Monday, May 28, 2018

Medical Deduction For Nonconventional Treatments

Is a tax deduction available for alternative medical care?

“Alternative” does not necessarily mean unusual. It includes, for example, chiropractic care. As a decades-long gym rat and chiropractic patient, I find that rather amusing.

What does the tax Code want to see before you are permitted a deductible medical expense?

You may ask: who cares? Starting in 2018 more and more people will claim the standard deduction rather than itemize under the new tax law. And – even if you itemize – what is the nondeductible percentage for medical expenses anyway – 2%, 7.5%, 10%, 100% of adjusted gross income? Congress abuses this deduction like an unwanted toy.

I’ll tell you why: because you have flexible spending accounts, health savings accounts and their siblings. To be reimbursable the expense must meet the definition of a deductible medical expense. This is a separate matter from whether you actually deduct any medical expenses on your tax return.

Let’s look at the Malev case.

Victoria Malev suffers from spinal disease. She had seen a chiropractor, but that offered only temporary and partial relief from pain.

You can probably guess the next type of doctor she would see, but Malev wanted nothing to do with surgery and its associated risks.

She instead decided to try four different alternative treatments.

The Court was diplomatic:
… Petitioner subscribed to various forms of treatment from four individuals, none of whom would be commonly recognized as a conventional medical caregiver. And to be sure, none of the methods utilized by these individuals would commonly be recognized as a conventional medical treatment. The methods Petitioner subscribed to might be termed “alternative medicine” by the polite, but we expect the less tolerant would characterize the treatments in other than legitimate or complimentary terms.”
When asked, Malev said that she had greatly improved.

She went to see an M.D a few years later – in 2016 – and the doctor suggested surgery. The doctor further suggested she investigate “integrative” medical care.

Seems to me she was already doing that.
Question: does she have a medical deduction?
The Court pointed out the obvious: had she seen the M.D. first, there would be no issue, as the M.D. recommended she investigate alternative medicine. By reversing the order, she was claiming medical deductions before the (traditional) medical diagnosis.

One can tell that the Court liked Malev. The Court acknowledged her “sincere belief” that the treatments received were beneficial, pointed out that she had not previously known the four providers and there was no reason to believe she would pay them except for the treatments given.

The Court looked at what the Code and Regulations do NOT require of deductible medical expenses:

(1) The services do not have to be furnished by one licensed to practice medicine in any particular discipline;
(2) The services do not have to be provided in-person;
(3) The services do not need to be universally accepted as effective; and
(4) The services do not have to be successful.

Malev could immediately use (1) and (3).

The Court was skeptical, but it wanted to allow for the wild card: the role a person’s state of mind plays in the treatment of disease.

Malev believed. The Court believed that she believed.

She got her medical deduction.

However, in an effort to indicate how fact-specific the case was, the Court continued:
… it is appropriate to note that we fully appreciate the position taken by the Respondent in this case, and [we] consider their position to be more than justified.”
I read Malev as a one-off. If you are thinking of alternative or integrative health care, see an M.D. – preferably an open-minded one – first. It will save both of us tax headaches.

Sunday, May 20, 2018

Blowing Up An IRA

I am not a fan of using retirement funds to address day-to-day financial stresses.

That is not to downplay financial stresses; it is instead to point out that using retirement funds too easily can open yet another set of problems.

Those who have followed me for a while know that I disapprove of using retirement funds to start a business: the so-called Rollovers as Business Startups, whose humorous acronym is ROBS. I know that – in a seminar setting – it is possible to mitigate the tax risks that ROBS pose. I do not however practice in a seminar setting. Heck, I am lucky if a client calls in advance to discuss whatever he/she is getting ready to do.

Let me give you a couple of ROBS pitfalls:

(1) You have your IRA buy a fourplex. You spend time cleaning, doing maintenance and repairs and routinely running to Home Depot.

Question: Is there a tax risk here?

(2) You have your IRA buy a business. You have your son and daughter run the business. You work there part-time and draw a paycheck.

Question: Is there a tax risk here?

The answer to both is yes. Consider:

(1) You are buying stuff at Home Depot, stuff that the IRA should have been buying - as the IRA owns the fourplex, not you. If you are over age 50, you can contribute $6,500 to the IRA annually. Say that you have already written that check for the year. You are now overfunding the IRA every time you go to Home Depot. Granted, one trip is not a big deal, but make routine trips – or incur a major repair – and the facts change. That triggers a 6% penalty – every year - until you take the money back out.

(2) There are restrictions on direct and indirect benefits from an IRA. You are receiving a paycheck from an asset the IRA owns. While arguable, I am confident that your paycheck is a prohibited benefit.

I am looking a Tax Court case where the taxpayer had her IRA lend $40,000 to her dad in 2005. A few years went by and she had the IRA lend $60,000 to a friend.

