California Taxes Already Prompt Moving Then Selling, No Deduction Could Mean Exodus

Writing off state income taxes is second nature to most high income Californians. One can say the same about a number of other high tax states, including New York, Connecticut, and others. Tens of millions of Americans claim this tax deduction, writing off their state and local taxes to reduce their federal income tax. However, state income tax deductions are itemized deductions. Thus, they are subject to numerous limits and phase-outs. And state income taxes are not deductible at all in computing the dreaded alternative minimum tax (AMT).

In that sense, the mere fact that you can write them off doesn’t actually mean you get any particular benefit. Some high income Californians might be surprised to find that they actually get no benefit at all from their state tax deduction. Still, losing something that you are used to claiming is hard, and California taxes are very high. California taxes income at rates up to a whopping 13.3% on top of IRS rates. To make matters even worse, California does not distinguish between ordinary income and capital gain. Thus, even before the pending tax bill passes, even while California taxes are still a write-off, they already seem to invite investors and business people to move away. 

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Many people want to make money in California, but to move elsewhere before it is taxed by the Golden State. Year after year, no state has a bigger and more persistent group of would-be tax fugitives than California. Some people worry that the outflow will be much worse under GOP proposals. Both the House and the Senate tax bills would eliminate the state income tax deduction. To an even greater degree, therefore, some people could rethink where they want to live. Some aggressive taxpayers may try to skip California taxes without moving by setting up a new type of trust in Nevada or Delaware. A ‘NING’ is a Nevada Incomplete Gift Non-Grantor Trust. A ‘DING’ is its Delaware sibling. There is even a ‘WING,’ from Wyoming.

Let’s say you can’t move quite yet, so you wonder if a trust in another state might work. The usual grantor trust you form for estate planning doesn’t help, since the grantor must include the income on his own return. An emerging answer for the adventurous is a Nevada or Delaware Incomplete Gift Non-Grantor Trusts. The donor makes an incomplete gift—with strings attached—to the trust, and the trust has an independent trustee in another state. The idea is to keep the grantor involved, but not technically as the owner.

New York State has changed the law to make the grantor taxable no matter what. California’s Franchise Tax Board is studying the issue. Some sellers hold significant assets and move states before they sell. A cleaner plan is an outright move, and some of those may happen if the tax bill passes in its current form. It has been true for many years that some Californians flee the state before a major income event. But, many leavers have unrealistic expectations about establishing residency elsewhere, and have a hard time distancing themselves from California.

The burden is on you to show that you are not a Californian. You can have only one domicile, and it depends on your intent. Start with where you own a home. If you own several, compare size and value. Where your spouse and children reside counts, as does the location where your children attend school. Days inside and outside the state are important, as is the purpose of your travels. Where do you have bank accounts and belong to social, religious, professional and other organizations? Voter registration, vehicle registration and driver’s licenses count. Where you are employed is key. You may be a California resident even if you travel extensively and are rarely in the state. If you leave California, sell your residence or rent it out on a long-term lease. Like other high tax states, California is likely to probe how and when you stopped being a resident.

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Bitcoin Investors Hunt For Transfers That Aren’t Taxable

With the stratospheric prices of Bitcoin and other digital currencies, there is understandable worry about diversification. Of course, diversifying without paying a big tax hit would be best if you can. Up until now, depending on how aggressive you were, and how you could orchestrate it, you could try swapping one asset for another. If different kinds of real estate can be swapped for one another tax-free, why not digital currencies? The IRS says that Bitcoin and other digital currencies are property, right? Whatever the arguments for the past, the House tax bill and the Senate tax bill both make it clear that after passage, 1031 exchanges are only for real estate.

