Archive for the ‘ Business ’ Category

Payday Lenders

Here is a very amusing and outraged report on “payday lenders” from John Oliver, the British reporter who apprenticed with Jon Stewart and Steven Colbert.

He’s accurate in presenting the problem: desperate and unthinking people can get money easily, but they will pay astronomical interest and the lenders are unscrupulous when it’s time to collect.

Few of my clients have “payday loans” to discharge, but one in particular stands out because the creditor threatened to arrest her. Actually, the creditor still threatens arrest today, but also gives no return address so I can’t serve it with papers to get an injunction and an award of attorney’s fees.

John Oliver bemoans the lack of regulation against these predators. I don’t see that better regulation will do much; industries almost always “capture” the governments trying to regulate them. Any industry has more capital and focused energy than the members of the general public who are exploited by the industry. Lawmakers will always listen respectfully to the industry’s side of the story, no matter how unconscionable their actions, because the industry can show results at election time.

On an issue like this, I become somewhat libertarian. The best defense against these predators is education, not regulation.

I love having my 18-year-old daughter work in my law firm.  She’s smart and motivated.  She gets to see law in action.  She’s done wonders for my website, and she gets the mail out.

She keeps a timesheet.  I pay her through a payroll company, which withholds funds for income and social security taxes, among other deductions.

Not every employer is as honest and real-world as I am about the employment relation with a child.  Hiring your child is perfectly legal, in fact, I encourage it, but it must be done carefully and transparently.  Some parents mistakenly believe that if they take some of their income and pay a child, they may take a deduction on the payment to the child and the child will pay tax at a lower marginal rate than the parent: a seeming win-win. Not so.

The IRS frowns on these schemes. The latest person to fall foul of the rules is a Ms. Patricia Diane Ross, who took her case to the Tax Court and lost: T.C. Summary Opinion 2014-68.

Ms. Ross owned a Schedule C business, Ross Professional Services, LLC, that helped government agencies staff their operations.  She had three children, ages 8 through 15.  The children, according to Ms. Ross, shredded paper, stuffed envelopes, copied, sorted checks, filed documents, put out the trash, carried equipment, and helped her shop for supplies. For these tasks, she paid the children.  But she made some mistakes that came back to haunt her:

  1. She paid the children in pizza.  Rather than give the children a paycheck, she claimed she kept a ledger of how much they had earned and deducted the cost of their restaurant meals and a tutoring/play activity service from that ledger.  These expenses sounded to the IRS and the Tax Court judge more like the regular kind of a support that a parent is expected to give to her children.

When I represented the Commissioner of Internal Revenue, I came across a family that paid their minor children a very regular wage: $5,000 twice a year, two days before the children’s private tuition bill was due.  The tuition bill got paid out of the children’s accounts.

Lesson one: if you employ your children, pay them in money rather than support.

  1. She did not pay a regular hourly wage.  Dividing “wages” paid by the hours Ms. Ross reported for each kid resulted in an hourly wage varying from $4 to $30 with little correlation between the child’s age, skill, or task, and the wage paid.

Lesson two: if you hire your child, keep good timesheets and pay a regular wage.

  1. She did not withhold Federal income tax or other deductions, saying that the children did not need to file tax returns.  But anyone who makes more than the standard deduction ($6,200) plus the exemption amount must file a tax return.  When the child is being claimed as a deduction on Mom’s tax return, the exemption amount is zero.

Lesson three: treat your employed child as a real employee subject to withholding.

  1. The children got paid for chores: “the activities performed by petitioner’s children seem analogous to . . . washing windows, cleaning screens; shoveling snow; moving grass; tending shrubs, trees, and underbrush; assembling papers; picking up mail.”  The Court found these activities sounded more like parental training and discipline, not services performed by an employee for an employer.

Lesson four: pay your children only for tasks that advance the business, not for tasks that advance the household.

  1. She did not give the children their own bank accounts.  Well, the children actually had bank accounts about 200 miles away (where their father lives?), but Ms. Ross said she was too busy to open local accounts for them.  Thus, she said, it was “more convenient” to pay for things as the children directed her to, matching spending against their “earnings.”  It does not appear that the judge found this explanation convincing.

