When A Tax Audit Is Not An Audit

 

I am cleaning-up files here at Galactic Command. I saw an e-mail from earlier this year chastising someone for running business deposits through a personal account.

I remember.

He wanted to know why his extension payment came in higher than expected.

Umm, dude, you ran umpteen thousands of dollars through your personal account. I am a CPA, not a psychic.

Let’s spend some time in this yard.

If you are self-employed – think gig worker – and are audited, the IRS is almost certain to ask for copies of your bank accounts. Not just the business account(s), mind you, but all your accounts, business and personal.

I have standard advice for gig workers: open a separate business account. Make all business deposits to that account. Pay all business expenses from that account. When you need personal money, draw the needed amount from the business account and deposit to your personal account.

This gives the accountant a starting point: all deposits are income until shown otherwise. Expenses are trickier because of depreciation, mileage, and other factors.

Is it necessary?

No, but it is best practice.

I stopped counting how many audits I have represented over the years. I may not win the examiner’s trust with my record-keeping, but I assure you that I will win their distrust without it.

Does the examiner want to pry money from you? You bet. Examiners do not like to return to their managers with a no-change.

Will the examiner back-off if all the “i’s” are dotted? That varies per person, of course, but the odds are with you.

And sometimes unexpected things happen.

Let’s look at the Showalter case.

Richard Showalter (RS) owned a single-member LLC. The LLC in turn had one bank account with Wells Fargo.

This should be easy, I am thinking.

RS did not file a tax return for 2013.

Yep, horror stories often start with that line.

The IRS prepared a substitute for return (SFR) for 2013.

COMMENT: The IRS prepares the SFR with information available to it. It will add the 1099s for your interest and dividends, the sales price for any securities trades, any 1099s for your gig, and so forth. It considers the sum to be taxable income.

         Where is the issue?

Here’s one: the IRS does not spot you any cost for securities you sold. Your stock may have gone through the roof, but the odds that it has no cost is astronomical.

Here is another. You have a gig. You have gig expenses. Guess what the IRS does not include in its SFR? Yep, you get no gig expenses.

You may be thinking this has to be the worst tax return ever. It is leaving out obvious numbers.

Except that the IRS is not trying to prepare your tax return. It is trying to get your attention. The IRS throws an inflated number out there and hopes that you have enough savvy to finally file a tax return.

So, RS caught an SFR. The IRS sent him a 90-day notice (also known as a statutory notice of deficiency or SNOD), which is the procedure by which the IRS can move your file to Collections. You already know the tender mercies of IRS Collections.

RS responded to the SNOD by filing with the Tax Court. He wanted his business expenses.

Well, yeah.

RS provided bank statements. The IRS went through and – sure enough – found about $250 grand of deductions, either business or itemized.

That turned out rather well for RS. He should have done this up-front and spared himself the headache.

Then the IRS looked at his deposits. Lo and behold, they found another hundred grand or so that RS did not report as income.

It is not taxable, said RS.

Prove it, said the IRS.

RS did not.

COMMENT: It is unclear to me whether this disputed deposit was fully or partially taxable or wholly nontaxable. The deposit came from a closing statement. Maybe I am being pedantic, but I expect a cost for every sale. The closing statement for the sale is not going to show cost. Still, RS did not argue the point, so ….  

Now think about what RS did by getting into IRS dispute.

RS filed with the Tax Court because he wanted his deductions. Mind you, he could have gotten them by filing a return when required. But no, he did this the hard way.

He now submitted invoices and bank statements to support his deductions.

However, using bank statements is an audit procedure. Why is the IRS using an audit procedure?

Well, he is in Tax Court and all. He picked the battleground.

Had RS filed a return, the IRS might have processed the return without examination or further hassle. Since bank statements are an examination step, the IRS would never have seen them.

Just saying.

Was this this fair play by the IRS?

The Court thought so. The IRS cannot run wild. There must be a “minimal evidentiary showing” tying the taxpayer to potential income. The IRS added up his deposits; that exceeded what he reported as income. Seems to me the IRS cleared the required “minimal” hurdle.

By my reckoning, RS should still come out ahead. The IRS bumped his income by a smidgeon less than a hundred grand, but they also spotted him around a quarter million in business and itemized deductions. Unless there is crazy in that return, this should have improved his tax compared to the SFR.