(Photo by Alain Pitton/NurPhoto via Getty Images)

Most swaps are taxable as sales, so a 1031 exchange is an exception to the rule that swaps are taxable. When it comes to whether 1031 applies to cryptocurrency, the debates are over the fundamentals. The IRS has been asked about this, but has so far remained mum. The big question is whether exchanges of cryptocurrency should be considered swaps of property of like-kind. A direct Bitcoin for Bitcoin swap might be fine, but that is hardly diversification. A Bitcoin for Ripple or Ethereum trade is much more appealing, but that might not qualify.

If you don’t argue for 1031 treatment, or if the IRS rules against 1031 exchanges even for the past, are there any other choices for transfers that might be tax free? Some investors put Bitcoin and other virtual currencies into an investment or trading company, but can it be done tax efficiently? That is, if you form an LLC or a corporation, can you transfer Bitcoin and other digital currencies to your new entity tax free? Generally, yes. Both the partnership tax rules and the corporate tax rules allow for tax free transfers, if you meet certain rules. So, in a simple case, if you transfer $X worth of Bitcoin to a new LLC or corporation you form, swapping your $X worth of Bitcoin for all of the ownership interests in your new entity, it should be tax free.

Of course, then your new entity will be buying and selling, and paying tax on any gains. You may not have changed the ultimate tax due when you sell. But you might alter the reporting playing field materially. For example, suppose that you are worried about IRS Form 1099 reporting rules. The IRS has said that payments for services in Bitcoin are subject to IRS Form 1099 reporting. The payor is supposed to file the form, filing a Form 1099 with the IRS to report the payment. The Form 1099 reports as if the Bitcoin was cash, reporting at its then dollar value.

However, payments to corporations generally do not need to be issued IRS Forms 1099. Corporations–both S corporations that are taxed as flow-throughs and C corporations that are taxed as entities–can be end-runs around the Form 1099 reporting rules. Not having to deal with Forms 1099 could be one advantage. You might also change (and reduce) your tax audit profile with an entity tax return. Sole proprietorship tax returns (Schedule C to IRS Form 1040) are one of the most likely types of tax returns (or portions of tax returns) to be audited. So forming an entity can materially reduce your audit risk.

Finally, there could be some types of transactions that you might more readily facilitate with an investment or business entity of your own. For example, you might end up combining your company with one or more others, in effecting ending up with a smaller percentage interest in a larger entity, rather than owing your small entity all by yourself. There is no magic solution that allows tax-free diversification. But it can be worth trying to be creative.

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House And Senate Tax Bills Bar Lawyer Tax Write-Offs For Costs

If lawyers pay for a deposition transcript, a court reporter, or travel expenses for a hearing, you might assume they can deduct them as business expenses. The same for expert witness fees. These all seem like typical business expenses for lawyers, so how could there be a problem? One question is who is bearing the impact of these expenses, lawyer or client, and when? The tax law says that business expenses must be ordinary and necessary to be deductible, but don’t these qualify?

In this Thursday, Nov. 30, 2017, file photo, the sky over The Capitol is lit up at dawn as Senate Republicans work to pass their sweeping tax bill, in Washington. (AP Photo/J. Scott Applewhite, File)

The House and Senate tax bills both say no for contingent fee lawyers, until the very end of the case when it is resolved. Under most contingent fee agreements, the client pays nothing (not even costs) unless there is a recovery. Under some fee agreements, costs are subtracted from the client’s share. In others, costs are taken off the top, before the client and lawyer split the remainder. But someone has to pay these costs up front as they are incurred, and that is almost always the lawyer.

Lawyers understandably want to write them off right away. But the IRS has battled successfully to prevent these deductions. In fact, for plaintiff lawyers who don’t want to fight with the IRS about tax deductions, the safest course is to treat costs they pay for clients as loans to the client. You can’t deduct loans. That is painful, for it means paying the costs currently, but not deducting them on your taxes until what could be years later when the case finally resolves. Only at that point could you write them off.

But there was a way out in California, and throughout the Ninth Circuit, thanks to a tax case called Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995). The Ninth Circuit court held that attorneys could currently deduct costs if they had a gross fee contract, under which the attorney receives a percentage of the gross recovery, with costs paid by the attorney taken solely out of the attorney’s percentage. Any other type of fee agreement is a loan of the costs.