Lesson five: give your employed children real accounts in a real bank.

I am pleased to say that, if the IRS were to audit my law firm, it would find that my daughter’s earnings are real earnings and a real deduction from the income I collect.

 

 

 

Investment Activity and Your Tax Return

Have your Investment Expenses Been Disallowed on Your Tax Return?

Most people know that they can’t claim losses incurred by a hobby – say, for instance, their side hobby of breeding and raising Great Pyrenees dogs.  No profit motive, no deduction of losses.

Despite the profit motive in investing, the same rule goes for investment activities that are not a “trade or a business.”  If an investor claims a loss on a Schedule C business whose sole purpose is lending and collecting money, IRS auditors will almost automatically disallow the expenses.  Even though most of us know better, the auditors see investment activities as something less than a business.

What, then, makes an investment activity a business in the eyes of the taxman?

Courts look for continuous and regular involvement in the activity, as well as a profit motive, to turn any activity into a trade or business.  When it comes to money-lending, the activity is a trade or business in those “exceptional” situations where the involvement is so continuous and extensive as to “elevate” the activity to that of a separate business.  Imel v. Commissioner, 61 T.C. 318, 323 (1973).

How do you prove this?

This question generally comes up in an audit, so the first person to convince about the “trade or business” is the IRS auditor.  An investor being challenged on these expenses should produce any documentation and explanations of the business that show continuous and extensive involvement in managing the investments, such as timesheets, advertising, loan agreements, and so forth.

IRS audits start with low-level employees who have little discretion, and who are likely to just deny the expenses.  When a taxpayer doesn’t just agree with the audit results, the audit gets handed to people who have successively more discretion than the prior person. Expect to rehearse the same story not only to the auditor, but also to the auditor’s manager, the appeals officer, the IRS docket attorney, and eventually the Tax Court judge.  The longer and further you escalate the audit, the better the odds of having your investment losses deducted.

This gauntlet of decision-makers will look for certain factors: the number of loans made by the taxpayer (more is better); the time period over which the loans were made (again, more is better); the quality of the taxpayer’s books and records relating to this activity (a trade or business will have good books and records); the time the taxpayer spends on the lending activity (it doesn’t need to be full-time, but the lender should seem committed to spending time at the activity); how the taxpayer sought out lending business, including word-of-mouth referrals and advertising (more aggressive marketing suggests a trade or business); whether the taxpayer had a separate office for the business (again, a devoted office looks more businesslike); the taxpayer’s general reputation as a lender (someone in the trade of lending will be known as a lender); and the relationship of the debtors to the taxpayer-lender (borrowers who are not relatives help this factor).  U.S. v. Henderson, 375 F.2d 36, 41 (5th Cir. 1967).

Interestingly, the failure to claim the activity as a trade or business for some time, even decades, does not prevent the lender from starting to do so.

If any one of the series of decision-makers agrees with the taxpayer, the audit closes with no change to the taxpayer’s return.  Because it gets more expensive to fight the IRS the longer the fight lasts, a taxpayer has a good incentive to show up with as much documentation and argument as possible from the beginning.  In some situations, taxpayers may recover part of their attorney fees from the IRS if they can show that the IRS took an unreasonable position, such as when an auditor completely ignores documentation of the Henderson factors.

Taxpayers seem to do very well according to the case law: most reported cases show the IRS losing on this issue.  However, every case turns on its own unique facts, and we don’t know how many lenders decided to agree with the IRS and not fight the “trade or business” battle.  What the case law does tell lenders is that it is often worth fighting the IRS on this issue.

Why incorporate a sole proprietorship?

Bankruptcy guru Cathy Moran writes again about corporate debt.  What’s the point of incorporating?  It’s usually more effective at protecting the business from the owner’s debts than it is in protecting the owner from the business’s debts.  Click here to read her article.

The flip side of this is when a corporation incurs a huge judgment against it.  Then the incorporation does protect the owner from the corporation’s debts.  That scenario is usually more dramatic, but occurs less often.

Business credit cards

Many of my clients come to me with credit card debt on a business card.  Here are some of the ins and outs about getting a business card, from Cathy Moran in Redwood City.

