How To Hack Off An IRS Auditor

Let’s discuss an excellent way to anger a revenue agent auditing your tax return.

Eric and Mary Kahmann have owned a jewelry business for 45 years. They report the business on their personal return as a proprietorship (that is, a Schedule C). they primarily sell at shows throughout the United States, although they also sell through Amazon and PayPal.

PayPal introduces a tax variable: Form 1099-K.

Yep, another blasted 1099. This time Congress was concerned that people were selling stuff (through Amazon, for example) and not correctly reporting their income. Amazon will sell your stuff, but the cash is likely going through Pay Pal or its equivalent. Do enough business and PayPal will send you a 1099-K at the end of the year.

Issue number one.

In addition, Mr. Kahmann’s two brothers were also in the jewelry business. Whereas they did not work with or for him, they would use his two merchant accounts to process payments.

Issue number two.

The IRS audited the Kahmann’s 2011 year.

Why? Who knows. What did not help were the following numbers:

Gross sales reported by the Kahmanns     $128,070

Gross sales reported on the 1099-Ks         $151,834

Guess what? This happens quite a bit, and it does not necessarily mean shenanigans. I will give you one example:

Customer refunds

If one accounts for customer refunds by subtracting them from sales, one can have the above discrepancy. The 1099-K does not – of course – know about any refunds.

The revenue agent asked for bank statements.

COMMENT: This has become standard IRS procedure for a Schedule C audit. It means nothing. You can however flame it into roaring meaningfulness by …

The Kahmanns refused to provide the bank statements.

Brilliant!  

I would seriously consider firing a client who did that to me. Is it a pain? Yes. Will the bank charge you for the copies? Yep. Is it fair? Fair is beside the point. It is what it is.

The revenue agent issued a summons to the bank for the three accounts she knew about. 

COMMENT: Yes, the IRS can get to those accounts. In addition, now the agent has to question whether she knows about all your accounts. Your chances of getting her to believe anything you say are falling fast.

Let’s grade the Kahmanns’ conduct during this audit so far:

                  F

The agent got the bank statements and added up all the deposits. The total was $169,603.

Wait, it gets better.

She could not trace one of the 1099-Ks into the bank statements, so she added that number ($15,745) to the $169,603. She now calculated gross receipts as $188,073.

The Kahmanns have a problem.

They have to show that some of those deposits were not income. Could be. Perhaps they borrowed money. Perhaps they transferred monies between accounts. Perhaps they received family gifts.

Perhaps Mr. Kahmann deposited his brothers’ PayPal transactions, given that they were using his merchant accounts.

There are two technical issues here that a tax nerd would recognize:

(1) There is recourse to having the IRS add-in $15,745 from a 1099-K just because the agent could not figure-out how it was deposited. A taxpayer can shift the burden of proof back to the IRS, meaning that the IRS is going to need something more than a piece of paper with “1099-K” printed somewhere on it.

There is a catch: you must cooperate with the IRS during the exam. Guess who did not cooperate by refusing to provide bank statements?

Bingo!

(2) Alternatively, a taxpayer can show that the deposits are not income.

Say that a deposit belonged to Kahmann’s brother. You can have the brother (or his accountant, more likely) show that the deposit was included in gross sales reported on the brother’s tax return.

It’s a pain, but it is not brain surgery.

The Kahmanns provided letters from the brothers.

The IRS wanted to meet with the brothers.

The brothers did not want to meet with the IRS.

The Kahmanns submitted books and records to support their tax return. The handwriting appeared to have been written all at once rather than over the year. The ink was also the same throughout.

Unlikely. Suspicious. Dumb.

You can guess how this wound up.

The Court agreed with the IRS recalculation of income. The Kahmanns owed big bucks. There were penalties too. 

Normally I am quite pro-taxpayer.  Am I sympathetic this time?

Not a bit.

Being Unemployed, Depressed And Owing The IRS

The case is 55 pages long.

Even a tax guy gets tired of marathon reading.

The story got me fired up, however, so let’s talk about it.

A frequent area of taxpayer request for IRS relief from penalties is rollovers of retirement monies, especially IRAs. Used to be that one filed for a Private Letter Ruling to obtain official absolution. Those bad boys are not cheap, as you will pay a tax CPA or attorney to draft the PLR, as well as pay the IRS filing fee. The filing fee alone can run you $10,000.

In 2016 the IRS published Revenue Procedure 2016-47 allowing for alternate means of absolution without requesting a PLR. Even the IRS got tired of taking your money.