Some lawyers in California and other states in the Ninth Circuit went to great pains to make sure they qualified. Some lawyers may be more careless but still hope they get some protection from Boccardo. The IRS has long been unhappy over this issue. In fact, the IRS issued a Field Service Advice, 1997 FSA 442 (basically a memo to IRS personnel) stating that it would not follow Boccardo except in the Ninth Circuit.

The IRS has long wanted uniform tax treatment, and now so does Congress. Both House and Senate tax bills say no to deductions, even in the Ninth Circuit. Thus, the more favorable Ninth Circuit rule will probably change. Lawyers should consider anticipated costs, and should consider what kind of fee agreement they want to use. In the Ninth Circuit, that decision up to now has been heavily influenced by taxes. But that may soon change. Plaintiffs’ lawyers in most of the country won’t feel the burn, for they have had this rule for years now.

The House version of tax reform, the Tax Cuts and Jobs Act, includes a provision that bars contingency fee lawyers from deducting case-related expenses before cases are resolved: “No deduction shall be allowed … for any expense paid or incurred in the course of the trade or business of practicing law, and resulting from a case for which the taxpayer is compensated primarily on a contingent basis, until such time as such contingency is resolved.” The Senate proposal explains that it “denies attorneys an otherwise-allowable deduction for litigation costs paid under arrangements that are primarily on a contingent fee basis until the contingency ends.” Estimates say that this provision will save an estimated $500 million over 10 years.

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Collecting Gross-Up Damages For Taxes In Litigation Gets Easier

Can plaintiffs collect damages in litigation for additional taxes they owe because of the defendant’s actions? Historically, some courts have been reluctant to ‘gross-up’ a plaintiff’s damages for taxes. One reason is a lack of precision in tax calculations. Another is that the plaintiff must pay taxes in any event, regardless of the activity of the defendant. Sometimes, though, the lump-sum nature of a verdict or settlement itself causes a tax problem, where payments should have been made over time but were not.In such a case, shouldn’t a plaintiff who can prove that but-for link be able to recover for such an item of damage? It would seem so, and the Ninth Circuit in Arthur Clemens, Jr. v. Centurylink Inc. and Qwest Corporation, 2017 WL 5013661 (9th Cir. 2017), recently said yes, at least in Title VII employment cases.

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The case started when Arthur Clemens, Jr., sued his employer (Qwest) for Title VII violations. A jury awarded him damages for back pay, emotional distress, and punitive damages. Clemens also asked for extra damages for taxes. He claimed that a lump sum would cost him more in taxes than if Qwest had paid him over time, as it should have. But the trial court denied his request for a tax enhancement. Accordingly, Clemens appealed to the Ninth Circuit, which said that Clemens was right. Taxes as an element of damages may be easier to recover, at least in Title VII cases.

Yet the impact could be broader still. Some other courts have considered this question in Title VII cases. The Third, Seventh, and Tenth Circuits have all held that district courts have the discretion to “gross up” an award to account for income-tax consequences. See Eshelman v. Agere Sys., Inc., 554 F.3d 426, 440–43 (3d Cir. 2009); EEOC v. N. Star Hosp., Inc., 777 F.3d 898, 903–04 (7th Cir. 2015); Sears v. Atchison, Topeka & Santa Fe Ry., Co., 749 F.2d 1451, 1456–57 (10th Cir. 1984). In contrast, the D.C. Circuit has ruled against such gross ups. See Rann v. Chao, 346 F.3d 192, 197–98 (D.C. Cir. 2003).

The party seeking a gross-up bears the burden of justifying any adjustment. How about tax gross ups in other kinds of cases? There may well be a practical impact, an expansion of the concept generally. Still, tax gross ups are often hard to obtain in any context. Yet they can be both appropriate and available in a variety of cases. In another recent case, Sonoma Apartment Associates v. United States, 2017 WL 5078032 (Court of Federal Claims, Nov. 3, 2017), the plaintiff in a complex suit against the federal government, sought various damages.

