The IRS Goes Rounds With Cohan

 

The decision begins with the IRS seeking taxes of $805,149, $1,145,104, $1,161,864, and $831,771 for years 2013 through 2016. The penalties were unsurprisingly also enormous.

I want to know what happened here.

The taxpayer was Mohammad Nasser Aboui, and he was the sole shareholder of an S corporation called HPPO. He owned several used vehicle lots, and in 2009 he put them into HPPO as its initial corporate capitalization.

It sounds like a tough business:

·       Most of HPPO customers had bad credit.

·       Many did not have a checking account and instead paid HPPO in cash.

·       HPPO financed between 90% and 95% of its sales.

·       Customers repaid their loans less than 10% of the time.

·       HPPO repossessed approximately 25% of the cars it sold within 3 or 4 months.

·       HPPO had quite the barter system going with its mechanics: the mechanic would work on HPPO cars in exchange for rent of HPPO’s garage space.

Around 2014 Aboui decided to close the business. There were serious family health issues and HPPO was not making any money.

The IRS started its audit in September 2015.

HPPO’s accountant was ill at the time and later died.

To its credit, the IRS waited.

More than 3 years later HPPO engaged another accountant to represent the audit.

The second accountant made immediate mistakes, such as getting HPPO’s accounting method wrong when dealing with the IRS Revenue Agent (RA).

COMMENT: More specifically, the accountant told the RA that HPPO used the overall cash basis of accounting. HPPO did not. In fact, it could not because inventory was a material income-producing factor.

The RA wanted HPPO’s books and records, including access to its accounting software. HPPO could provide much but not the software. Its software license expired when it left the vehicle business in 2018.

This is a nightmare.

HPPO did eventually reactivate the software, but it was too late to help with the RA.

The RA – being told by the second accountant that HPPO used the cash basis of accounting – decided to use bank statements to reconstruct gross income.

BTW HPPO wound up dismissing the second accountant.

The results were odd: HPPO had reported more sales for 2013 through 2015 – nearly $3.25 million - than was deposited at the bank.

The pattern reversed in 2016 when HPPO deposited approximately $539 grand more than it reported in sales.

COMMENT: I have an idea what happened.

The RA also saw following bad debt expense:

          2013             $1,069,739

          2014             $ 668,537

          2015             $ 902,967

          2016             $ 436,738    

Here is something about the cash basis of accounting: you cannot have bad debt expense. It makes sense when you remember that gross income is reported as monies are deposited. Bad debts are receivables that are never collected, meaning there is nothing to deposit. One never leaves home plate.

So, the RA disallowed the bad debt expense entirely.

I am pretty sure about my earlier hunch.

The RA also determined that HPPO had distributed the following monies to Aboui, one way or another:

          2013             $2,476,301

          2014             $1,704,329

          2015             $1,406,893

2016             $1,934,033

There were other issues too.

Off they went to Tax Court.

Remember what I said about reactivating the accounting software license? Aboui now presented thousands of pages to document cost of sales and other expenses. The Court encouraged the IRS to accept and review the new records.

The IRS said, “nah, we’re good.”

COMMENT: Strike one.

The Court started its opinion with HPPO’s sales.

The RA stated to the Court that HPPO used the overall cash basis of accounting.

Don’t think so, said the Court. The Court saw HPPO using the accrual basis of accounting for sales and the cash basis of accounting for everything else.

COMMENT: This is referred to as a hybrid method: a pinch of this, a sprinkle of that. If one is consistent – and the results are not misleading – a hybrid is an acceptable method of accounting.

The Court asked Treasury why it thought that HPPO used the cash basis of accounting.

Treasury replied that it had never said that.

The Court pointed out that the RA had said that she understood HPPO to be a cash basis taxpayer. To be fair, that is what the second accountant had told her.

Nope, never used the cash method insisted Treasury.

