross income consists of certain categories, including:

Net gains or net income, less net losses, derived from the sale, exchange or other disposition of property, including real or personal, whether tangible or intangible as determined in accordance with the method of accounting allowed for federal income tax purposes.

The judge reasoned that the Act "does not mirror federal taxing statutes" and observed that the Supreme Court explained in Smith v. Director, Division of Taxation, 108 N.J. 19, 32 (1987), that:

Even a cursory comparison of the New Jersey Gross Income Tax and the Internal Revenue Code indicate [sic] that they are fundamentally disparate statutes. The federal income tax model was rejected by the Legislature in favor of a gross income tax to avoid the loopholes available under the Code.

The court recognized that in Walsh the Legislature determined that the New Jersey Gross Income Tax should contain fewer deductions from income than the federal income tax. This was seen as a way of making the Gross Income Tax fairer. The Legislature did not explicitly provide for a deduction of a nonbusiness bad debt. Thus, in view of the legislative history, it would appear that the Legislature did not intend for N.J.S.A. 54A:5-1c to be read broadly to include a deduction for nonbusiness bad debts.

On appeal, plaintiffs contend that the decision of the judge conflicts with N.J.S.A. 54A:5-1(c) and the Supreme Court's clear direction to apply substantive federal tax rules to determine net gains and loses.

In Walsh, the taxpayers sought to deduct a nonbusiness bad debt following a personal loan to a corporation in which they were also shareholders. The corporation then transferred its assets to a second corporation, "but [the taxpayers] remained liable as . . . guarantor[s] on the bank loans." After the second corporation defaulted on the bank loans that the taxpayers guaranteed, the taxpayers paid off the debt and deducted the losses on their New Jersey Gross Income Tax return.

Quoting the Tax Court, the Appellate Court held that the worthless debt, although treated as a loss from the sale or exchange of a capital asset held for not more than one year . . . under the Internal Revenue Code, does not fit the statutory rubric of sale, exchange or other disposition of property" found in N.J.S.A. 54A:5-1(c).

Because Waksal's loss from their nonbusiness bad debt cannot be used to offset gains derived from the "sale, exchange or other disposition of property" under N.J.S.A. 54A:5-1(c), the judge concluded that plaintiffs could not report the loss to offset capital gains on their New Jersey income tax return.

Should You Make a Loan to Your Child This Month?

Yes!

During the month of October is the time to make a loan to you child assuming the child is not subject to the "kiddie tax." Why? Because the imputed interest rate for October is at an all time low and therefore as a planning tool you can move wealth to your children gift and estate tax free.

Generally loans between related parties are governed by the IRS code so that related parties cannot assign income without adverse tax consequences. There is a small exclusion for related parties so that a loan of $10,000 generally does not require that interest be charged.

In some cases if a loan of $100,000 or less is made between related parties there is no imputed interest to the lender so long as the borrow does not earn more than $1,000 from investments. If the borrower earns a greater amount then the lender can be charged with interest income.

Because of the current extremely low interest rate environment making a loan to a child can avoid the imputed interest charge and shift wealth to the borrower.

The following is an illustration of the advantage of making a loan using the low applicable federal interest rates (AFR).

Let's assume that a loan is made to your child $1 million. The loan will require that you use the current applicable rate for a short term loan- 0.16%. A short term loan is a loan with a term of less than three years. Assuming further that the child pays the interest rate due annually of $16,000; after three years a child will pay $48,000.

Now assume that the child invests the $1 million in a market investment returning 4%. At the end of three years the return on the investment will be $120,000. The net benefit to the child is $72,000 ($120,000-$48,000). Now couple this with annual gifts to the child of the current annual exclusion of $13,000 which for two parents is $26,000, the net benefit (and wealth shift) to the child over the three years is $150,000 including gifts. The parent will receive back his or her $1,000,000 plus the earned interest.


This is simple illustration underscores the advantage of making a low interest loan to a child using the current interest rates.

The simple technique when applied to several children can pass wealth at no tax cost (gift or income) to the parents. If the borrower were a trust for the benefit of the child, the net benefit earned on the investment and by way of annual gift can be protected from creditors and be available for the child during his/her lifetime.