Among the damage claims and calculations was a tax neutralization payment. The plaintiff asked for an additional $2,136,681, representing compensation for the increased federal and state income taxes the plaintiff’s partners would owe. Not unlike in a Title VII case, the plaintiff claimed that it (and its partners) were receiving a lump-sum in lieu of a twenty-four-year-long stream of market-rate rental income. That meant more taxes on the lump sum, just like Mr. Clemens argued in his Ninth Circuit Title VII case. In Sonoma Apartment Associates, the federal government admitted liability, so the only question was the extent and calculation of damages.

Timing and precision are also important. When a tax claim might be appropriate should be considered in virtually any context. An expert witness on tax issues and/or damage calculations is often appropriate. You may need to show by clear and convincing evidence that these specific taxes were caused solely by the defendant, and that you would not have paid them otherwise.

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Bitcoin Tax Troubles Get More Worrisome

The IRS has not yet announced a tax amnesty for people who failed to report their gains and income from Bitcoin and other virtual currencies. But there has long been speculation that it might happen. Soon would be good. It is well-known that the IRS is looking hard at Bitcoin and other cryptocurrency transactions, hoping to collect big. Frighteningly, much of the IRS attention appears to be focused on the criminal end of the spectrum. The IRS Criminal Investigation Division not only ordered training for its agents. It also entered into a contract with Chainanalysis for tracking. We may expect this area to unfold materially in the coming years, and not in a happy way.

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The Coinbase summons saga has been resolved for the time being here. As a result, some account holders are going to be exposed to the IRS. They may have nothing to fear, if they have been reporting their gains. However, given what the IRS has said about the paucity of Bitcoin transactions reported on tax returns, it seems likely that some people have not been reporting. That means there could be a scramble to get to the IRS before the IRS collects the data and acts on it. Some people will surely consider filing amended tax returns. The IRS looks on self-correction as vastly better than just being caught.

This is where an IRS amnesty of some sort could be huge. There have been more than a few comparisons raised with the Swiss and other offshore bank controversies. For models on special amnesty programs, the IRS has good examples. The Swiss bank controversies of a decade back prompted two IRS programs, and they are both still in existence. First was the so-called OVDP, and second was the Streamlined programs. These formulaic voluntary disclosure programs could be helpful blueprints.

One Justice Department attorney recently noted that IRS scrutiny on tax reporting could prompt some kind of program. Mark F. Daly, senior litigation counsel in the Justice Department Tax Division, made the remarks in a November 3, 2017 symposium held by the State Bar of Texas Tax Section. It does seem about time. Other than the 2014 “it is property” notice, the IRS has not provided taxpayers with more information. The fact that the IRS is going to get data from Coinbase might suggest that the IRS does not need to extend a carrot to non-compliant taxpayers.

But the carrot and stick approach was exactly what the IRS did with the offshore bank accounts. The IRS won big with a John Doe Summons to UBS, the Swiss bank. The IRS used a John Doe Summons against Coinbase too. The IRS prosecuted big foreign banks for helping Americans stash money overseas, and prosecuted individuals too. The IRS used whistleblowers, and strong-armed foreign governments and banks to turn over data. But perhaps the greatest coup in the IRS’s strategy was a type of limited amnesty. The IRS collected more than $10 billion in these efforts, and the money train isn’t done yet.

Coinbase was ordered to supply the IRS with the identities of all users in the U.S. who conducted at least one bitcoin transaction equivalent to at least $20,000 between 2012 and 2015. Coinbase will be required to turn over the names, addresses, tax identification numbers, and account details on 14,355 account holders out of its nearly 6 million customers. The UBS release that started the Swiss avalanche was only 4,250 names. Meantime, Bitcoin values have gone meteoric. It seems likely that the IRS could use both carrots and sticks to get what it wants from Bitcoin and other digital currency gains. Some sticks are certainly coming. Hopefully a carrot is too.

