Ohio Practical Business Law : Columbus Ohio Business Lawyer & Attorney : Teri Rasmussen : Plunkett Cooney Law Firm : Commercial Law, Creditors, Business Formation : Columbus, Central Ohio

Women, even professional women with careers as lawyers, CPA, bankers, etc., have been encouraged to give their "man" a little deference when it comes to things like our income tax return.  And we do, even in circumstances where we might tell a client they should be more alert.  But what happens if your spouse (and typically it IS the husband) decides to take a few shortcuts and be a little "aggressive" in his -- and YOUR - tax reporting to Uncle Sam?  A recent Sixth Circuit Court of Appeals decision should give us all pause.  

WAKE UP!!!   Totally apart from any moral or ethical obligations, what you sign off on with respect to your joint tax return CAN come back to haunt you BIG TIME!!!  So, calling all spouses, male or female, you really do need to pay attention and understand that tax return.

Recently, in Greer v. Commissioner of Internal Revenue Service, Case No. 09-1420, the United States Sixth Circuit addressed the "innocent spouse" doctrine whereby a spouse can escape liability for the wrongdoing of his or her spouse (traditionally the husband) if they essentially  had no knowledge of what that spouse was up to and no reason to be suspicious.  

In Greer, the case involved a high school music teacher wife who sought to evade liability for a failure to report tax liability associated with investments made by her husband.  The case concerned the Greers 1982 tax return and alleged understatement of income through erroneous deductions- at that time the Greers had been married for 15 years.  In part because the tax benefits exceeded the amount invested, the Tax Court had denied "innocent spouse" relief because it believed Mrs. Greer "should have at least made further inquiry."  The Sixth Circuit affirmed that decision.  The case dealt with erroneous deductions rather than omitted income and left the "knowledge of the transaction" test in place for omitted income cases.

The "innocent spouse" defense is based on section 6015 of the Internal Revenue Code which requires that the spose seeking to avoid liability must establish:

• they did not know and had no reason to know that there was an understatement of income.
• "taking into account all the facts and circumstances, it is inequitable" to hold that individual liable for the deficiency.

The Sixth Circuit began by determining "what test should be used in determining whether a taxpayer had a reason to know of an understatement, or to suspect a possible understatement, resulting from disallowed deductions or credits."  The Court ultimately adopted the "duty of inquiry" test laid out by the Ninth Circuit Court of Appeals in Price v. Comm'r, 897 F.2d 959 (1989) for erroneous deduction cases:

Even if a spouse is not aware of sufficient facts to give her reason to know of the substantial understatement, she nevertheless may know enough facts to put her on notice that such an understatement exists.  Such notice is provided if the spouse knows sufficient facts such that a reasonably taxpayer in her position would be led to question the legitimacy of the deduction.  In such a scenario, a duty of inquiry arises, which, if not satisfied by the spouse, may result in constructive knowledge of the understatement being imputed to her.

To determine whether a "duty of inquiry' has been triggered with respect to cases involving an erroneous deduction, the Court foud four factors relevant:

• Spouse's education
• Spouse's involvement in the family's financial affairs
• Presence of unusual or lavish expenditures beyond the family's norm
• Other spouse's evasiveness or deceitfulness concerning the family's finances

In some respects, this seems like a close case.  Indeed, the Sixth Circuit said as much, observing "[w]ere this de novo review, we might view the matter differently."  On the one hand, Mrs. Greer, while obviously well-educated, did not possess a financial education and there was no substantial change in the family's lifestyle.  However, although the Court also acknowledged that Mrs. Greer in fact had no actual knowledge of the erroneousness of the deductions taken and had no more involvement in the family finances than many spouses afforded the "innocent spouse" defense, it ultimately found that "Mrs. Greer was probably familiar enough with basic budgeting and accounting to understand representations made on a tax return, even if the ultimate legitimacy of sheltering income was beyond her experience. " Seems like this factor could have gone either way.  As far as evasiveness of her husband, the Court was unwilling to overturn the Tax Court'ds finding weighing this factor against Mrs. Greer because it thought the presence of the deduction on the return was enough.

The crux of Mrs. Greer's argument was that she left the family's financial matters to her husband.  Sound familiar?  Here the Court pointed out that several courts have held "being a homemaker cannot alone relieve a spouse of joint and several tax liability on a joint return and... one spouse cannot bury his or her head in the sand or turn a blind eye to the other's accounting." 

