An IRS Employee And Unreported Income

 

You may have heard that Congress is tightening the 1099 reporting requirements for third party payment entities such as PayPal and Venmo. The ultimate goal is to report cumulative payments exceeding $600. Because of implementation issues, the IRS has adjusted this threshold to $5,000 for 2024.

Many, I suspect, will be caught by surprise.

Receiving a 1099-K does not necessarily mean that you have taxable income. It does mean that you were paid by one of the reporting organizations, and that payment will be presumed business-related. This is of concern with Venmo, for example, as a common use is payment of group-incurred personal expenses, such as the cost of dining out. Venmo will request one to identify a transaction as business or personal, using that as the criterion for IRS reporting  

What you cannot do, however, is ignore the matter. This IRS matching is wholly computerized; the notice does not pass by human eyes before being mailed. In fact, the first time the IRS reviews the notice is when you (or your tax preparer) respond to it. Ignore the notice however and you may wind up in Collections, wondering what happened.

The IRS adjusted the 2004 and 2005 returns for Andrea Orellana.

The IRS had spotted unreported income from eBay. Orellana had reported no eBay sales, so the computer match was easy.

There was a problem, though: Orellana worked for the IRS as a revenue officer.

COMMENT: A revenue officer is primarily concerned with Collections. A revenue agent, on the other hand, is the person who audits you.

Someone working at the IRS is expected to know and comply with his/her tax reporting obligations. As a revenue officer, she should have known about 1099-Ks and computer matching.

It started as a criminal tax investigation.

Way to give the benefit of the doubt there, IRS.

There were issues with identifying the cost of the items sold, so the criminal case was closed and a civil case opened in its place.

The agent requested and obtained copies of bank statements and some PayPal records. A best guess analysis indicated that over $36 thousand had been omitted over the two years.

Orellana was having none of this. She requested that the case be forwarded to Appeals.

Orellana hired an attorney. She was advised to document as many expenses as possible. The IRS meanwhile subpoenaed PayPal for relevant records.

Orellana did prepare a summary of expenses. She did not include much in the way of documentation, however.

The agent meanwhile was matching records from PayPal to her bank deposits. This proved an unexpected challenge, as there were numerous duplicates and Orellana had multiple accounts under different names with PayPal.

The agent also needed Orellana’s help with the expenses. She was selling dresses and shoes and makeup and the like. It was difficult to identify which purchases were for personal use and which were for sale on eBay.

Orellana walked out of the meeting with the agent.

COMMENT: I would think this a fireable offense if one works for the IRS.

This placed the agent in a tough spot. Without Orellana’s assistance, the best she could do was assume that all purchases were for personal use.

Off they went to Tax Court.

Orellana introduced a chart of deposits under dispute. She did not try to trace deposits to specific bank accounts nor did she try to explain – with one exception - why certain deposits were nontaxable.

Her chart of expenses was no better. She explained that any documents she used to prepare the chart had been lost.

Orellana maintained that she was not in business and that any eBay activity was akin to a garage sale. No one makes a “profit” from a garage sale, as nothing is sold for more than its purchase price.

The IRS pointed out that many items she bought were marketed as “new." Some still had tags attached.

Orellana explained that she liked to shop. In addition, she had health issues affecting her weight, so she always had stuff to sell.

As for “new”: just a marketing gimmick, she explained.

I always advertise as new only because you can get a better price for that.” 

… I document them as new if it appears new.”

Alright then.

If she can show that there was no profit, then there is no tax due.

Orellana submitted records of purchases from PayPal.

… but they could not be connected or traced to her.

She used a PayPal debit card.

The agent worked with that. She separated charges between those clearly business and those clearly personal. She requested Orellana’s help for those in between. We already know how that turned out.

How about receipts?

She testified that she purchased personal items and never kept receipts.

That would be ridiculous, unheard of. Unless there was some really bizarre reason why I keep a receipt, there were no receipts.”

The IRS spotted her expenses that were clearly business. They were not enough to create a loss. Orellana had unreported income.

And the Court wanted to know why an IRS Revenue Officer would have unreported income.

Frankly, so would I.

Petitioner testified that she ‘had prepared 1040s since she was 16’ and that she ‘would ‘never look at the instructions.’”

Good grief.

The IRS also asked for an accuracy penalty.

The Court agreed.

Our case this time was Orellana v Commissioner, T.C. Summary Opinion 2010-51.

Firing A Client

We fired a client.

Nice enough fellow, but he would not listen. To us, to the IRS, to getting out of harm’s way.

