Deducting Something You Did Not Pay For

What caught my eye was the amount of penalties at issue:

     Year                       Amount

     2002                       $  100,000

     2003                       $  105,000

     2004                       $1,822,000

     2005                       $1,785,000

     2006                       $1,355,000

The penalties total over $5.1 million. I had to look this case over, even though it weighs in at 123 pages.

It involves Martin Knapp, a CPA. He got his license in 1983.

He had worked at the IRS. He also taught accounting and taxation at Pepperdine and Los Angeles City College.

Not a bad resume, methinks.

He did something I never did: he specialized his practice. He focused on transportation workers, including airline pilots and railroad workers. He especially focused on mariners.

As of 2004 he employed 10 people.

Sounds successful to me.

He began his mariner practice around 1993. Two of his clients wound up in Tax Court, and it is there that our story begins.

The first client was Mr. Johnson, a deep-sea mariner. He would routinely work for four months and then take a two-month vacation.

The second was Mr. Westling, a tugboat captain in and around Alaska. He would work 30-day shifts on the tugboat.

Knapp amended Johnson’s return and prepared Mr. Westling’s return for 1996. He claimed a per diem for every day they were on the boat.

So what, right?

Here is the what: The per diem included a meal allowance, and their employers provided the meals.

I do not get it. How can someone get a deduction if that someone did not incur an expense in the first place?

The IRS flagged the returns, and both went to Tax Court.

Since they presented the same issue, the cases were consolidated.

In September, 2000 the Tax Court decided that neither could deduct meal expenses but they could deduct incidental expenses.

COMMENT: The incidental portion of a per diem is for tips and miscellaneous stuff, such as mouthwash. It is only a few bucks per day and nowhere near the amount allowed for meals. In short, there was a (very) minor victory and a very large defeat.

Mr Kapp did not represent in the Tax Court case, but he did read the decisions. He contacted the attorney who represented the IRS to request a face-to-face meeting. The attorney could not do this, as Kapp was an “interested” party. I could (hypothetically) have met with the attorney (as I had nothing to do with either Johnson or Westling), but Kapp was the CPA and therefore very much an interested party.

Kapp doubled down. He kept advising his clients that they could deduct meals even if meals were provided by their employer.

He tripled down. He created websites promoting his services to mariners and asserting that he could obtain tax refunds for them.

He quadrupled down. He wrote articles for Professional Mariner and The National Public Accountant. Here is an example:

The exciting news for mariners is that two U.S. Tax Court decisions last year settled the legal issue of allowing mariners to claim an almost unlimited amount of travel deductions while working away from home, without ever having to show the IRS any receipts, just like other transportation workers.”

Enter Examining Officer Tiffany Smith, who informed Kapp that he was the target of an IRS investigation for tax shelter promotion.

He sent her a 9-page letter detailing the relevant authority for the mariner deduction and arguing that the IRS does not oppose his position.

Does not oppose…?

Kapp wrote a letter he titled “Why is IRS Harassing Me for Twice Winning in U.S. Tax Court?”

This is going south ….

The investigation was transferred to George Campos, a revenue agent investigating tax promoters and abusive tax return preparers.

There is back and forth with Kapp and his attorney. In August, 2005 Campos and Kapp meet. Campos points out that there is no deduction for something one has not paid. Kapp asserts that “it does not matter if *** receive a meal or not, they’re still entitled to a deduction.”

Campos prepared an injunction.

Kapp’s attorney started to worry. He had an associate research the issue of mariners and meal deductions and memo the same. The result was pretty much the same as the IRS position, which was a bad place to be when you represent Kapp.

In early 2006 the Department of Justice sent Kapp a letter informing him that it was considering filing a lawsuit and providing him an opportunity to call and discuss the matter.

For all that is holy, Kapp, please STOP ….

At this point we are on page 55 of a 123-page court decision, and I am going to end it.

The IRS wanted him to stop. If he stops, he may yet walk away with all limbs still attached. Continue this quixotic quest, however, and he might lose it all.

The Court decided he was wrong and hardheaded. Not being without compassion, however, the Court reduced the penalties to $3,218,000.

There goes a lifetime of savings.

Oh, why, Kapp, why?

An Engineer Draws A Tax Penalty

We have spoken in the past about clients I would not accept: one with an earned income credit, for example. The tax Code requires me to go all social worker, obtaining and reviewing documents to have reasonable confidence that there is a child and said child lives in given household. There are penalties if I do not.

Not happening.

Did you know that I can be penalized for not signing a tax return as a paid professional? Yep, it is in Section 6694 for the home gamers.

I saw a penalty recently under Section 6701. That one is a rare bird.

The 6701 penalty can reach someone who is not a preparer but who “aids,” “assists” or “advises” with respect to information, knowing that it will be used in a material tax situation.

Here is an example: you gift majority control of your (previously) wholly-owned business to your kids. This would require a valuation, which in turn requires a valuation expert. That expert is probably not preparing the gift tax return, but the preparer of the gift tax return is relying – and heavily – on his/her work.

The penalty is $1,000 for each incident. Pray that you are not advising a corporation, as then it goes to $10,000 per incident.

The IRS recently trotted out Section 6701 in Chief Counsel Advice (CCA) 201805001. Think of a CCA as an IRS attorney advising an IRS employee on what to do.

The situation here involved a “tax-consultant engineer” who analyzed a taxpayer’s assets to determine the classification of property for depreciation purposes.

In the trade, we call this type of work “cost segregation.”

If you have enough money tied-up in certain types of depreciable assets, a “cost seg” may be a very good idea.

What drives the cost seg is an abnormally-long tax life for commercial property: usually 39 years.  It is a tax fiction, divorced from any economic analysis to build or not build or from a bank decision to lend or not lend.

The grail is to “carve out” some of that 39-year property into something that can be depreciated faster. There is room. The parking lot and landscaping, for example, can be depreciated over 15 years. Upgraded wiring to run equipment can be depreciated with the equipment. The additional plumbing at a dentist’s office? Yep, that gets faster depreciation.

But it probably requires a cost seg. Realistically, an accountant can do only so much. A cost seg really needs an engineer.

The engineer in this CCA must have left the plot, as the IRS was nearly out-of-its-mind over his classification into five-year property. The word they used was “egregious.”

Unfortunately, we are not told what he “egregiously” misclassified.

We are however told that he is getting the Section 6701 chop.

What is the math on this penalty?

Well, his misclassification affected five years of individual returns. The penalty would be 5 times $1,000 or $5,000 for each individual client. Hopefully this was a one-off, as $5 grand should be enough to get his attention.

Can you imagine if it had been a corporation?