Illustration of the advantage of a loan using the current (Oct 2011) AFR

Loan to son/daughter 1,000,000
Interest rate using the short term (0-3yrs) AFR 0.16
annual interest payment* $16,000
Cumulative interest payments $48,000

Assume child invests loan amount @ 4% $40,000
Cumulative return on investment $120,000

Net benefit to child(120,000-48,000) 72,000

*child can make interest payments with annual exclusion
gift from parent.

Employee v. Independent Contractor

New IRS Voluntary Compliance Initiative

(What A Great Deal!)

In my Fairleigh Dickinson Tax Research class, one of the student projects is preparing a Protest involving the classification of workers. Those of you who have taken the class may remember my “Quickie” problem where the student must determine the proper classification of the “worker.” Employee v. Independent Contractor issue is a reoccurring one and important to practitioners.

Whether a worker is an independent contractor or employee generally is determined by whether the enterprise he works for has the right to control and direct him regarding the job he is to do and how he is to do it. Under the common law rules (so-called because they originate from court cases rather than from the Code), multiple factors are used to determine if an individual is a common law employee.

Section 3121(d) provides that the term "employee" means any individual who, under the usual common-law rules applicable in determining the employer employee relationship, has the status of an employee. Under the treasury regulations the term "employer" means any person for whom and individual performs or performed any service, of whatever nature, as the employee of such person.

Rev. Rul. 87 – 41 provides the guidelines for determining whether a particular worker is an employee or independent contractor. In this ruling the IRS determined that many factors are considered in evaluating whether a worker is an employee or independent contractor. No single factor or the absence of a factor is conclusive. The ruling outlined 20 factors to consider.

Section 530 of the '78 Revenue Act (as amended) provides retroactive and prospective relief from employment tax liability for employers who misclassified workers as independent contractors using the common law facts and circumstances standards. Section 530 applies only if:

(1) the taxpayer does not treat an individual as an employee for any period, and does not treat any other individual holding a substantially similar position as an employee for purposes of employment tax for any period—the substantive consistency requirement;

(2) for post-'78 periods, “all federal returns (including information returns) required to be filed by the taxpayer” with respect to the individual for such period “are filed on a basis consistent with the taxpayer's treatment” of the individual as a nonemployee—the reporting consistency requirement; and

(3) the taxpayer had a “reasonable basis” for not treating the worker as an employee (judicial precedent or IRS rulings, a past IRS audit, or a long-standing practice of a significant segment of the relevant industry)—the reasonable basis requirement.

Under IRS's pre-existing Worker Classification Settlement Program (CSP), which applies only for taxpayers under audit, the examiner first determines if the taxpayer is entitled to Section 530 relief (and if it is, there is no assessment). If the taxpayer is not entitled to this relief, a series of two graduated CSP settlement offers can occur.

If the service recipient has met the reporting consistency requirement of Section 530but either can't meet the reasonable basis requirement or can't meet the reporting consistency requirement, the offer is a full employment tax assessment under IRC 3509 (which sets forth the employer's liability for employment tax because of its treating an employee as not being an employee) for one tax year (with the employer agreeing to reclassify the workers as employees on a prospective basis).

If the service recipient has met the reporting consistency requirement and can reasonably argue that it met the reasonable basis and substantive consistency requirements, the offer will be an assessment of 25% of the employment tax liability for the audit year under IRC 3509 (with the employer agreeing to reclassify the workers as employees on a prospective basis).

If workers are recharacterized under the CSP, no interest will be due on the additional liability arising as a result of the recharacterization if certain conditions are met.

New IRS Voluntary Compliance Initiative

The IRS has determined that it would be beneficial to create a program that allows for voluntary reclassification of workers as employees outside of the examination context and without the need to go through normal administrative correction procedures applicable to employment taxes. The IRS reasons that the program will facilitate voluntary resolution of worker classification issues and achieve the resulting benefits of increased tax compliance and certainty for all parties involved.

Who's eligible?

