I Dreamed A (Tax Season) Dream

Have you ever heard or watched the show “True Life” on MTV? One of the directors for that show was James Huang. He has gone on to other efforts, one of which is his parody on the Les Miserables’ song “I Dreamed a Dream.”  It has a very noticeable accountant/tax season theme.

My favorite line?

            “Busy season has killed a dream I dreamed.”

Remember to laugh when and as much as you can.

NFL's Romanowski, Horses And A Hobby

He was a feared NFL football player. He played in the league for 16 seasons, winning 4 Super Bowls. He was ... volatile, at best. In 1997 he broke the jaw of Carolina Panthers quarterback Kerry Collins. He spat in the face of San Francisco 49ers wide receiver J.J. Stokes during a Monday night game.  In 2003 he confronted a player on his own team, ripping off that player’s helmet and crushing his eye socket with a punch.

His name is Bill Romanowski (BR). And he now has entered the tax literature.

BR decided to get into horse breeding – sort of. There is a Code section that disallows losses incurred in what the IRS considers a “hobby.” The IRS understands that one can try and fail in a business venture, but it wants the venture to truly be profit-driven. It is not interested in allowing losses from a weekend racecar hobby, or Tennessee walking horse competitions for one’s teenage child, or (more recently) owning an Amway distributorship. There are numerous factors to consider: one’s past experience and familiarity with the business or industry, development of a business plan, reaction to and modification of that plan when confronted with losses, and so on.

Horse breeding is a likely area for hobby-loss challenge by the IRS. It is also (or at least used to be) a popular tax shelter area. BR got involved and combined the two, to a financially detonative extent.

BR and his wife for many years used a financial planner by the name of Kathy Lintz. It sounds like she did a good job, including managing their portfolio and providing them a monthly stipend. Ms. Lintz also collected financial information for their tax returns and engaged a CPA. She would review the completed tax returns before sending them to the Romanowski’s.

During 2003 BR had tax issues with a real estate investment in Colorado. Ms. Lintz put BR in touch with Rodney Atherton (Atherton), a partner at Greenberg Traurig in Denver. BR went to Denver to discuss real estate, at which time Atherton told BR about a horse-breeding business, ClassicStar, which had retained his firm. It sounds like the meeting went well, as BR retained Greenberg Traurig. BR also wanted more information about the horse breeding deal.

BR received documents frequently associated with a tax shelter:

1. a 53-page opinion letter from the law firm Handler, Thayer& Duggan, LLC regarding tax aspects of horse-breeding;
2. a 22-page opinion letter from the accounting firm Karren, Hendrix & Associates regarding tax aspects of the horse-breeding business, and
3. a 6-page opinion letter from Karren Hendrix & Associates regarding tax aspects of NOLs generated from a horse-breeding business.

OBSERVATION: Folks, I am a career tax CPA. I have received and reviewed attorney opinion letters over the years. Allow me to assure you that such letters are not normal business practice. It is however normal tax shelter business practice. And your first clue that you are leaning a bit far over the ledge.

How did the deal work? It was relatively simple: BR would lease mares owned by ClassicStar, which in turn would provide boarding and care for the mares and breed the mares to stallions. Any foals produced from the breeding would belong to the Romanowski’s.

How much would this cost BR? Karren Hendrix, who did accounting work for ClassicStar, sent an “NOL illustration” regarding BR to Atherton. In the NOL illustration, Karren Hendrix estimated that BR needed an NOL of over $13 million to offset his taxable income from 1998 to 2003.

In 2003 Atherton and BR again traveled to Kentucky. This time Mrs. Romanowski reviewed the materials and made the trip to Kentucky. They toured the ClassicStar operation, saw the horses, visited auction houses, and met with ClassicStar personnel.

The Romanowski’s decided to invest approximately $13 million.

OBSERVATION: Wow! I wonder how they came up with that amount?         

Ms. Lintz, the financial advisor, was adamantly opposed. She believed it a tax scheme and a threat to the Romanowski’s financial health.