Our case this time was Richard Showalter v Commissioner, T.C. Memo 2022-114.

No Deduction For African Sculpture

 

You can anticipate the final decision when you read the following sentence:

One does not need to be a tax expert to open his eyes and read plain English.”

This time we are talking about art. Expensive art. And donations of said expensive art.

I am not a fan of the minutiae in this area. It strikes me as a deliberate gambit to blow-up an otherwise laudable donation for what one could consider ministerial oversight, but such is the state of tax law.

Then again, the taxpayer side of these transactions tends to have access to high-powered professional advice, so perhaps the IRS is not being intractable.

Still, one likes to see reasonable application of the rules, with acknowledgement that not everyone has advanced degrees and decades of experience in tax practice. Even if one does, there can be disagreement in reading a sentence, the interpretation of a comma, the precedence of a prior case, or the interplay - or weighting - of related tax provisions. Or maybe someone is overworked, exhausted, running the kids to activities, attending to aging parents and simply made - excuse a human foible - a mistake. 

It used to be known as reasonable cause and can be grounds for penalty abatement. I remember it existing when I was a younger tax practitioner. Today? Not so much.

One way to (almost certainly) blow reasonable cause?

Be an expert. I doubt the IRS would ever allow reasonable cause on my personal return, for example.

Let’s look at the Schweizer case.

Heinrich Schweizer was a high-powered art advisor.

He better not get into it with the IRS about art donations, then.

Schweizer received a law degree in Germany. He then worked an internship with Sotheby’s in New York City. When the internship ended, he returned to Germany to pursue a PhD, a goal interrupted when Sotheby’s recruited him for a position in their African art department. He there served as Director of African and Oceanic Art from 2006 to 2015. He increased the value of the annual auctions and provided price estimates at which customers might sell their art at auction. He also worked closely with Sotheby’s appraisal department in providing customers with formal appraisals.

Schweizer filed his first US tax return in 2007. He hired a CPA firm to help with the tax return. He continued this relationship to our year in question.

In 2011 Schweizer made a substantial donation to the Minneapolis Institute of Art (MIA). He donated a Dogon sculpture that he had acquired in Paris in 2003. The deduction was $600 grand.

The accountants filed for an extension and contacted the IRS Art Appraisal Services (AAS) unit.

COMMENT: One can spend a career in tax and never do this. AAS provides advice and assistance to the IRS and taxpayers on valuation questions. A reason to contact AAS is to obtain a statement of value (SOV) after donating but before filing a tax return. The donor can rely on the SOV as support for the value deducted on the tax return. It is – by the way – not easy to get into AAS. The minimum ticket is a $50 grand donation as well as a filing fee for time and attention.

Schweizer obtained his SOV. All he had to do now was file his return and include the magic forms (Form 8283 with all the required signatures and secret handshakes, a copy of the appraisal, yada yada).

Guess what he did not do?

No properly completed Form 8283, no copy of the appraisal, nothing.

Remember: form is everything in this area of the tax law.

Off to Tax Court they went.

His argument?

His failure to meet the documentation requirements was due to reasonable cause and not willful neglect.

 Move me with a story.

He received and reasonably relied on advice from the accounting firm that it was unnecessary to include either a qualified appraisal or a fully completed Form 8283 with his 2011 return.

Why would I believe this?

Because the IRS already had these documents through the SOV process.

I know the conclusion is wrong, but it gives me pause.

OK, reliance on tax advice can be grounds for reasonable cause. He will of course need the firm to back up his story ….

The spokesman for the firm testified but did not corroborate, in any respect, Schweizer’s testimony about the alleged advice.”

Well, that seems to be prompting a malpractice suit.

Schweizer’s attorney will have to cross-examine aggressively.

And petitioner’s counsel asked no questions of […] squarely directed to this point.”

Huh? Why not?

The fact that petitioner did not seek corroborative testimony from the person who might have supplied it weighs against him.”

Well, yeah. If someone can bail you out and they fail to do so, the Court will double-down on its skepticism.

Now it became a matter of whom the Court believed.

To tighten the screws even further, the Court noted that – even if the firm had told Schweizer that he need not include a phonebook with his tax return - the Court did not believe that Schweizer would have relied on such advice in good faith.

Why not, pray tell?