In 2013 she changed IRA custodians. The new custodian saw those two loans, and she had problems. Perhaps the custodian could not transfer the promissory notes. Perhaps there were no notes. Perhaps the custodian realized that a loan to one’s dad is not allowed. This part of the case is not clear.
COMMENT: It is possible to have an IRA lend money. I have a client who does so on a regular basis. Think however of acting like a bank, with due diligence, promissory notes, periodic interest and lending to nonrelated independent third-parties.
The IRS saw easy money:

(1)  There was a taxable distribution in 2013;
(2)  … and a 10% penalty for early distribution;
(3)  … and the “substantial understatement” penalty because the tax numbers changed enough to rise to the level of “substantial.”

How do you think it turned out for our tax protagonist?

Go back to the dates.

She loaned money to her dad in 2005.

Let’s glance over IRC Section 408(e)(2)
 (2)  Loss of exemption of account where employee engages in prohibited transaction.

(A)  In general. If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year.

The loan was a prohibited transaction. She blew up her IRA as of January 1, 2005. This means that she should have reported ALL of her IRA as taxable income in 2005, of which we can be quite sure she did not.

Can the IRS assess taxes for 2005?

Nope. Too many years have gone by. The standard statute of limitations for assessments is three years.

So, the IRS will tag her in 2013, right?

Nope, they cannot. For one thing, the prohibited transaction did not occur in 2013, and the IRS is not allowed to time-travel just because it serves their purpose.

But there is a bigger reason. Read the last part of Sec 408(e)(2) again.

There was no IRA in 2013. There could be no distribution, no 10% penalty, none of that, as “that” would require the existence of an IRA.

And there was no IRA.

The name of the case for the home gamers is Marks v Commissioner.

Sunday, May 13, 2018

Penalties And Reliance On A Tax Professional

I am working a penalty appeal case. The owner was fortunate: the business survived. There was a time when his fate was uncertain.

The IRS is being … difficult. The IRS considers “reasonable cause” when considering whether to mitigate or abate many penalties. The idea is simple enough: would a “reasonable” person have acted the same way, knowing his/her responsibility under the tax law?

That is a surprisingly high standard, considering that there are professionals who spend a career mastering the tax law. There is stuff in there that no reasonable person would suspect. I know. I make a living at it.

Back to my appeal case: take an overworked and overstressed business owner. He is facing the more-than-unlikely possibility of bankruptcy. It is the end of the year and his accountant mails him W-2s for distribution to employees. He does so and puts the envelope on a stack of paperwork. He forgets to send the employer copies to the IRS. Granted, this is not as likely to happen today with electronic filing, but it did happen and not so many years ago.

The IRS nails him. Mind you, he distributed the W-2s to the employees. He filed all the quarterly reports, he made all the tax deposits. He had a bad day, a messy office and forgot to put a piece of paper in the mail.

Do you think he has reasonable cause – at least to reduce the penalties - considering all the other factors in his favor?  I think so. The IRS thinks otherwise.

Here is another one: you hire me to prepare an estate return. These things are rare enough. First of all, someone has to die. Second, someone has to have enough assets to be required to file. I tell you that the return is due next March. It turns out I am wrong, and the return is actually due in February.

The IRS sends a you a zillion-dollar penalty notice for filing the estate return late.

Do you have reasonable cause?

You might think this is relatively straightforward, but you would be wrong.

Let’s go through it:
(Q) Did you hire a professional?
(A) Yes
(Q) Was the professional qualified?
(A) I presume so. He/she had initials after their name.
(Q) Did you disclose all facts to the professional?
(A) I think so. Someone died. I presume the professional would prompt and question me on matters I would not know or have thought of.
(Q) Did you rely on the professional for matters of tax law?
(A) Uh, yes. Do you know what these accountants charge?
(Q) I mean, as opposed to something you can look up yourself.
(A) What do you mean?
That last one is alluding to a “ministerial” act. Think signing a return, putting a stamp on the envelope and dropping it in the mailbox. All the hard lifting is done, and it is time to break down and throw away the moving boxes.

Sounds easy enough.

Until someone pulls the rug out from underneath you by changing the meaning of “ministerial.”

That someone was the Supreme Court in Boyle, when it decided that a taxpayer’s reliance on a tax professional for an estate return’s due date was not enough. The taxpayer knew that a return was required. The taxpayer could not “delegate” the responsibility for timely filing by …. accepting the tax professional’s advice on when the return was due.

If that sentence makes no sense, it is because Boyle makes no sense outside the fantasy world of a tax zealot.

If you go to see a dentist, are you required to study-up on dental compounds, as the decision to use silver rather than composite could be deemed “ministerial?”

The IRS, sniffing an opportunity to ram even more penalties down your throat, has taken Boyle and characterized it to mean that reliance on a tax professional can never rise to reasonable cause.

As a tax professional, I take offense at that.

The IRS gets occasionally stopped in its tracks, fortunately, but not often enough.

