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Will You Be Audited?

Will You Be Audited? Where You Stand With The IRS: The IRS annually publishes a “data book” providing extensive data on IRS activities. It provides clues as to what would flag a return for audit. For the fiscal year ending 9/30/13, about 1% of all individual income tax returns were audited. Certain areas indicate they are at higher risk for audit selection than others. While a detailed review of the 2013 data book is beyond the scope of this article, certain highlights are noted.

Of those returns audited, an extremely high 34% claimed “earned income tax credit,” making this among the highest audit risks on personal tax returns. With the average audit rate being 1%, 3% of individual tax returns which showed business gross receipts of $100,000-$200,000 were audited, while only .4% of farm income returns were audited. The rate of audit for returns showing total positive income of $200,000- $1,000,000 was 2.5%, and for returns showing positive income of $1,000,000 or more was 10.8%. In summary, claiming earned income tax credit, individual business returns showing gross receipts of $100,000-$200,000, and high income individuals were the highest targets for audit.

Other highlights: 83% of the 146,000,000 individual income tax returns were e-filed, refunds were paid to 118,000,000 of those 146,000,000 returns, with refunds exceeding $312 billion. The IRS spent 41 cents to collect each 100 dollars in tax revenue during the fiscal year.

An electronic version of the 2013 Data Book can be found on the Tax Stats page of the IRS website, www.IRS.gov.

A Jewel Falls from the Crown of Qualified Retirement Plans– Inherited IRAs are No Longer Immune from Creditor Claims.

Since the mid-1970’s, qualified retirement plans in all forms (profit-sharing, pension, IRA, SEP, 401K, etc.) have been the crown jewels of financial planning: funded with before-tax dollars, compounding rapidly in tax-deferred investments, and protected in bankruptcy from creditors.  What could be better?  A recent Supreme Court decision took one of the jewels from the crown when it found that inherited IRAs are not protected from creditors.

In the approximately 40 years since qualified retirement plans took center stage, their favored status  has been proven by the fact that they now own close to a majority of the publicly traded stocks in the United States, trillions of dollars’ worth.  Available in many forms, they allow earned income to avoid income taxes when first invested in the plan; the plans then grow rapidly because the  earnings  compound annually without income taxes being assessed against the growth; and finally, in the payout years, when income taxes are assessed, tax brackets are typically much lower than the years when the contributions and earnings were accruing.  As if this weren’t enough, such plans are flexible, allowing transfers from one plan to another, or rollovers to an IRA, and permit one spouse to inherit them from another spouse without paying either estate or income taxes.  All of this is significantly enhanced by the fact that such plans are generally immune from the claims of creditors, even when the owners of those funds file bankruptcy.  In recent years, it has become legally possible to inherit IRAs, so that succeeding generations may continue the deferral of income on these growing assets.

Finally, one jewel has fallen from this many-faceted crown of the investment world.  In its decision of June 12, 2014, the United States Supreme Court decided in Clark v. Rameker that inherited IRAs are not exempt from the claims of creditors.  Pointing out the many, significant differences between an inherited IRA and one that has been created by a person’s own earned income, the Supreme Court refused to make such assets immune from creditors’ claims in bankruptcy.  In that case, Ruth Heffron died and left her IRA of $450,000 to her daughter.  Her daughter had drawn it down to about $300,000 when she was compelled by her debt situation to file bankruptcy.  The exemption of inherited IRAs from bankruptcy claims had been a topic of much speculation and contradictory rulings in lower courts.  The daughter argued that the IRA funds should be preserved to her through the bankruptcy because they were retirement funds.  The Bankruptcy Court agreed  with creditors that the funds could be seized; the United States District Court for the Western District of Wisconsin reversed the Bankruptcy Court, and was reversed in turn by the U.S. Court of Appeals for the 7th Circuit, landing the long-pending question before the U.S. Supreme Court.  It is now clear and final that inherited IRA funds are not exempt in bankruptcy from the claims of creditors.

That is not the end of the story.  There remain ways to continue the deferral of income tax on such funds for the benefit of successor generations, after the contributor’s death, while protecting such funds from creditors (see our April 7, 2014 post on Spendthrift Trusts). However, this is a far more complex arrangement than simply naming your heirs as beneficiaries of your IRA, and requires specialized legal assistance and planning.

$340,000 Home Up In Smoke And No Tax Deduction

You may be aware that sometimes fire departments are allowed by property owners to burn private structures for training purposes. It may be fun to watch, and the fire department will certainly enjoy the training opportunity, but the Tax Court has ruled that there is no tax deduction for the loss. A Virginia property owner purchased a house and lot for $625,000 and then granted to the local fire departments the right to burn the house (appraised at $340,000) for a training exercise. The house was burned over several weeks in training exercises in which half a dozen different fire departments participated. The taxpayer claimed the donation of the $340,000 house to charity, which resulted in a $98,000 deduction on their tax return. The deduction was disallowed, and the IRS position was confirmed in the United States Tax Court.