He brought us an examination that started with the following:

We filed in Tax Court. I was optimistic that we could resolve the matter when the file returned to Appeals. There was Thanos-level dumb there, but there was no intentional underreporting or anything like that.

It may have been one of the most demanding audits of my career. The demanding part was the client.

Folks, staring down a $700 grand-plus assessment from the IRS is not the time to rage against the machine.  An audit requires documentation: of receipts, of expenses. Yes, it is bothersome (if not embarrassing) to contact a supplier for their paperwork on your purchases in a prior year. Consider it an incentive to improve your recordkeeping.

At one point we drew a very harsh rebuke from the Appeals Officer over difficulties in providing documentation and adhering to schedules. This behavior, especially if repetitive, could be seen as the bob and weave of a tax protester, and the practitioner involved could also be seen as enabling said protestor.

As said practitioner I was not amused.

We offered to provide a cash roll to the AO. There was oddball cash movement between the client and a related family company, and one did not need a psychology degree to read  that the AO was uncomfortable. The roll would show that all numbers had been included on the return. I wanted the client to do the heavy lifting here, especially since he knew the transactions and I did not. There were a lot of transactions, and I had a remaining book of clients requiring attention. We needed to soothe the AO somehow.

He did not take my request well at all.

I in turn did not take his response well.

Voices may have been raised.

Wouldn’t you know that the roll showed that the client had missed several expenses?

Eventually we settled with the IRS for about 4 percent of the above total. I knew he would have to pay something, even if only interest and penalties on taxes he had paid late. 

And that deal was threatened near the very end.

IRS counsel did not care for the condition of taxpayer’s signature on a signoff. I get it: at one point there was live ink, but that did not survive the copy/scan/PDF cycle all too well. Counsel wanted a fresh signature, meaning the AO wanted it and then I wanted it too.

Taxpayer was on a cruise.

I left a message: “Call me immediately upon return. There is a wobble with the IRS audit. It is easily resolved, but we have time pressure.”

He returned. He did not call immediately. Meanwhile the attorneys are calling the AO. The AO is calling me. She could tell that I was beyond annoyed with him, which noticeably changed her tone and interaction. We were both suffering by this point.

The client finally surfaced, complaining about having to stop everything when the IRS popped up.

Not so. The IRS reduced its preliminary assessment by 96%. We probably could have cut that remaining 4% in half had we done a better job responding and providing information. Some of that 2% was stupid tax.”

And second, you did not stop everything. You had been in town a week before calling me.”

We had a frank conversation about upping his accounting game. I understand that he does not make money doing accounting. I am not interested in repeating that audit. Perhaps  we could use a public bookkeeper. Perhaps we could use our accountants. Perhaps he (or someone working for him) could keep a bare-boned QuickBooks and our accountants would review and scrub it two or three times a year.

Would not listen.

We fired a client.

Filing A Zero-Income Tax Return

Here’s a question:

Would you file a tax return if you have no income – or minimal income - to report?

I would if there was a refund.

I also lean to filing if one has a history of tax filings.

The former is obvious, unless the incremental cost of filing the return is more than the refund.

The latter is because of my skepticism. I do not want a letter from the IRS stating they have not received a tax return for name-a-year. Granted, the issue should be easily resolved, but I have lost track of how many should-be’s have turned out to not-be.

Another reason is a rerun of Congress’ decision to automatically send advance payments back in 2021 – specifically, the child tax credit.       

You were ahead of the game by having filed a prior year return.

Ruben Varela filed a 1040EZ for 2017. It showed a refund of $1,373.

OK.

Ruben attached four Forms 4852 Substitute for Form W-2.

This form is used when an employer fails to send a W-2, among other situations. It happens and I see one every few years. But four …? That is odd.

The 4852’s that Ruben prepared showed zero wages.

And the $1,373 included Social Security and Medicare taxes., taxes which are not refundable.

Ruben, stop that yesterday. This is common tax protestor nonsense.

Let’s read on. There was third party reporting (think computer matching) for wages of $11,311 and cancellation of indebtedness income of $1,436.

Not surprisingly, the IRS considered it a protest filing and assessed a Section 6702(a) penalty.

§ 6702 Frivolous tax submissions.

(a)  Civil penalty for frivolous tax returns.

A person shall pay a penalty of $5,000 if-

(1)  such person files what purports to be a return of a tax imposed by this title but which-

(A)  does not contain information on which the substantial correctness of the self-assessment may be judged, or

(B)  contains information that on its face indicates that the self-assessment is substantially incorrect, and

(2)  the conduct referred to in paragraph (1) -

(A)  is based on a position which the Secretary has identified as frivolous under subsection (c) , or

(B)  reflects a desire to delay or impede the administration of Federal tax laws. 