Schweizer was a high-powered art advisor. He was also trained in law. He had done this - or something very similar - for clients at Sotheby’s over the years. The Court said: he knew. He may not have been an expert in tax, but he had been up and down this stretch of road enough to know the rules.

There was no deduction for Schweizer.

Our case this time was Schweizer v Commissioner, T.C. Memo 2022-102.

A House And A Specialized Trust

I saw a QPRT here at Galactic Command recently,

It had been a while. These things are not as common in a low interest rate environment.

A QPRT (pronounced “cue-pert”) is a specialized trust. It holds a primary or secondary residence and – usually – that is it.

Why in the world would someone do this?

 I’ll give you a common example: to own a second home.

Let’s say that you have a second home, perhaps a lake or mountain home. The children and grandchildren congregate there every year (say summer for a lake home or the holidays for a mountain home), and you would like for this routine and its memories to continue after you are gone.

A couple of alternatives come immediately to mind:  

(1)  You can bequeath the property under will when you die.

(2)  You can gift the property now.

Each has it pros and cons.

(1) The property could continue to appreciate. If you have significant other assets, this appreciation could cause or exacerbate potential estate taxes down the road.

(2) You enjoy having and using the property and are not quite ready to part with it. You might be ready years from now - you know: when you are “older.”

A QPRT might work. Here is what happens:

(1) You create an irrevocable trust.

a.    Irrevocable means that you cannot undo the trust. There are no backsies.

(2) You transfer a residence to the trust.

a.    The technique works better if there is no mortgage on the property. For one thing, if there is a mortgage, you must get money into the trust to make the mortgage payment. Hint: it can be a mess.

(3) You reserve the right to use the property for a period of years.

a.    This is where the fancy planning comes in.

b.    It starts off with the acknowledgement that a dollar today is more valuable than a dollar a year (or years) from now. This is the “time value of money.”

c.    At some point in time the property is going to the kids and grandkids, but … not … right …now.     

d.    If the property is worth a million dollars today, the time value of money tells us that the gift (that is, when the property goes to the kids and grandkids) must be less than a million dollars.  

e.    There is a calculation here to figure out the amount of the gift. There are three key variables:

                                               i.     The age of the person making the gift

                                             ii.     The trust term

                                           iii.     An interest rate

A critical requirement of a QPRT is that you must outlive the trust term. The world doesn’t end if you do not (well, it does end for you), but the trust itself goes “poof.” Taxwise, it would be as if you never created a trust at all.

(4) There is a mortality consideration implicit here. The math is not the same for someone aged 50 compared to someone aged 90.

(5) Your retained right of use is the same thing as the trust term. You probably lean toward this period being as long as possible (if a dollar a year from now is worth less than a dollar today, imagine a dollar ten years from now!). That reduces the amount of the gift, which is good, but remember that you must outlive the trust term. There is push-and-pull here, and trust terms of 10 to 15 years are common.

We also need an interest rate to pull this sled. The government fortunately provides this rate.

But let’s go sidebar for a moment.

Let’s say you need to put away enough money today to have $5 a year from now. You put it in a bank CD, so the only help coming is the interest the CD will pay. Let’s say the CD pays 2%. How much do you have to put away today?

·      $5 divided by (100% + 2%) = $4.90

OK.

How much do you have to put away if the CD pays 6%?

·      $5 divided by (100% + 6%) = $4.72

It makes sense if you think about it. If the interest rate increases, then it is doing more of the heavy lifting to get you to $5. Another way to say this is that you need to put less away today, because the higher interest is picking up the slack.

Let’s flip this.

Say the money you are putting in the CD constitutes a gift. How much is your gift in the first example?

$4.90

How much is your gift in the second example?

$4.72

Your gift is less in the second example.

The amount of your gift goes down as interest rates go up.

What have interest rates been doing recently?

Rising, of course.

That makes certain interest-sensitive tax strategies more attractive.

Strategies like a QPRT.

Which explains why I had not seen any for a while.

Let me point out something subtle about this type of trust.

·      What did we say was the amount of the gift in the above examples?

·      Either $4.90 or $4.72, depending.

·      When did the gift occur?

·      When the trust was funded.

·      When do the kids and grandkids take over the property?

·      Years down the road.

·      How can you have a gift now when the property doesn’t transfer until years from now?

·      It’s tax magic.

But what it does is freeze the value of that house for purposes of the gift. The house could double or triple in value before it passes to the kids and grandkids without affecting the amount of your gift. That math was done upfront and will not change.