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DMX Tax Fraud Guilty Plea Cut 44 Year Prison Exposure To 5 Years

DMX, the recording artist whose real name is Earl Simmons, cut a deal with prosecutors that slashed his potential prison exposure in a big way. His guilty plea to only one count of tax fraud could still mean up to five years in prison. However, earlier this year, he faced a fourteen count indictment over allegedly avoiding paying $1.7 million in federal taxes by hiding his income. The combination of those charges, if he was found guilty of them all, could have meant up to a staggering 44 years of prison time. Although he might well not have faced that term under even the worst of circumstances, it was a frightening possibility. Now, his sentencing is set for March 29, 2018, and the biggest dangers are removed. The one-count deal was surely a savvy one, and the potential five-year prison term could end up being much less.

FILE – In this Sept. 23, 2009 photo, DMX arrives at the 2009 VH1 Hip Hop Honors at the Brooklyn Academy of Music in New York. (AP Photo/Peter Kramer, file)

Guilty pleas are common in tax cases, in part because the government usually has plenty of evidence before they charge a tax crime. As is typical in cases of high profile defendants, prosecutors here made much of DMX’s financial success and public acclaim. And his alleged actions were hard to explain without using the word “willful.” The Indictment claims that for years, he made millions from chart-topping songs, concert performances and television shows. Part of tax cases is about intent or willfulness, and prosecutors claimed that it was not just slopping records or forgetting to handle taxes. Prosecutors alleged that DMX went out of his way to evade taxes. They claim he avoided personal bank accounts, set up accounts in other people’s names, and paid personal expenses in cash. According to prosecutors, DMX once even refused to tape the television show ‘Celebrity Couples Therapy’ until they replaced his paycheck–which had taxes taken out–with a check that did not withhold taxes.

Although DMX no longer must worry about the long list of 14 counts, it is worth reviewing just how pervasive tax-related charges can be. In his case, there was one count of corruptly endeavoring to obstruct and impede the due administration of Internal Revenue Laws, one count of evasion of payment of income taxes, six counts of evasion of assessment of income tax liability, and six counts of failure to file a U.S. individual income tax return. Count One carried a maximum sentence of three years. Counts Two through Eight carried a maximum sentence of five years—each. Counts Nine through Fourteen carried a maximum sentence of one year–each.

If you assumed the worst–that the feds might have succeeded in convicting him on all counts–the potential prison time could have been up to 44 years. Although that kind of potential term may sound crazy, this was no single event the feds were targeting. The indictment alleged that Simmons’ earnings from musical recordings and performances from 2002 through 2005 meant that he owed federal income tax liabilities of approximately $1.7 million. Those early liabilities went unpaid.

Then, in 2005, the IRS began efforts to collect on these unpaid tax liabilities. That’s when Simmons’ alleged conduct went from bad to worse. Plus, from 2010 through 2015, Simmons earned over $2.3 million. Even so, prosecutors say he did not file tax returns for those years. Instead, they claim, he used cash, and avoided personal bank accounts. He used the bank accounts of nominees, including business managers to pay personal expenses. He received hundreds of thousands of dollars of royalty income from his music recordings, but managed to skate on taxes, prosecutors claimed. The indictment claimed that Simmons would get his managers to accept the royalties, then give Simmons cash.

Prosecutors claim that he filed a false affidavit in U.S. Bankruptcy Court, listing his income as “unknown” for 2011 and 2012. Then, he said he made $10,000 for 2013. In reality, said prosecutors, Simmons received hundreds of thousands of dollars of income in each of those years.

