Residence to Rental Property; Revoking Mark-to-Market Accounting; "Reverse" Piercing of a Sham Trust

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, September 19, 1999.

Copyright 1999 Robert L. Sommers, all rights reserved.

Question: My accountant says I should wait 12 months before converting my rental (received in a Sec. 1031 tax-free exchange) to my residence. Your last column stated the period was 3 years. Who's right?

Answer: My column discussed time periods under the new residence exclusion rules and their impact on converting a residence (personal property) to a rental (investment property). In general, Sec. 1031 requires an exchange of investment property for like-kind investment property; therefore, an exchange of a residence is not covered by the statute.

Your question involves the opposite issue: conversing rental property received in a Sec. 1031 exchange to your principal residence. Because there is no statutory period as specified by the tax code for a conversion from a rental to a residence, many advisors recommend waiting at least one year after an exchange. Sec. 1031 requires that investment property received in an exchange (replacement property) must continue as investment property.

To protect yourself if IRS audits you, many advisors maintain that you should file your return listing the replacement property as a rental throughout the tax year, then make the conversion to your residence the following tax year. In that way, your tax return the year of the exchange will be consistent with the requirements of Sec. 1031.

Question: I am a full-time securities trader ("Trader") and want to elect mark-to-market accounting for my securities. If I decide later to revoke the mark-to-market accounting election, may I do it?

Answer: Not unless you obtain IRS permission to revoke the election.

Although the election may be made separately for each trade or business without IRS consent, once made it applies in that taxable year to all trades made and to all subsequent taxable years unless revoked with IRS consent. This prevents distortions in reporting income and expenses that might otherwise occur.

I wrote in an earlier column that Traders are permitted to elect "mark-to-market" accounting so that securities transactions are taxed as follows: (1) the Trader recognizes gains and losses on securities at year’s end; and (2) gain or loss is determined and reported as though the security were sold at the fair market value at year’s end. In short, gains and losses are netted, whether or not the stock is actually sold, and the difference is reported as ordinary income or loss. Also, because securities are capital assets, gains are not subject to self-employment tax.

Under mark-to-market accounting, gains and losses are treated as ordinary income or loss and reported on Form 1040, Schedule C as a business activity. Traders must clearly identify property not subject to the election, such as stocks held for long-term investment.

Question: If assets are held in a sham trust and the beneficiaries owe taxes, can IRS pierce the trust to satisfy the taxes?

Answer: Yes, according to a recent Eighth Circuit Court of Appeals case. The "alter ego" doctrine used to pierce a corporation to hold shareholders individually liable may be applied in a trust case as well. The court upheld a "reverse piercing" of business trust, ruling the trust was a sham entity created to evade taxes and operated in a fraudulent manner toward the government's efforts to collect taxes. Thus, the trust became liable for the taxes owed by the individual beneficiaries and IRS could satisfy the tax obligations by selling trust assets.

The court rejected the trustee's claim that the trust was being unfairly penalized for acts over which the trust had no control, explaining that the trust was the taxpayers’ alter ego and, therefore, did not have a separate existence apart from the taxpayers.

This case marks the first time a reverse piercing case has been successfully brought by IRS to collect taxes. The lesson: Transferring assets to a trust just to protect them against the tax collector will not work.


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