Takeaways?  Leaving the responsibility for filing your taxes to your spouse, while certainly convenient, may have really bad consequences.  So either file separately or be prepared to actually go over the return and ask questions before you sign.  Just because you didn't know what your spouse was doing does not let you offf the hook.

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And now, another GUEST POST from my source on small business tax stuff, CPA Karen deLaubenfels, who previously guest-posted on this blog regarding "What's Your Tax Basis? Does It Matter?":

If you’re a limited liability company (LLC) with just one owner, or if you’re a QSub, something happened to you on January 1, 2009.

Before that date, you could file your payroll taxes in two ways: either under your company’s own employer identification number (EIN) issued by the IRS, or under the owner’s number (Social Security number or EIN).   As a matter of fact, the IRS in times past would take care to point out that the sole proprietor didn’t necessarily need an EIN.

Now, your single-member LLC (SMLLC) or QSub (an entity formed by election of a parent S corporation to disregard a wholly-owned corporate subsidiary) will need its own EIN to file federal payroll taxes.  You can access the full text of the Treasury Decision here.  In this post, we'll focus on the SMLLC.

Here’s a bit of a digression on what it means to be a “disregarded entity.”  LLCs (an entity formed at the state level) have always presented a bit of a challenge to regulators at the federal level – are they more like partnerships, or more like corporations?  What about an LLC with just one member (owner)?  How could an SMLLC be a partnership, when partnerships must have at least two partners?  How could it be a corporation, when income flows through to the owners? 

The sole proprietor is a default business entity type, in the sense that there are no papers to file, no permissions needed. If you’re doing business and you're not another type of entity, you're a sole proprietor.   As Teri Rasmussen explained in her previous post on this blog entitled : "Partnerships, Corporations, LLCs, Sole Proprietorships, Oh my - Understanding the  Business Entity Choices in Ohio" , this has both advantages and disadvantages.  Simplicity is a major advantage; there are no board meetings, stock certificates, or separate tax forms for the sole proprietorship.  The taxpayer merely includes two additional schedules with his or her regular form 1040: Schedule C showing income and expenses, and Schedule SE for calculating self-employment tax.  The most glaring disadvantage of the sole proprietorship is the lack of personal liability protection, since creditors could “look through” your company to your personal assets in satisfaction of liabilities.

When LLCs came along, there was some discussion about how to treat the entity at the federal level. The result was that any LLC with two or more members is taxed as a partnership as a default, but can elect to be taxed as a corporation.  An SMLLC, though, is taxed as a sole proprietorship as a default (but can elect to be taxed as a corporation as well).  Thus the term “disregarded entity”; at the federal level, the SMLLC does not exist as either a taxpaying entity or (unless it requested an EIN) as an employer. 

At the federal level, the SMLLC is nothing more than a sole proprietorship. 

If your sole proprietorship has employees, you generally need to file several payroll tax forms, usually at the federal, state, and local levels.  If your SMLLC elects to file as a corporation, it is required to have an EIN.  If your SMLLC does not, it was heretofore treated as any other sole proprietorship, and not required to have an EIN. So some SMLLCs with employees had EINs, and some didn’t.

If you’re an SMLLC with employees that has been filing federal payroll tax forms under an EIN, you’re not required to do anything differently than you’re doing now.  However, if you’re an SMLLC with employees that has been filing federal payroll tax forms under the owner’s Social Security number, you have an action item: 

Get an EIN for your SMLLC, and file all payroll filings for wages paid after January 1, 2009 under your EIN.

If you need an EIN quickly, you can get one online here.   You’ll receive your EIN immediately and can use it right away for any purpose, with the exception of IRS e-services, since it will take a couple of weeks for the IRS to update all its files. Paper forms can be filed using the new EIN if a filing deadline is imminent.

In summary, SMLLCs are no longer disregarded entities as regards employment taxes and related reporting at the federal level. It’s important to note, though, that for all other purposes, your SMLLC will continue to be a disregarded entity at the federal level; for example, you as an owner will continue to be subject to self-employment tax on your personal tax return.