That caught Ruben’s attention, and he disputed the penalty. On to Tax Court they went.

How can I owe a penalty if there was NO TAX, argued Ruben.

On first impression, it seems a reasonable argument.

But this is tax. Let’s look at that Code section again. 

              Such person files ….                                                      OK

              What purports to be a tax return …                                OK

      Does not contain information on

   which the substantial correctness …                             ?

 

Let’s talk about this last one. The Tax Court has a history of characterizing “zero” W-2s as both substantially incorrect and not containing sufficient information allowing one to judge the self-assessment of tax.

We have a third “OK.”

Back to Section 6702.

Is there any reference in Section 6702 to whether the return did or did not show tax due?

I am not seeing it.

The Court did not see it either.

They upheld the Section 6702 penalty.

The IRS wanted more, of course. They also wanted the Section 6673 penalty.

§ 6673 Sanctions and costs awarded by court

This penalty can be imposed when somebody clogs the Court in order to impede tax administration. The penalty can be harsh.

How harsh?

Up to $25 grand of fresh-brewed harsh.

The Court noted they had not seen Ruben Varela before nor was it aware of him previously pursuing similar arguments. They declined to impose the Section 6673 penalty, but …

We caution petitioner that a penalty may be imposed in future cases before this Court should he continue to pursue these misguided positions.”

The Court was warning him in the strongest legalese it could muster.

Our case this time was Ruben Varela v Commissioner, T.C. Memo 2024-92.

 

Whose Job Is It Anyway?

One of our accountants asked me recently:

R:      Do you think [so and so] qualifies as a real estate professional?

CTG: I do not know [so and so]. Tell me a little.

R:      Husband pulls a W-2.

CTG: How much and how many hours?

R:      Blah blah dollars.

CTG: Works in real estate?

R:      Nah.

CTG: Hours?

R:      Maybe 2,000.

CTG: Is the wife in real estate?

R:      No.

I have told you (almost) everything you need to answer the question.

Let’s look at the Warren case.

James Warren organized Warren Assisted Living, LLC in 2015.

He purchased a group home in 2016.

He started repairing the home almost immediately.

In 2017 he worked at Lockheed Martin for 1,913 hours as an engineer.

On his 2017 tax return he claimed a $41 thousand-plus loss from the group home. He claimed he was a real estate professional.

Warren did not keep time logs.

What sets this up are the passive activity rules under Section 469. As initially passed, that Section considered rental activities (with minimal exceptions) to be “per se” passive.

The passive activity rules would then stifle your ability to claim losses. You – for the most part – had to wait until you had income from the activity. You could then use the losses against the income. 

Well, that caught real estate landlords and others around the country by surprise. When you do one thing, it is difficult to have a Congressional staffer decide that your thing is not a regular thing like the next thing across the street.

Congress made a change.

(c)(7)  Special rules for taxpayers in real property business.

 

(A)  In general. If this paragraph applies to any taxpayer for a taxable year-

 

(i)  paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and

(ii)  this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.

 

Notwithstanding clause (ii) , a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

 

(B)   Taxpayers to whom paragraph applies. This paragraph shall apply to a taxpayer for a taxable year if-

 

(i)  more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

(ii)  such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

 

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

The above is called the real estate professional exception. It is a mercy release from the per se rule that would otherwise inaccurately (and unfairly) consider people who work in real estate all day to not be working at all.

It has two main parts:

(1) You have to spend at least 750 hours working in real estate, and

(2)  You have to spend more than 50% of your “working at something” total hours actually “working in real estate.”

If you are a real estate professional, you avoid the “per se” label. You have not yet escaped the passive activity rules – you still have to show that you worked - but at least you have the opportunity to present your case.

The Court looked at Warren’s 1,913 hours at Lockheed. That means he would need 3,827 total hours for real estate to be more than ½ of his total work hours. (1,913 times 2 plus 1).

First of all, 3,827 total hours means he was working at least 74 hours a week, every week, without fail, for the entire year.

Maybe. Doubt it.

Warren is going to need really good records to prove it.

Here is the Court:

Mr Warren did not keep contemporaneous logs of his time renovating the group home.”

Not good, but not necessarily fatal. I represented a client who kept Outlook and other records. She created her log after the fact but from records which themselves were contemporaneous. Mind you, we had to go to Appeals, but she won.