The case reporting this was Patel vs. Commissioner, 138, T.C.#23, issued on June 27, 2012. It invoked several quite complex provisions of the Tax Code, having to do with the charitable deduction of “partial interests” in property. While there were seemingly angles that could have been resolved in the taxpayer’s favor, the court prominently noted in its Opinion that the taxpayer had purchased the property with the intent to promptly demolish the house existing on it and build a new house.  While that particular facet did not directly relate to the very complex analysis of the charitable gifting provisions of the Internal Revenue Code reviewed by the court, one cannot help but wonder how much the court was influenced by this fact. It is a frequent subject of challenge by the IRS what the value of a particular charitable gift may be: a painting, a tract of real estate or a stamp or coin collection. The taxpayer, of course, wants the highest possible value for the charitable gift; the IRS seeks the opposite. If the starting place for analysis is that the taxpayer really thought the property was worthless, should it be justified as a charitable donation?  The Tax Court thought not in these circumstances.

Rewriting the Will After Death: Family Settlement Agreements

Every competent person under law may direct the distribution of his or her estate after death through a Will, or in a more sophisticated plan, a Revocable Trust.  It certainly is good business to have a carefully thought out and written plan for disposing of one’s estate after death, and thus lawyers persistently admonish their clients to have in effect current “estate plans.”  Sometimes, however, “the best laid plans go astray.” Unforeseen circumstances arising before or even after death may cause strict compliance with the directions in a Will and Trust to have unexpected, unfair and unhappy results for the family and beneficiaries involved.  There may be a solution. Provided everyone with an expectancy in the estate agrees, it is possible for all of the beneficiaries through a “Family Settlement Agreement” to effectively rewrite the Will or Trust and settle the estate as they wish, rather than as directed by the deceased person. In fact, Family Settlement Agreements are “favorites of the law,” eagerly enforced by the courts when properly entered (Arkansas Supreme Court, Machen vs. Machen, 2011 Ark. 531). There are also procedures for informally or judicially revoking or amending otherwise “irrevocable” Trusts. It is frequently surprising to clients to find out that, presuming all agree, they can rewrite their parents’, grandparents’, or other decedent’s Wills to accommodate current circumstances after the death.

Independent Contractor Or An Employee In Sheep’s Clothing?

Independent contractors are attractive to many businesses as the business avoids the overtime, insurance and tax expenses that are required to be paid on behalf of an employee.  Additionally, the business is, generally, not subject to tort liability for the negligence of an independent contractor.  These savings sometimes sway a business to characterize a worker as an independent contractor, when, legally, the worker is not considered an independent contractor.  Unfortunately, improperly classifying an employee as an independent contractor can result in hefty fines, taxes, penalties and liabilities for your business.  Also unfortunately, the specific tests used to determine this differs among various agencies who regulate it: IRS standards differ from Workers Compensation insurance standards, differ from wage and hour standards, differ from tort liability standards.

Generally, an independent contractor is defined as one who contracts to do a job according to his own method, with his/her own tools, and without being subject to control of the other party, except as to the result of the work.  Generally, the determination of whether an independent contractor relationship exists primarily hinges upon the employer’s right to control the work of the independent contractor.  It is the right of control, not the actual control, that matters.  The greater the right to control, the more likely an employer/employee relationship exists.  Although control is the primary factor examined in determining a worker’s status, it is not the only factor considered.

For purposes of general liability, the Arkansas Supreme Court has laid out ten factors to consider in determining whether an individual is an employee or independent contractor. These factors are:

1. The extent of control which, by the agreement, the master may exercise over the details of the work;

2. Whether the one employed is engaged in a distinct occupation or business;

3. The kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the employer or by a specialist without supervision;

4. The skill required in the particular occupation;

5. Whether the employer or the workman supplies the instrumentalities, tools, and the place of work for the person doing the work;

6. The length of time for which the person is employed;

7. The method of payment, whether by the time or by the job;

8. Whether the work is a part of the regular business of the employer;

9. Whether the parties believe they are creating the relation of master and servant; and,

10. Whether the worker represents the independent contractor services as a business, separate from him as an individual.

Applying such factors to the circumstances surrounding your purported independent contractor requires a careful and thorough examination.  Moreover, depending upon the nature of the risk, e.g., unemployment taxes, the Fair Labor Standards Act, tax or tort liability, the weight of the above factors can vary, or the entire standard may be different.  Please contact this firm if interested in reviewing your business’s independent contractor relationships.