Mr Trimmer was a retired cop with the New York Police Department. He was moving on after 20 years with the NPD, taking a security job with the New York Stock Exchange. He needed the job to supplement his pension, as he had two sons going through college. The new job however fell through. He was hosed, as the NYPD does not rehire.

And Trimmer went major depressive. He was antisocial, rarely left the house, neglected his hygiene and grooming – all the classic symptoms.

Somewhere in there he received two retirement checks: one for $99,990 and a second for $710. They lay on his dresser for weeks until he finally got around to depositing them into … his checking account.

COMMENT: If you were thinking a rollover, he flubbed because the roll did not go into an IRA account.

Months later Trimmer and his wife met with their accountant for their taxes. The accountant advised that he transfer the monies to an IRA immediately.

COMMENT: Trimmer was well outside the 60-day window at that point.

The IRS sent him a notice asserting that he failed to report over $100,000 of income and demanded taxes, penalties, interest, a Weimaraner puppy and a month’s pass to Planet Fitness.

It added up close to $40.000.

Yipes!

Trimmer wrote back to the IRS: 

    Dear Sirs:

I am contesting the amount of money said to be owed. Please allow me to explain the situation. In April 2011 I retired from my job and took a pension loan. After my retirement I went through a period of depression and was not managing my affairs. I received my check for the loan and deposited it into Santander bank on July 5, 2011. The money remained in this account until April of 2012 when it was switched to an I.R.A. in the same bank where it remains to this day.

A few points

- There was no deception or spending, investing of the money at all. I received the check and deposited it into the bank.

- My wife and I have been paying taxes for a combined 60 years and NEVER had the least bit a problem.

- There was no harm done to anyone with the money staying in the bank except me (I was receiving 0.25% interest.)

- I switched the money to an I.R.A. before I was notified by the I.R.S.

I am now employed again and am driving a school bus and have a son in college and another a year away. To pay $40,000 in taxes for money that is in an I.R.A. would absolutely cripple my family as it would be 3 years of my salary. Sir no harm was done to anyone. I went through a rough time upon separation from my job, causing me emotional hard times that caused this situation. Penalizing me and my family would not benefit anybody, only cause extreme duress and punish my children who played no part in this situation. I ask you to consider these facts and please come to a fair decision. Please contact me if you need at [phone number redacted].

Thank You,

John Trimmer

I feel sorry for the guy.

Here is the IRS reply:

“The law requires you to roll over your distribution within 60 days of the distribution date. If the roll over exceeds the time frame it becomes fully taxable.”

Nice folk over there.

Here is the tax issue: The IRS can issue waivers for this penalty, but they did not mention such fact to Mr Trimmer or how to apply for a waiver. Heck, they did not even reference Trimmer’s unfortunate circumstances. A reasonable person could question whether anyone even read his letter.

The IRS sent a Statutory Notice of Deficiency, also known as a 90-day letter.

Trimmer filed with the Tax Court.

The IRS went right for the throat:

•  Trimmer did not follow procedures (Rev Proc 2013-16 for the nerds).
• This made the hardship waiver provision “inapplicable.”
•  Since Trimmer had not pressed the point, there technically had been no “final administrative determination.”
• Without that “final,” the Tax Court had no authority over the case.
• In any event, Trimmer had never explained why he was unable to accomplish the two rollovers within 60 days.
• And where is that puppy?

Well, thank you Darth.

The Tax Court seemed to like Trimmer:

(1) OK, so he did not follow procedures.

(2) Not so quick, Sith Lord. How does the IRS reconcile 2003-16 with the following from the Internal Revenue Manual:

Examiners are given the authority to recommend the proper disposition of all identified issues, as well as any issued raised by the taxpayer.”

(3) The examiner’s authority to consider a hardship waiver “strongly implies” that the taxpayer may request the waiver.

COMMENT: 

(4) From the Court:

As might be expected from a self-represented taxpayer unversed in the technicalities of the tax law, he did not expressly cite section 402(c)(3)(B). But his letter leaves little doubt that he was seeking a hardship waiver of the 60-day rollover requirement….”

(5) The Court points out that the examiner 

… did not decline to consider Mr. Trimmer’ request, did not request that petitioners provide any additional information, and did not advise them that they were required to submit a private letter request or do anything else in particular to have their request considered.”

(6) If anything, the examiner wrote Mr. Trimmer that

… you do not need to do anything else for now. We will contact you within 60 days to let you know what action we are taking.”

(7) And 3 days later the examiner

… wrote petitioners again, denying requested relief, not on the basis that petitioners had requested it in the wrong manner or had provided insufficient information, but on the basis of cursory and incomplete legal analysis that failed to take into account the provision for hardship waivers under section 402(c)(3)(B).”