Karen L. deLaubenfels, CPA offers accounting advice, including a full line of tax consulting and preparation services, to clients in Central Ohio.  She also offers QuickBooks consulting and bookkeeping services, as well as training for tax staff.   For more information, you can visit her website at www.karendcpa.com.

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Unless I’ve somehow agreed to get up at the crack of dawn to play golf, Sunday morning is a lazy relaxing time for me - definitely a law free zone.  I gradually become aware that I’m awake.  The cats and I have a little “quality” time while I lie in bed watching the CBS Sunday Morning television news magazine.  Eventually I rouse myself to get showered and go downstairs to read the newspaper while watching one of the Sunday morning news talk shows. 

THE HOOK.  After the politicians have had their debates, an infomercial typically comes on next which I sometimes leave on whilst I'm preparing lunch.  This week, it’s “JOHN BECK'S FREE & CLEAR REAL ESTATE SYSYTEM" which promises me that I can profitably invest in all manner of real estate by spending only a few hundred dollars at government “tax sales”.  I’ve seen part of this infomercial on other Sunday mornings, but this time I became intrigued and went on a mission, in part because a client had recently been asking me some questions about real estate investments.

For only $39.95, the infomercial promised to send me a kit explaining how I too could make wads of money  -- just like the folks giving testimonials  -- by taking advantage of government tax foreclosure sales most people don't even know exist.  According to the infomercial, by using the special "Free & Clear Real Estate System",  I will be able to buy tax foreclosure properties for "pennies on the dollar" and own them "free and clear" with no monthly payments.  The infomercial also tells me that all I have to do to get these properties is pay the back taxes owed on them and assures me there are many properties in my area I could get.  Numerous examples were shown of houses bought for only a few hundred dollars, but  worth far more.  And of course there's a money-back guarantee!!! 

TAKING A CLOSER LOOK.  Having long been an adherent of the “if it sounds too good to be true, it probably is” school of thought, I found it difficult to believe this “system” actually worked, but was nevertheless curious.  As an attorney with substantial experience in real estate and foreclosure law, it also just didn’t square with what I thought I knew about Ohio law in this area.  But I’m always willing to learn new things….

So I decided to investigate.  Google and the internet are a wonderful tool!!  It wasn’t long before I found a website called Infomercialscams.com with page after page of complaints about this very program.  Among the least of the issues with the “Free & Clear Real Estate System” was that the $39.95 apparently wasn’t a one-time fee as the program certainly implied, but instead was a recurring monthly charge.  There was also heart-wrenching story after story of people induced to part with thousands of dollars to "upgrade" to more intensive training and/or who vainly tried to cancel the entire transaction.  Well, if I had been inclined to shell out some money just to check it out, I certainly wasn’t going to do it anymore.  

But I was still confused about how this would work even in theory.  The idea is that because county governments need the tax money to provide necessary services to citizens, they have the power to sell property on which taxes have not been paid.  OK, so far so good – that’s all true and some Ohio counties do indeed have annual tax lien sales.  That, however, is where reality stops.    

A quick look at the Ohio Revised Code (See ORC 5721.30 through 5721.43) and a little more internet research.  I soon determined that while I suppose it’s possible (though I think unlikely) this “buy at tax sales” plan might work in other states, it CERTAINLY DOESN’T WORK IN OHIO!!!

OFFER NOT VALID IN OHIO. Here’s why:

1.  No Such Sales.  Perhaps the most important reason it won’t work here is that Ohio simply doesn’t do a retail “over-the-counter” business in tax lien sales.  Since 1997, only counties with more than 200,000 in population are even permitted to have tax lien sales AND all of them sell tax liens once annually solely to an institutional investor as a single lot costing more than a million dollars.

2.  The Long Wait.  Even if you could participate in a tax lien sale in Ohio, it isn’t the carefree and direct road to quick profits portrayed on the infomercial.  While it is true that if property taxes remain unpaid, the county will eventually offer a tax lien certificate for sale with respect to a particular parcel, that is only the beginning of a rather long journey towards making any money. 

The tax lien certificate does in fact carry an 18% interest rate plus penalties that are dangled before the uninitiated as the safe, secure, and amazingly large return on investment.  What is not disclosed is that having once purchased the tax lien certificate, probably at a discount (i.e. with an interest rate less than 18%), you CANNOT do anything with it for TWELVE MONTHS. 