Large local business files chapter 11

I often ride my bike past the headquarters for THQ, a large video-game company in Agoura Hills, California.  In fact, it’s the third-largest employer in the city, after Bank of America and the local school district.   Two days ago, it filed for bankruptcy protection under Chapter 11 of the code (click here to view the LA Times article).  The debtor’s attorneys listed on the filing are Gibson, Dunn, and Crutcher in Los Angeles, and Young Conaway Stargatt & Taylor, a local firm in Wilmington, Delaware, where the corporation filed its case.

Even though world headquarters for this company are down the street, the Delaware filing is a reminder that the venue provisions for bankruptcy courts allow a filing in the debtor’s district of (1) residence, (2) domicile (residence and domicile are not the same thing), (3) principal place of business in the United States, (4) principal site of assets in the United States, or (5) incorporation.  The first four work for people as well as corporations: I once filed a case for a U.S. citizen residing in Switzerland by showing that he owned a bank account and shares in a corporation doing business in Agoura Hills.

THQ’s president spins the chapter 11 filing as an opportunity, and I admire that.  The company faced undeniable problems (which, having almost no interest in video games, I am happily ignorant of) and had lost $2 billion in market capitalization over the last six years.  That’s a lot of mojo down the drain.  If, as the company and the LA Times report, the company found an investor to purchase its assets, bankruptcy will be a great vehicle for it to strip off the liens attaching to those assets and allow it to continue doing business and catering to the tastes of hard-core action gamers.  We’re probably all better off in that case, because those guys will stay off the streets, to blow up zombies on their electronic screens, rather than interact with the rest of society.

Where can you file a bankruptcy case?

I had a client who lived in Europe – Luxembourg, of all places.  He went there because his business ventures in the US were going bad, so he took time away from this country.  His wife was a national of Luxembourg, so he moved his whole family to a house in the shadow of his inlaws.

But one creditor in the US didn’t like this.  The creditor sought a judgment and managed to get the Luxembourgish authorities to garnish the debtor’s wages for a prospective US judgment.  So the debtor contacted me and asked me to file a bankruptcy petition in the US.

There is a statute (28 USC 1408, if you’re interested) that tells us what bankruptcy courts have jurisdiction over a case.  The debtor may file in any judicial district in the U.S. in which he has had his residence, his domicile, his principal place of business in the U.S., or his principal assets in the U.S., for the greater part of the 180 days preceding the case filing.

My debtor had moved into his mother’s house in Simi Valley prior to moving to Luxembourg two years earlier.  He intended to move back to his mother’s house when his children finish high school in another five years.  He had two failed businesses in Canoga Park, both of which were now-inactive corporations.

The debtor didn’t have residence.  The trustee and I fought over whether he had domicile: that tricky concept requires physical presence in a spot in which you have the intent to live permanently; having created domicile, you can move around, so long as you don’t change your mind about where you want to end up.  The trustee said it wasn’t clear that my client intended to come back to California.

We also argued over whether his principal assets were in California.  He owned an overencumbered house in Luxembourg, but had a bank account with $600 and stock in a corporation owning a breakfast café in Woodland Hills (he was essentially a silent partner in that one, and it had no value).  The statute refers to “principal assets in the United States;” I argued that since he had no assets anywhere else in the U.S., his Luxembourg assets were irrelevant, and the court in the Central District of California had jurisdiction.

But the trustee finally agreed that the debtor had a principal place of business in the Central District.  He had opened and closed businesses here; he was a wage slave in Luxembourg, thus that wasn’t a “principal place of business.”  So the trustee agreed to no longer challenge jurisdiction, and my client in Luxembourg could file his bankruptcy case in Woodland Hills.

The trustee’s concession created new problems, because now the debtor had to show up at a meeting of creditors.  Sometimes the trustee will allow an out-of-country debtor to submit to the meeting of creditors by telephone or by written interrogatories; here, the trustee insisted that the debtor be present in the U.S. for the meeting of creditors. She would have been okay with the debtor landing in New York and sitting at a U.S. Trustee’s office and answering questions by phone; my debtors decided that since they needed to fly to the U.S. anyway, why not just go all the way to California?