A couple of more nerd notes:

(6) We are also going to make the QPRT a “grantor” trust. This means that we have introduced language somewhere in the trust document so that the IRS does not consider the QPRT to be a “real” trust, at least for income tax purposes. Since it is not a “real” trust, it does not file a “real” income tax return. If so, how and where do the trust numbers get reported to the IRS? They will be reported on the grantor’s tax return (hence “grantor trust”). In this case, the grantor is the person who created the QPRT.

(7)  What happens after 10 (or 15 or whatever) years? Will the trust just kick you out of the house?

Nah, but you will have to pay fair-market rent when you use the place. It is not worst case.

There are other considerations with QPRTs – like selling the place, qualifying for the home sale exclusion, and forfeiting the step-up upon the grantor’s death. We’ll leave those topics for another day, though.

How A Drug Dealer Then Affects Marijuana Taxation Today

 

I spent substantial time last week reviewing and researching issues related to the marijuana industry. There is one Code section – Section 280E – that overpowers almost all tax planning in this area.

That section came into the Code in 1982.

It came in response to a Tax Court decision.

Let’s talk about it.

Here is the Court setting the table:

During …, petitioner Jeffrey Edmonson was self-employed in the trade or business of selling amphetamines, cocaine, and marijuana. His primary source of controlled substances was one Jerome Caby, who delivered the goods to petitioner in Minneapolis on consignment. Petitioner paid Caby after the drugs were sold. Petitioner received on consignment 1,100,000 amphetamine tablets, 100 pounds of marijuana, and 13 ounces of cocaine during the taxable year 1974. He had no beginning inventory of any of these goods and had an ending inventory of only 8 ounces of cocaine.

What got this bus in motion was a 1961 Supreme Court decision holding that everyone who made money – whether through legal or illegal activities – had to pay taxes on that money.

Edmonson got busted.

The IRS came in with a jeopardy assessment.

The IRS was concerned about Edmonson skipping, hence the jeopardy. This assessment causes all taxes, penalties, and interest to become immediately due. This allows to IRS to exercise its Collections powers (liens, levies, not answering phone calls for extreme durations) on an expedited basis.

Edmonson might not have been too concerned about po-po, but he wasn’t about to mess with the IRS. Although he did not keep books and records (obviously), he came up with a bunch of expenses to reduce his taxable income.

The IRS said: are you kidding me?

Off they went to Tax Court.

Edmonson went green eyeshade.

·      He calculated cost of goods sold for the amphetamines, marijuana, and cocaine

·      He calculated his business mileage

·      He had business trips and meals

·      He paid packing expenses

·      He had bought a small scale

·      He used a phone

·      He even deducted an office-in-home

The IRS, on the other hand, reduced his cost of goods sold and simply disallowed all other expenses.

The Court reduced or disallowed some expenses (it reduced his office in home, for example), but it allowed many others, including his cost of goods sold.

Here is the Court:

Petitioner asserts by his testimony that he had a cost of goods sold of $106,200. The nature of petitioner’s role in the drug market, together with his appearance and candor at trial, cause us to believe that he was honest, forthright, and candid in his reconstruction of the income and expenses from his illegal activities in the taxable year 1974.

The Edmonson decision revealed an unanticipated quirk in the tax Code. This did not go over well with Congress, which closed the Edmonson loophole by passing Code section 280E in 1982:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

This Code section pretty much disallows all business deductions (marijuana is classified as a controlled substance), except for cost of goods sold. Cost of goods sold is not considered a deduction in the tax Code; rather it is a subtraction from gross receipts to arrive at gross income. Think about a business where you could not deduct (most or all) your salaries, rent, utilities, taxes, insurance and so on. That is the headwind a marijuana business faces.

Meanwhile, things around us have changed greatly since 1982. Marijuana is legal in 21 states, and medical marijuana is legal in almost twice that number. Colorado by itself has collected over $2 billion in taxes since legalizing marijuana. There are publicly traded companies in the marijuana industry. There are even ETFs should you want to invest in this sector.

And that is how we have business activity that may be legal under state law but is illegal under federal law. The federal tax Code taps into federal law – that is, the Controlled Substances Act – and that tap activates Section 280E and its harsh tax result. 

Our case this time was Edmonson v Commissioner, T.C. Memo 1981-623.