The voluntary classification settlement program (VCSP) is available to taxpayers who are currently treating their workers (or a class or group of workers) as independent contractors or other non-employees and want to prospectively (presently and in the future) treat the workers as employees. Ann. 2011-64, 2011-41 IRB , provides that the program is open to businesses, tax-exempt organizations, and government entities.

To be eligible:

• A taxpayer must have consistently treated the workers as non-employees;
• A taxpayer must have filed all required Forms 1099 for the workers for the previous three years. The Instructions for Form 8952, Application for Voluntary Classification Settlement Program (VCSP), clarify that this requirement must be satisfied for each of the affected workers for the three preceding calendar years ending before the date Form 8952 is filed.
• The taxpayer cannot currently be under audit by IRS, or currently under audit concerning the classification of the workers by the Department of Labor (DOL) or by a state government agency.
Notwithstanding a taxpayer that was previously audited by IRS or DOL about the classification of the workers will only be eligible if it has complied with the results of that audit.

Terms of the offer

A taxpayer who applies for and is accepted into the VCSP will agree to prospectively treat the class of workers as employees for future tax periods and in exchange:
(A) Will pay 10% of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of IRC 3509;
(B) Will not be liable for any interest and penalties on the liability;
(C) Will not be subject to an employment tax audit for the worker classification of the workers for prior years; and
(D) Will agree to extend the period of limitations on assessment of employment taxes for three years for the first, second and third calendar years beginning after the date on which the taxpayer has agreed under the VCSP closing agreement to begin treating the workers as employees.

Application process

Taxpayers will have to apply on Form 8952 for participation in the VCSP, and provide the name of a contact or an authorized representative with a valid Power of Attorney (Form 2848). The Instructions to Form 8952 provide that although Form 8952 can be filed at any time, it should be filed at least 60 days before the date a service recipient wants to begin treating the class or classes of workers as employees. IRS will contact the taxpayer or authorized representative to complete the process once it has reviewed the application and verified the taxpayer's eligibility. IRS retains discretion as to whether to accept a VCSP application. Those who are accepted will enter into a closing agreement with IRS to finalize the terms of the VCSP and will simultaneously make full and complete payment of any amount due under the closing agreement.

Property Inherited in 2010: Carryover (Step-Up) Basis Rules

The federal estate tax has undergone several changes in recent years. We had an estate tax in 2009, and none in 2010. In December of 2010, Congress retroactively enacted an estate tax for 2010, but gave executors options to determine basis of assets inherited from a decedent.
In a legislative compromise at the end of 2010, congress retroactively reinstated the estate tax to apply to decedents who died in 2010. However, an important feature of the law that revived the estate tax is that it gave executors of estates of decedents who died in 2010 a choice. The executor can either:
(a) have the new estate tax rules ($5 million exemption, with a flat rate of 35% imposed on all transfers over that amount) apply to the estate, in which case the traditional stepped-up basis rules (which provide that the basis of assets received from a decedent is equal to the value of such assets on the date of the decedent's death) would apply in determining the basis of property acquired from the decedent; OR
(b) elect not to be subject to the estate tax, meaning that the estate would pass to the heirs free from estate tax, but the modified carryover basis rules (discussed below) would apply in determining the basis of property acquired from the decedent.
Modified Carryover Basis Rules
Under the modified carryover basis rules IRC Sec. 1022, the basis of property acquired from an individual dying in 2010, in the hands of the person acquiring it, generally is the lower of the fair market value on the date of the decedent's death or the adjusted basis of the property immediately before the death of the decedent.