The Tax Court found in favor of Trimmer. He could do a late rollover. He was not subject to tax or penalty and could keep his Weimaraner puppy.

Good.

But it should not have gone this far. We are not in unexplored tax country here.

One could argue that our tax system is near-to breaking when you have to hire a professional to resolve near-routine tax problems. This man did not roll-over his money within 60 days. He was clinically depressed for a while. I can see requesting a doctor’s letter attesting to the taxpayer’s condition, but this is not cutting-edge tax practice.  

So why the HBO-level drama?

Here is one commentator’s remark:

We have a lazy revenue agent who probably just glances over the response. Is it the revenue agent’s fault? No, I don’t blame the revenue agent. With budget cuts, the caseloads of revenue agents are insane.”

I was listening until the “overworked” card. Seriously? I recommend this revenue agent not consider a career as a tax CPA, although – as a positive – it would probably be a short one.  

I do think our case highlights a disturbingly under-skilled IRS employee.

I also think it shows a trigger-happy IRS assessing penalties on anyone for anything. That examiners are throwing them around like sugar packets from a McDonalds drive-through indicates that they are under pressure to sweeten the take, irrespective of whether penalties are appropriate. Those penalties are under-the-table income to an IRS already facing a tight budget.

We have spoken before of a goose-and-gander bill, requiring the IRS to pay a taxpayer when the agency acts recklessly. The IRS already has people on payroll to pin your ears back, whereas you have to hire someone like me to fend them off. Their incremental cost to chase you is minimal, but your incremental cost to defend yourself can be significant if not ruinous.

Our goose-and-gander bill might or might not have protected Trimmer specifically, but eventually the IRS would lose enough cases to reconsider the automatic-tax-and-penalty-no-reasonable-cause-raised-middle-finger policy it has adopted. Cutting a check really focuses one’s attention.

The Qualified Small Business Stock Exemption

Let’s say that you are going to start your own company. You talk to me about different ways to organize:

(1) Sole proprietor – you wake up in the morning, get in your car and go out there and shake hands. There is no paperwork to file, unless you want to get a separate tax ID number. You and your proprietorship are alter-egos. If it gets sued, you get sued.

(2) Limited liability company – you stick that proprietorship in a single-member LLC, writing a check to your attorney and secretary of state for the privilege. You gain little to nothing tax-wise, but you may have helped your attorney (and yourself) if you ever get sued.

(3) Form a corporation - a corporation is the old-fashioned way to limit your liability. Once again there is a check to your attorney and secretary of state. Corporations have been out there long before LLCs walked the land.

You then have to make a decision as to the tax flavor of your corporation: 

a.    The “C” corporation – think Krogers, Proctor & Gamble and Macy’s. The C is a default for the big boys – and many non-bigs. There are some goodies here if you are into tax-free reorganizations, spin-offs and fancy whatnot.

Problem is that the C pays its own tax. You as the shareholder then pay tax a second time when you take money out (think a dividend) from the C.  This is not an issue when there are a million shareholders. It may be an issue when it is just you.

b.    The “S” corporation – geared more to the closely-held crowd. The S (normally) does not pay tax. Its income is instead included on your personal tax return. Own 65% of an S and you will pay tax on 65% of its income, along with your own W-2, interest, dividends and other income.

This makes your personal return somewhat a motley, as it will combine personal, investment and business income into one. Don’t be surprised if you are considered big-bucks by the business-illiterate crowd.

The S has been the go-to corporate choice for family-owned corporations since I have been in practice. A key reason is avoiding that double-tax.

But you can avoid the double tax by taking out all profits through salaries, right?

There is a nerdy issue here, but let’s say you are right.

Who cares then?

You will. When you sell your company.

Think about it. You spend years building a business. You are now age 65. You sell it for crazy money. The corporation pays tax. It distributes whatever cash it has left-over to you.

You pay taxes again.

And you vividly see the tax viciousness of the C corporation.

How many times are you going to flog this horse? Apple is a multinational corporation with a quarter of a trillion dollars in the bank. Your corporate office is your dining room.

The C stinks on the way out.

Except ….

Let’s talk Section 1202, which serves as a relief valve for many C corporation shareholders when they sell.

You are hosed on the first round of tax. That tax is on the corporation and Section 1202 will not touch it.

But it will touch the second round, which is the tax on you personally.

The idea is that a percentage of the gain will be excluded if you meet all the requirements.

What is the percentage?

Nowadays it is 100%. It has bounced around in prior years, however.

That 100% exclusion gets you back to S corporation territory. Sort of.

So what are the requirements?