BR blew her off.

The Romanowski’s created Romanowski Thoroughbreds, LLC, through which they would operate the horse activities.

In December 2003, the Romanowski’s wrote a $300,000 check to ClassicStar as a deposit. They then signed a mare lease and board agreement with ClassicStar. Pursuant to the agreement, Romanowski Thoroughbreds agreed to spend $13,092,072 on the breeding program to produce foals.

Mind you, when the Romanowski’s signed this agreement, they had not negotiated or seen any list of horse pairings. Rather, they relied on ClassicStar to pick the horse pairings and to set the fees and expenses they would pay.

Right....

They later received a list of the horse pairings they would receive. They would receive 68 pairings, but only 4 of the 68 pairings were to thoroughbreds. The remainder were to quarter horses.

NOTE: What?? Sounds to me like a good time to call the attorney and back out of this deal, right?

The Romanowski’s were assured by ClassicStar that they would substitute an unknown number of thoroughbred pairings for quarter horse pairings. Of course, nothing was written down.

Right....

Meanwhile, Ms Lintz became aware that Atherton was receiving a “due diligence fee” from ClassicStar. She was concerned, as she considered it a conflict of interest. Why? Because Atherton was the Romanowski’s attorney, and he was suppose to have their best interest at heart.

In February 2004, Ms. Lintz resigned as the Romanowski’s financial adviser, partially because of their investment in the horse program. Her resignation letter states that the Romanowski’s choose to “enter into an aggressive tax shelter.”

Later that month Ms. Lintz sent the Romanowski’s another letter identifying two independent horse and tax experts whom they could contact if they “need[ed] further assistance”. The letter stated that one of the experts told Ms. Lintz that  ClassicStar had “come on strong in the last couple of years” and that there had been “No scandals thus far” even though “some of the principals were involved in bad prior deals.”

OBSERVATION: Ms. Lintz sounds like a very attentive financial advisor for her clients.

Atherton of course denied receiving any improper payments from ClassicStar. What happened is – if Atheron referred a client to ClassicStar - ClassicStar would pay Atherton a percentage of the deal.  Atherton would escrow the funds and bill against them at a much higher hourly rate than his normal rate. For example, in an email to another client, Atherton wrote:

 “Here is what I propose, I simply bill my time on your clients at a premium--I usually bill 365 an hour. Are [sic] okay if I bill 1000 an hour   and just charge an hourly rate?

He of course never told the Romanowski’s about any arrangement.

NOTE: Nice guy. We will probably hear his name again when he runs for Congress.

In a completely unexpected development, ClassicStar filed for chapter 11 bankruptcy protection in 2007. The Romanowski’s filed claim in the bankruptcy court and also filed separate claims against ClassicStar and against Greenberg Traurig.

Fast forwarding, the IRS challenged the whole deal as a hobby, wanting back over $4.7 million dollars of tax refunds. Oh, they also levied an accuracy penalty of over $950,000 to boot.

They go to court. The experts trot out onto the field. The IRS expert asserts that the activity “had absolutely no chance of making a profit”.

The Romanowski’s expert counters:

 “that there was absolutely no chance that any of the non-Thoroughbred horses listed on * * * would produce profitable foals.”

The expert argued that the quarter horses “were obviously placeholders” and that if ClassicStar “had honored their contract and provided Thoroughbred mares of at least the same quality as those * * * [eventually bred for petitioners] then there was definitely profit potential.”

Wow! And this is the taxpayers’ expert?

The Tax Court decided against the Romanowski's. They now owed well north of $4 million in taxes. The Court did however let them off the hook for the accuracy penalties, though. The Court felt that their reliance on an attorney was sufficient to avoid the penalty. Small victory, I suppose.

MY TAKE: The IRS took a risk, as they have lost their share of horse-related litigation. The courts have been receptive to the “long shot” argument: someone could legitimately keep funding a losing business if the payday would be outsized. Why would the IRS pursue the case? There is one feature here the IRS likes: the recognizable taxpayer name. No one would note or remember if you or I lost a tax case. Substitute Brad Pitt, however, and you have something.