For example, the decedent died on Jan. 1, 2010, owning 200 shares of Corporation Y stock having a fair market value of $40,000. His adjusted basis in the stock immediately before his death was $30,000, which was the amount he paid for the 200 shares several years ago. Absent from a permitted basis increase for the stock, the basis of the Corporation Y stock in the hands of the person acquiring it from the decedent is $30,000. Now, assume the stock is worth $20,000 on the date of decedent's death. Under the modified basis rule, the basis in the hands of the person acquiring or receiving it would be $20,000.
The basis of property determined under the modified basis rule (i.e., the lesser of adjusted basis or fair market value) is increased by a general basis increase amount of $1.3 million. In other words, each estate receives a $1.3 million of basis plus more (depending on marital status at time of death and other circumstances) to be added to the carryover basis of any one or more of the assets held at death. However, no addition to basis can increase the new basis of any asset above its fair market value on the date of death.
The allocations of the general basis increase and other increases must be made by the executor, or other person in possession of a decedent's property, and must be reported to IRS and the property recipients.
Generally, if an estate is less than or equal to $5,000,000 ($10,000,000 for a married couple), the likely choice will be to apply the retroactive estate tax and remain subject to the estate tax rules (and receive the step-up in basis to date-of-death fair market value). However, in many cases, the circumstances will be more complex and will require careful analysis to determine whether or not to elect out of the default estate tax rules. For these situations, other specific factors will be considered and decisions will depend on each person’s specific circumstances.
By way of an announcement on September 13, 2011, the IRS pushed back the due date of these estate tax returns. The returns are now due March 19, 2012.
Please contact Frank Brunetti with any concerns or help that you may need with any of the aforementioned issues.
Circular 230 requires that we notify you that, in the absence of written advice that strictly complies with such rules, you cannot rely on advice given to you relating to any Internal Revenue Code matter for protection against a tax penalty. This notice is neither intended to be used for the purpose of avoiding any tax penalty nor can it be relied on in support of any marketed transaction. It is our intention to continue to deliver the highest quality services to you and in a cost efficient manner. Please call us if you have and questions about how the Circular may affect our representation of you.

So I am a Resident of New York And New Jersey?

As a follow-up to my recent posting of my article “Domicile is Like an Inertia,” I received an interesting article discussing New York’s Statutory Residence Rule in the Tax Analysts Special Report dated April 4, 2011. The article written by Peter L. Faber criticizes the statutory residence test and argues that it should be repealed. In his article, the author points out that New York State taxes residents on all their world wide income, regardless of whether it has any connection to New York. A person who is not legally domiciled in New York is treated as a resident for income tax purposes if he maintains a permanent place of abode in New York and is present in the state for more than 183 days during the tax year. This individual is known as a “statutory residence.” The statutory residence rule only applies for personal income taxes.

In the article, the author points out that the statutory residence test was conceived as an objective surrogate for the domicile test. It was intended to avoid the complex inquiry that goes into determining a person’s domicile and to ensure that a person who really lived in New York could not avoid resident status by arguing that his “state of mind” placed primary loyalty elsewhere.

The article points out that the New York Department of Taxation has taken an expansive view of the statutory language. The Department views the word “permanent” as relating to the nature of the residence and not the taxpayer’s use of it. The only structural exclusion is “for a mere camp or cottage, which is suitable and used only for vacations.” 20 NYCRR, Section 105.20(e)(1). Therefore, a house or apartment that is not a camp or cottage is treated as a permanent place of abode even if it is in fact used only for vacations or for that matter not at all.

The author goes on to discuss a number of cases involving individuals who clearly were not New York residents but because of the statutory residence test were required to litigate the issue as to whether they were New York residents and therefore to count days. The problem with counting days is that typically taxpayers do not maintain good records of their whereabouts. Certainly the taxpayer has the burden of proof in determining whether he or she does or does not meet the 183-day test. The result is that invariably taxpayers have trouble proving that they were not in New York for more than 183 days during a tax year. Proving a negative is always hard, and proving that a person was not in New York for any part of a given day as the author points out can be extremely difficult.

The advice given is to keep contemporaneous records including a diary every day and any part of every day. The author goes on to recommend that the individual maintain a separate folder for each day and insert in the folder copies of any documentation that they have showing there whereabouts on that day. Still all in all the taxpayer will in all likelihood have a difficult time proving that they are not a New York resident. The author points out that the audit process is time consuming and expensive and can go on for many years. Most taxpayers do not have the time or money to spend on such an audit. The author argues that the statutory residence rule should be repealed and replaced by the domicile test for income tax purposes. Indeed, that would eliminate counting days and refocus the incidence of taxation only on those individuals who are truly domiciled in New York and should bear the burden of the state’s income tax.