There are several:

(1) You have to be a noncorporate shareholder. Apple is not invited to this soiree.

(2) You have owned the stock from day one … that is, when stock was issued (with minimal exceptions, such as a gift).

(3) The company can be only so big. Since big is described as $50 million, you can squeeze a good-sized business in there. BTW, this limit applies when you receive the stock, not when you sell it.

(4) The corporation and you consent to have Section 1202 apply.

(5) You have owned the stock for at least 5 years.

(6) Only certain active trades or businesses qualify.

Here are trades or businesses that will not qualify under requirement (5):

(1) A hotel, motel, restaurant or similar company.

(2) A farm.

(3) A bank, financing, leasing or similar company.

(4) Anything where depletion is involved.

(5) A service business, such as health, law, actuarial science or accounting.

A CPA firm cannot qualify as a Section 1202, for example.

Then there is a limit on the excludable gain. The maximum exclusion is the greater of:

(1) $10 million or

(2) 10 times your basis in the stock

Frankly, I do not see a lot of C’s – except maybe legacy C’s – anymore, so it appears that Section 1202 has been insufficient to sway many advisors, at least those outside Silicon Valley.

To be fair, however, this Code section has a manic history. It appears and disappears, its percentages change on a whim, and its neck-snapping interaction with the alternative minimum tax have soured many practitioners.  I am one of them.

I can give you a list of reasons why. Here are two:

(1) You and I start the company.

(2) I buy your stock when you retire.

(3) I sell the company.

I get Section 1202 treatment on my original stock but not on the stock I purchased from you.

Here is a second:

(1) You and I start the company.

(2) You and I sell the company for $30 million.

We can exclude $20 million, meaning we are back to ye-old-double-tax with the remaining $10 million.

Heck with that. Make it an S corporation and we get a break on all our stock.

What could make me change my mind?

Lower the C corporation tax rate from 35%.

Trump has mentioned 15%, although that sounds a bit low.

But it would mean that the corporate rate would be meaningfully lower than the individual rate. Remember that an S pays tax at an individual rate. That fact alone would make me consider a C over an S.

Section 1202 would then get my attention.

The Foreign Income Exclusion When You Leave Mid-Year

We have a client who worked as a contractor in Afghanistan last year.

Let’s talk foreign income exclusion.

There are ropes.

The first is simple: to get to that exclusion you (a) must be a bona fide resident of a foreign country or (b) you have to be outside the United States for a certain number of days.

The bona fide exception is few and far between, and I doubt Afghanistan-as-a-destination would ever enter the conversation. In my experience, bona fide means a military, military-contractor or foreign service person (or family) who went overseas and did not return. There are only so many of those folks.

Nope, you and I (likely) have to meet a second test: the “physical presence” test. You and I have to be outside the United States for at least 330 days in a 365-day stretch.

A few things about this:

(1) 365 days does not necessarily mean a calendar year. It just needs to be 365 successive days. It does not have to end on December 31 or start on January 1.

(2) Let’s say that you are overseas for years. You can reset that 365-day period every year, as long as you can get to 330 days each time you reset.

(3) It does not mean that you have to be in the same country for 330 days. It just means that you have to be outside the United States. You can travel like a fiend – as long as you do not come back to the U.S.

(4) This is an all-or-nothing test. Botch the 330 days and you get nothing. There is no participation trophy here.

The maximum 2016 foreign income exclusion is $100,800.

Wait! There is a second calculation.

You have to prorate $100,800 by the number of days you were outside the U.S.

Huh?

Leave the U.S. late in the year – say August – and most of the exclusion disappears. Why? An August departure means the most you can claim is 5/12 of the maximum exclusion.

This second calculation very much means a calendar year.

And there you have the reason for much confusion in this area: there are two 12-month tests. The first one does not care whether your 12 months line-up with the calendar. The second one definitely means a calendar year.

Let’s recap:

(1) Take a 365-day period. It does not have to start on January 1; you can start it whenever you want.

a.    You need 330 days.

b.    Implicit in that statement is that some of those 330 days may have occurred in the calendar year before or following. It doesn’t matter. The 365 does not need to be in the same calendar year.

c.     Fail this test and you are done.

d.    Pass this test and you have a shot at winning the $100,800 prize.

(2) Next calculate how many days you were outside the U.S. in 2016. Divide that number by 365, giving you a ratio. We will call the ratio Mortimer.

a.    Multiply Mortimer by $100,800.

b.    The result is your maximum 2016 foreign income exclusion.

The first year can be a tax surprise for an American working overseas. It was for our client.

Why?

He was counting on the full $100,800.

What went wrong?

He did not leave the United States until April.

He was not happy.