But quarter horses ...? What was Romanowski thinking? The only way Romanowski could have made money off this deal is if he bought a lottery ticket while he was visiting Lexington.

Can Your Accountant Owe Your Payroll Taxes?

You own an accounting firm. A potential client is willing to pay you $4,900 month to do their accounting, including payroll. You will be writing checks and paying vendors, including deposits with the IRS.

Are you interested?

What can go wrong, you ask. Since this is a tax blog, you can anticipate that someone is going to step on the IRS’ or state tax agency’s tail, but that does not means that someone is automatically wrong. A significant part of my practice is representation, for example, which usually entails arguing that my client is right.

Buddy and Barry are brothers and together own an accounting firm. There is a North Carolina entrepreneur (Erwin) who owns or operated at least 60 restaurants. He has a new deal to start a Golden Corral franchise, which he does under the name GCAD. There will eventually be five franchises under GCAD. 

The restaurants start to lag. There is negative cash flow of approximately $2 million. Understandably, GCAD has difficulty paying its creditors. Erwin hires a new business manager (Pintner), who knows Buddy and Barry.  They are hired to handle the accounting and taxes for GCAD.

Buddy and Barry obtain data by accessing the restaurant computers remotely. After running payroll, they send the checks to Pintner for distribution to employees. GCAD allows them direct access to the bank account to remit withholdings. They do not need further authorization to make payroll tax deposits.

They are also responsible for paying vendors, but that process is a bit different. Initially they send checks for signature, but eventually they are given a signature stamp.

By the way, remember that they too are a vendor of GCAD. They are paid $4,900 a month.

The brothers are aware of the cash stress. They inform GCAD and Erwin that there is not enough money to pay everybody.

Erwin learns that the brothers had failed to remit payroll taxes. He and another partner fund a capital call, sending the brothers $150,000 with the following instructions:

“that absolutely under no circumstances whatsoever were [you] to be late with any taxes.”

That did not seem to take, and GCAD is again late with payroll taxes.

Business does not improve. Erwin obtains release from one of the leases. GCAD goes three more quarters without remitting payroll taxes. Erwin and his partners make another capital call.

Erwin eventually fires Buddy and Barry. He moves the accounting to North Carolina, and GCAD gets current with its payroll taxes. GCAD however does not pay its back taxes. It can’t. It needs all the money it has to remain in business.

GCAD finally folds.

Uncle Sam shows up, and he wants his payroll taxes. Erwin pays some, then immediately countersues to get the monies back. The IRS starts swinging, suing Erwin and Pintner and Buddy and Barry.

Erwin lawyers up. Pintner lawyers up. The brothers do not. They show up in court “pro se,” which means they are representing themselves. I consider that decision to be suicidal.

Why suicidal? The IRS considers the brothers a “responsible person,” and the IRS has a point. The brothers did have quite a bit of discretion over who was paid with the limited cash available. The IRS argues that it gets paid first, a point they are now emphasizing by going after Erwin and Pintner and the brothers for trust fund penalties. This is the “big boy” penalty, and it is 100 percent of the withholding taxes.

How did it turn out? Read the court’s verdict for yourself:

... the Light Brothers are jointly and severally indebted to the United States for the unpaid withholding taxes assessed against them, plus the applicable interest accruing according to law.”

The tab?  Try $325,734.

The monthly $4,900 fee was sweet, but not enough to cover the penalty.

Could representation have saved the brothers? I am speculating at this point, but I do not believe so. The brothers took on too many of the trappings of a corporate officer. The IRS would be harsh on their control over the checking account, for example. The IRS takes priority when it comes to payroll withholdings, and it reserves the right to disregard other vendors – even if not paying other vendors would put one out of business. The brothers paid other vendors (including themselves) before paying the IRS.  They walked directly into the IRS crosshairs.