COMMENT: An explanation is in order here. Treasury Department attorneys take over when the matter goes to Court. Perhaps the attorneys meant “direct” Treasury. The RA – while working for the IRS which itself is part of the Treasury – would then be “indirect” Treasury. I am only speculating, as this unforced error makes no sense. Clearly it bothered the Court.

Strike two.

The Court then reasoned why HPPO was reporting more sales than it deposited in the bank: it was reporting the total vehicle sale price in revenues at the time of sale. That also explained the bad debt expense: HPPO financed most of its sales and most of those loans went sour.

But why the reversal in 2016?

Aboui explained to the Court that by 2016 he was closing the vehicle business. He would have slowed and eventually stopped selling cars, with the result that he would be depositing more in the bank than he currently sold.

The Court decided that HPPO had correctly recorded its sales for the years at issue.

Next came the cost of vehicles sold.

This accounting was complicated because so much cash was running through the business. Sometimes cash was used to immediately pay expenses without first being deposited into a bank account – NOT a recommended accounting practice.

The RA had also identified certain debits to HPPO’s bank account that were either distributions or otherwise nondeductible.

The Court could find no evidence that those identified debits had been deducted on the tax returns.

The RA – and by extension, the … Treasury – was losing credibility.

Aboui meanwhile provided extensive documentation of HPPO’s expenses at trial. Some of these were records the Court had asked the IRS to accept and review – and which the IRS passed on.

Here is the Court:

Petitioners provided extensive documentation at trial to substantiate the COGS and business expenses. Mr. Aboui testified that HPPO was unprofitable. Given the record in its entirety, we find that petitioners have substantiated HPPO’s COGS and business expenses as reported on HPPO’s returns for each year at issue, except for meal and entertainment expenses of …..”

COMMENT: Strike three.

The Court went to the bad debts.

Mr. Aboui credibly testified that he was unable to repossess approximately 250 cars during the years at issue. The loss of these cars adequately substantiates the amount of HPPO’s bad debt deductions for the years at issue under the Cohan rule.”

The Court went to the distributions.

Respondent determined that petitioners failed to report approximately $7.5 million in taxable distributions from HPPO during the years at issue.”

COMMENT: Remember that HPPO is an S corporation, and Aboui would be able to withdraw his invested capital – plus any business income he had paid taxes on personally but left in the business – without further tax. This amount is Aboui’s “basis” in his S corporation stock.

Here is the Court:

Respondent argues that petitioners have not established Mr. Aboui’s basis in HPPO during the years at issue. We disagree and that the record and Mr. Aboui’s credible testimony provides sufficient evidence for us to reasonably estimate his basis under the Cohan rule.”

The IRS won a partial victory with the distributions. The Court thought Aboui’s basis in HPPO was approximately $5.1 million.

The IRS had wanted zero basis.

The effect was to reduce the excess distributions to $$2.4 million ($7.5 minus $5.1).

Still, it was a rare win for the IRS.

Excess distributions are taxable. Aboui had taxable distributions of $2.4 million. Yes, it is a lot, but it is also a lot less than the IRS wanted.

COMMENT: The nerd part of me wonders how the Court arrived at an estimate of $5.1 million for Aboui’s basis. Unfortunately, there is no further explanation on this point.

Oh, one more thing from the Court:

… we hold that petitioners are not liable for any penalties.”

While not contained within the four corners of this decision, I am curious why the Court repetitively went to the Cohan rule. I have followed this literature for years, and this result is not normal. Courts generally expect a business to maintain an accounting system that produces reliable numbers. Yes, every now and then there may be a leak in the numbers, and the court may use Cohan to plug said leak. That is not what we have here, though. This boat was sinking.

Perhaps Aboui presented his case well.

Mr. Aboui was incredibly forthright in his testimony.”

And perhaps the IRS should not have argued that an RA – an IRS employee – is not the IRS.

Our case this time was Aboui and Mizani v Commissioner, T.C. Memo 2024-106.