What you hope happens is that the delinquent taxpayer somehow has an upturn in his financial fortunes and suddenly becomes able to pay off the taxes, plus interest and penalties – in the unlikely event this happens, then yes, you will make money.  However, you are not permitted to contact the delinquent taxpayer during this period and must just wait and see.  In at least some counties, payment plans are offered to those delinquent taxpayers wishing to redeeem their property, thus further delaying your ability to profit on the investment.   In addition, during this period, you may also find yourself dealing with zoning and nuisance issues associated with the property. 

3.  Working Through Foreclosure of the Lien.  If the property is not “redeemed” during this year following your purchase of the tax lien certificate, then you have the “opportunity” to foreclose on your tax lien certificate and finally get possession of the property.  However, you must do so within three years.  In addition,  Ohio is a “judicial” foreclosure state which means that you can’t just schedule a sale of the property and be done with it.  No, a foreclosure action requiring a court filing fee of probably at least $200, has to be filed in the local Court of Common Pleas and wind its way through the courts.  For a fee, generally around $3,500, you can use the services of the County Prosecutor to get this done; it’s also possible for you to engage the services of a lawyer in private practice although I rather doubt there would be any savings with this approach.  By this time you should be adding up the time and expense and wondering why anyone would want to do this.  But there's more......

4.  Minimum Bids Required.  So, assume that you finally get through the foreclosure litigation in a timely manner, perhaps in only a few months. Now what?  Can you still get real estate at a fraction of its true fair market value?  Nope.  Under Ohio law, property sold at foreclosure sale must be appraised (more court costs) and offered for a MINIMUM BID of TWO-THIRDS of its VALUE.  If no one is willing to pay the minimum bid, then the property will be reappraised and offered at a somewhat lower price, but probably not enough less to make it worthwhile.

5.  Dealing with Lenders "Bidding It In".  Maybe you think buying property at two-thirds of its value still sounds like a good deal, especially if you can immediately “flip” it.  Unfortunately, the likelihood of getting the property for that little is not particularly good in practice.  Usually, there will be at least one mortgage on the property as well as possibly some judgment liens.  The bank or financial institution holding the mortgage will not infrequently “bid it in”, meaning that until it bids more than is owed on the mortgage, the lender is essentially playing with “house” money and will not have to come out of pocket to take title to the property.  If the property IS worth having, chances are the lender will have figured that out and bid accordingly.

6.  If You Don't Believe Me...  For the "official" version of what I've just explained, visit the explanations of tax lien sales provided by the Franklin County Treasurer, Hamilton County Treasurer, Cuyahoga County Treasurer, and Lucas County Treasurer.

Look Before You Leap.  Every state is different so the strategy might be more viable elsewhere, but there are bound to be some important procedures you should be sure you’re aware of that must be followed before you can realize any profits.  Some of those may be similar to what I've pointed out above.  In particular, at a minimum, I would suggest determining if the state is a “judicial” foreclosure state like Ohio.  If it is, then it will probably take longer and cost more to get to the point where you can sell or take possession of the property.  Make sure you really understand ALL the steps that need to be taken for you to get from putting money out to supposedly getting more money back.        

My point in going into some detail here is that it’s important to understand fully the process by which you are supposed to get rich before investing even a little hard-earned cash into the deal.  Whether it's this "system" or some other way to invest in real estate, or some other "plan" to make lost of money quickly with almost no risk and little effort, it really is BUYER BEWARE out there.  If there really was a foolproof method of turning real estate into cash, many more people would be financially independent.

Soo.. now you know how I spent part of my Sunday… Scary, huh?

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 I've often said that I consider TAX a four-letter word.  So I was most pleased when CPA Karen deLaubenfels accepted my invitation to make a guest post on this very subject. 

>>>>>>>>>> So, without further ado, KAREN DELAUBENFELS on TAX:....

A business tax issue that is somewhat neglected is owner tax basis, which is, roughly speaking, the owner’s stake in the business. Tax basis of business ownership is a topic of interest regardless of entity choice because it can affect the amount (and whether)  you may owe the government for taxes.  However, we focus here on the tax basis of a corporate shareholder.   