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Meghan Markle & Prince Harry Filing Taxes Separately? Here’s Why

It sounds like a feel good story, an American actress wedding a British Prince. Leave it to complex U.S. tax laws to spoil it with tax problems. And here, they could be positively huge. Buckingham Palace has announced that Markle will become a British citizen after marriage. Yet tax lawyers quickly point out that Meghan Markle’s U.S. citizenship could cause tax headaches for Britain’s royal family. After all, unless she renounces her American citizenship, no matter where she lives, she’ll have to file U.S. tax returns, plus FBARs, every year, reporting her worldwide income, and disclosing assets.

Photo by: KGC-375/STAR MAX/IPx 2017 11/27/17 Prince Harry and Meghan Markle during an official photocall to announce the engagement of Prince Harry and actress Meghan Markle at The Sunken Gardens at Kensington Palace on November 27, 2017 in London, England. His Royal Highness Prince Harry Of Wales and Ms. Meghan Markle are engaged to be married. The wedding will take place in Spring 2018. The couple became engaged in London earlier this month. Prince Harry informed The Queen and other close members of his family and also sought and received the blessing of Ms. Markle’s parents. (London, England, UK)

Many a dual country couple innocently starts filing U.S. taxes together, and that can be a very costly mistake. 95% of married couples file joint tax returns, often as a knee-jerk reaction. Yet that simple step makes each spouse liable for everything on the return–and anything that might not be on the return. Markle will surely be advised to file taxes separately, so Prince Harry will hopefully not be caught within the U.S. tax net. But if they have children, what about them?

It isn’t just income that the IRS wants to know about. It’s assets too, maybe even some royal ones. FATCA, the Foreign Account Tax Compliance Act, is a uniquely American law. It was passed in 2010, and is now ramped up worldwide. It requires an annual Form 8938 filing with the IRS that could end up involving royal assets. FATCA spans the globe with an unparalleled network of reporting. America requires foreign banks and governments to hand over secret bank data about depositors. Non-U.S. banks and financial institutions around the world must reveal American account details or risk big penalties. Perhaps Markle will follow London’s former Mayor Boris Johnson, now Britain’s Foreign Secretary. Having been born in New York but raised in Britain, Johnson was a dual citizen of the U.S. and U.K. But a run-in with the IRS eventually led him to renounce his American citizenship.

Renouncing is trending too. The number of renunciations for the first quarter of 2017 was 1,313. The second quarter’s list went up to 1,759, the second highest quarterly number ever. The total for calendar 2016 was 5,411, while 2015 had 4,279 published expatriates. Despite the official list, many who leave are not counted, although both the IRS and FBI track Americans who renounce. Expats have clamored for tax relief for years. Even if you are not royal, America’s global income tax compliance and disclosure laws can be a burden, especially for U.S. persons living abroad. Many foreign banks do not want American account holders.

Americans living and working in foreign countries must generally report and pay tax where they live. But they must also continue to file taxes in the U.S., where reporting is based on their worldwide income. A foreign tax credit often does not eliminate double taxes. Annual foreign bank account reports called FBARs carry big civil and even criminal penalties. The civil penalties alone can consume the entire balance of an account. Ironically, even leaving America can be costly.

America charges $2,350 to hand in your passport, a fee that is more than twenty times the average of other high-income countries. The U.S. hiked the fee to renounce by 422%, as previously there was a $450 fee to renounce, and no fee to relinquish. Now, there is a $2,350 fee either way. The State Department said raising the fee was about demand and paperwork, but the number of American expatriations kept increasing. Moreover, to exit, one generally must prove 5 years of IRS tax compliance. And getting into IRS compliance can be expensive and worrisome.

For some, a reason to get into compliance is to renounce, which itself can be expensive. If you have a net worth greater than $2 million, or have average annual net income tax for the 5 previous years of $162,000 or more, you can pay an exit tax. It is a capital gain tax, calculated as if you sold your property when you left. A long-term resident giving up a Green Card can be required to pay the exit tax too. Sometimes, planning and valuations can reduce or eliminate the tax, but the tax worry can be real, even for those who will not face it.

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