In preparation for trial, Mr Warren created – and presented – two time logs.”

Good grief.

The first log maintained that he worked 1,421 hours at the group home; it was created one week before trial.”

End it. That is less than his 1,913 hours at Lockheed.

The second log maintained that Mr. Warren worked 1,628 at the group home; it was created the night before trial.”

Why bother?

This was a slam dunk for the Court. They did not have to dwell on contemporaneous or competing logs or believability or whether the Bengals will turn their season around. Whether 1,421 or 1,628, he could not get to more-than-50%.

Warren lost.

As a rule of thumb, if you have a full-time W-2, it will be almost impossible to qualify as a real estate professional. The exception is when your full-time W-2 is in real estate, maybe with an employer such as CBRE or Cushman & Wakefield.  At 1,900-plus Lockheed hours, I have no idea what Warren was thinking, although I see that it was a per se case. That means he represented himself, and it shows.

I suppose one could have a W-2 and work crazy hours and meet the more-than-50% requirement, but your records should be much tighter. And skip the night before thing.

BTW another way to meet this test is by being married.

Look at (B)(ii) again:

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

If your spouse can meet the test (both parts), then you will qualify by riding on the shoulders of your spouse.

Our case this time was Warren v Commissioner, T.C. Summary Opinion 2024-20.

Some Thoughts After The Tax Filing Deadline(s)

 

There is something happening in the public accounting profession. The profession itself is aging. The AICPA expected 75% of practicing CPAs to reach retirement age by 2020 – which was four years ago. Many smaller firms do not have succession plans, meaning that an owner’s retirement plan likely involves being acquired by another firm. Fewer college students are pursuing accounting majors, placing stress on recruiting and retaining accountants in the early years of their career. We see firms releasing clients and sometimes entire lines of practice. I know of one which released its trust work, which surprised me. I contributed to this several years ago when we released our inbound (that is, international) work. These clients still need professional advice, but fewer CPAs are providing these services.

On the flip side, it is a great time for someone to start (or grow) an accounting practice. A challenge here is step growth – that is, growth that requires hiring. One circles back to the issue of the talent shortage. A bad hire is damaging, perhaps even more so in a small firm.

Even the IRS is not immune to the talent shortage. In 2019 the IRS employed approximately 75,000 people. The Inflation Reduction Act supposedly provided funds to hire an additional 87,000 people through the year 2031. It hasn’t, of course, as the IRS is competing with every other employer in the market.

I suspect the profession has done much of the damage to itself. One can easily point to the 150-hour requirement for a CPA license. That may have made sense years ago, but with today’s exorbitant college costs that additional year of class, books and housing might be difficult to justify.

And then we have the toxicity of the profession itself. I cannot recall the last time that a CPA my age has not shared his/her “horror” stories: the stress, hours, near-impossible deadlines, psychopathic personalities, power dynamics and whatnot. I remember a managing partner bringing cigars so we could “talk”; we sat outside, and he explained how infeasible it was for me to visit my ailing grandmother in Florida. My grandmother died that year. I also left the firm that year. I suspect Gen Z will not tolerate this behavior as passively, and rightfully so.   

Congress has greatly exacerbated the problem with its never-ending and wildly metastasizing tax changes. It used to be that accountants would spread their tax work over the course of the year by placing their business clients on a fiscal year – that is, a tax year ending other than December 31. This allowed work to be distributed more sanely over the year. Congress changed this in 1986 by requiring almost everyone to use the calendar year. Yes, there was an “out,” and the out was for the business to pay a “deposit” for taxes it would have paid had it changed to a calendar year. I suspect that – even if not a CPA – you can guess how well those client conversations went. Combine that with Congress’ recent-enough 1099 reporting fetish and you have a crippling steamroller than begins in January and ends … well, who know when.  

I think we overstretched ourselves here at Galactic Command this year. Potential clients are calling for appointments, and it can be hard (for some of us) to say no. After the just-concluded September and October extension deadlines, however, we must learn to say no. We do not have the resources, and we are burning the resources – including me – that we do have.    

Then there is AI – will artificial intelligence replace any/some/much of what a CPA does? Depending on what the accountant does, I suppose it is possible. First year audit work, for example, scarcely requires a 150-hour degree. That might be a viable onramp for AI. Then again, I remember when QuickBooks was going to put accounting services departments out of business. It didn’t, and accounting services is one of the most sought-after practice areas in accounting firms today. Will AI take away much of my 1040 workload? 

I hope so.