Many entities aside from actual corporations, such as LLCs, may wish to be taxed as a corporation under the “check-the-box” regulations, which allow the non-corporate entity to choose whether to be taxed as a “flow-through” partnership/sole proprietorship or a C (regular) corporation. The C corporation can then elect to be taxed as a “flow-through” S corporation, as Teri Rasmussen mentions in her article, "Taking the Plunge - How to Choose the Right Business Entity for Your Business." In a “flow-through” entity, the owners are taxed on their share of the company’s income, regardless of whether they receive any actual distributions of cash or property. Many of these non-corporate entities choose to be taxed as S corporations to maintain the flow-through aspect of the business, while avoiding possible ambiguity about whether owners may be treated as employees, allowing for withholding and tax-free fringe benefits available only to employees. Regardless of the entity choice, though, basis is a key player in determining taxability of any distributions to owners.

Each business owner has a tax basis in that ownership, unique to that individual. This basis is often, roughly speaking, the owner’s investment, plus earnings of the business, minus distributions to the owners and losses of the business, although the calculation differs somewhat depending on the type of business entity. We’ll focus on an entity that comprises 61.9% of the total number of corporations in the U.S. according to 2003 IRS statistics: the S corporation.

So what happens when the owner of an S corporation takes a distribution of cash or property? The short answer is that it’s generally not taxable, since the owner has already been taxed on the flow-through income; however, the exceptions to this general situation can have serious tax consequences for the business owner, and deserve a look.

An S corporation has a different set-up than other business entities, and is distinct even from other flow-through entities. The owner’s basis in shares of stock generally begins as just their cost, as with any other corporate shares; however, whereas the C corporation owner’s stock basis doesn’t change, the S corporation shareholder’s basis in the shares is a moving target, changing with corporate earnings and the owner’s contributions and distributions. In addition, if the owner makes any loans to the S corporation, there’s an additional quirk of the S corporation, loan basis. Although loan basis is beyond the scope of this post, it should be noted that it can affect the deductibility of corporate flow-through losses, and is thus worthy of consideration by the S corporation shareholder as well. 

Whether a distribution to the shareholder is taxable or not depends on whether the corporation has sufficient AAA, PTI, AEP, and OAA, and then on whether the shareholder has any tax basis in his/her shares.

This jumble of letters deserves some explanation. 

• AAA (the Accumulated Adjustments Account) tracks the corporation’s contributions, taxable earnings/losses, and distributions. A positive balance in this account represents corporate earnings that have been taxed as flow-through income, but not yet distributed to owners.

• PTI (Previously Taxed Income) is an “old-school” analog of AAA, which is only (possibly) relevant for S corporations that were in existence before 1983.

• AEP (Accumulated Earnings and Profits) is only (possibly) relevant for S corporations that were formerly C corporations. AEP is a topic in itself, and deserves its own separate discussion. For now, let’s note that any distributions from AEP are taxable as corporate dividends.

• Finally, OAA (the Other Adjustments Account) tracks the corporation’s non-taxable items affecting shareholder basis. This would include such items as tax-exempt municipal bond interest and “key person” life insurance proceeds, along with their associated non-deductible expenses.

Every time a cash or property distribution is made to shareholders, it reduces the balances in these accounts, in the order given above. As long as distributions do not use up AAA and PTI, they are not taxable. If AAA and PTI are gone, any distributions are next deemed to come from AEP, and are taxable as regular corporation dividends, subject to lower tax rates at present. When AEP is gone, distributions are deemed to come from OAA, and are again not taxable.

Next, though, we have the situation to watch out for, as it’s generally avoidable with good tax planning: If AAA, PTI, AEP, and OAA are consumed, the distributions are a return of the shareholder’s capital, lowering his basis in his shares. Once basis is used up by distributions, any additional distributions are taxable gain to the shareholder. 

Do you need to know your AAA, PTI, AEP, and OAA?  If your corporation has ever been a C corporation, you need to look at all four. If not, you need at least AAA; if you sell your ownership interest, your taxable gain may be reduced by your share of any positive balance in the AAA account.

Do you need to know your tax basis in your corporate ownership?  Absolutely. How else will you know whether your distributions have crossed the line from tax-free to taxable gain? 

Karen L. deLaubenfels, CPA offers accounting advice, including a full line of tax consulting and preparation service, to clients in Central Ohio.  She also offers Quickbooks consulting and bookeeping services.   For more information, you can visit her website at www.karendcpa.com,  

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