I practice. I am only too aware that “it” happens. It is not a matter of being irresponsible or lacking diligence or other snarky phrases. It is a matter that one person – or a very small group of people – is multitasking as management, labor, owner, analyst, financier, ombudsman and so on. Perhaps you are a business owner thinking that you waited too long on replacing that employee who left…  did you call the insurance agent about the new business vehicle … you have to find time to talk to the banker about increasing your credit line… hey, did you see something from the accountant in the mail?

Yes, I get frustrated with the IRS and its unrealistic “reasonable” standard. Reasonable should be real-world based and not require pilgrimage to a Platonic ideal. Life is not a movie. “It” happens, even in an accounting firm. Yes, accountants make mistakes too.

Rounding back, though, there is one thing you must show if you are arguing that you relied on a tax professional.

I am reading the recent Keenan case. This thing has to do with Section 419 plans, which are employee welfare plans that were unfortunately abused by charlatans. The abuse is simple enough. Set up a welfare plan, preferably just for you. Stuff the thing to the gills with life insurance. Deduct everything for a few years. Then close the plan, buy the insurance for a pittance and meet with a financial planner about retirement.

The IRS got cranky – understandably - and starting looking at these things as tax shelters.

Which means outsized penalties.

So Keenan was in a penalty situation. He points at the accountant and says “Hey, I relied on you to keep me out of trouble.”

Problem: the taxpayer did whatever the taxpayer was going to so. There was sweet money at the end of that rainbow. Accountant? Please.

Not that the accountant was without fault. He should have researched these things harder. If he then had reservations, he should have either insisted on the correct tax reporting or have fired Keenan as a client.

The correct reporting is not hard. You can take the deduction, but you have to flag it for the IRS. The IRS can then pursue or not, but you met your responsibility. I have done so myself when a partner has brought in a hyper-aggressive client. By doing so I am protecting both my license and the client from those outsized penalties.

That was not going to happen with Keenan.

Keenan lost the case for the most obvious reason: to argue reliance on a professional you have to actually rely on a professional.

Sunday, May 6, 2018

Tax Return That Surprised An Accountant

Let’s do something a little different this time.

I want you to see numbers the way a tax CPA does.

Let’s say that you are semi-retired and you bring me your following tax information:

                    W-2                                         24,000
                    Interest income                            600
                    Qualified dividend income      40,000
                    Long-term capital gains          10,000
                    IRA                                         24,000

Looks to me like you have income of $98,600.

How about deductions?

                    Real estate taxes                    10,000
                    Mortgage interest                      5,000
                    Donations                                26,000

I am seeing $41,000, not including your exemptions.

You did some quick calculations and figure that your federal taxes will be about $6,500. You want to do some tax planning anyway, so you set up an appointment. What can you do to reduce your tax? 

What do I see here?

I’ll give you a hint.

Long-term capital gains have a neat tax trick: the capital gains tax rate is 0% as long as your ordinary income tax rate is 15% or lower. This does not mean that you cannot have a tax, mind you. To the extent that you have taxable income in excess of those capital gains, you will have tax.

Let’s walk though this word salad.

Income $98,600 – deductions $41,000 – exemptions $8,100 = $49,500 taxable income.

You have capital gains of $10,000.

Question: will you have to pay tax on the difference – the $39,500?

Answer: qualified dividends also have a neat tax trick: for this purpose, they are taxed similarly to long-term capital gains.
NOTE: Think of qualified dividends as dividends from a U.S. company or a foreign company that trades on an U.S. exchange and you are on the right path.
You have capital gains and qualified dividends totaling $50,000.

Your taxable income is $49,500.

All of your taxable income is qualified dividends and capital gains, and you never left the 15% tax bracket.

What is your tax?


How is that for tax planning, huh?

From a tax perspective, you hit a home run.

Let me change two of the numbers so we can better understand this qualified dividend/capital gain/taxable income/15% tax bracket thing.

                    W-2                                         36,000
                    Qualified dividends                 28,000

As you probably can guess, I left your taxable income untouched at $49,500, but I changed its composition.

You now have capital gains and qualified dividends of $38,000. Your taxable income is $49,500, meaning that you have “other” income in there. You are going to have to pay tax on that “other” income, as it does not have that qualified dividend/capital gain trick.

The tax will be $1,153.

You still did great. It is just that no tax beats some tax any day of the week.

It is something to consider when you think about retirement planning. We are used to thinking about 401(k)s, deductible IRAs, Roth IRAs, social security and so on, but let’s not leave out qualified dividends and capital gains. Granted, capital gains are unpredictable and not a good fit for reliable income, but dividend-paying stocks might work for you. When was the last time Proctor & Gamble missed a dividend payment, for example?

OK, I admit: if you leave the 15% tax bracket the above technique fizzles. That however would take approximately $76,000 taxable income for marrieds filing jointly. Congrats if that is you.

BTW I saw scenario one during tax season (I tweaked the numbers somewhat for discussion, of course). The accountant was perplexed and asked me to look at the return with him. The zero tax threw him.

Now he knows the dividend/capital gain thing, and so do you.