Can You Really Be Working If You Work Remotely?

Have you ever thought of working remotely?

Whether it is possible of course depends on what one does. It is unlikely a nurse could pull it off, but could an experienced tax CPA…?  I admit there have been moments over the years when I would have appreciated the flexibility, especially with out-of-state family.

I am looking at a case where someone pulled it off.

Fred lived in Chicago. He sold his company for tens of millions of dollars.

COMMENT: I probably would pull the (at least semi-) retirement trigger right there.

He used some of the proceeds to start a money-lending business. He was capitalizing on all the contacts he had made during the years he owned the previous company. He kept an office downtown at Archer Avenue and Canal Street, and he kept two employees on payroll.

Fred called all the shots: when to make loans, how to handle defaulted loans. He kept over 40 loans outstanding for the years under discussion.

Chicago has winters. Fred and his wife spent 60% of the year in Florida. Fred was no one’s fool.

But Fred racked up some big losses. The IRS came a-looking, and they wanted the following:

                   Year                          Tax

                   2009                     $336,666

                   2011                     $  90,699

                   2012                     $109,355

The IRS said that Fred was not materially participating in the business.

What sets this up are the passive activity rules that entered the Code in 1986. The IRS had been chasing tax-shelter and related activities for years. The effort introduced levels of incoherence into the tax Code (Section 465 at risk rules, Section 704(b) economic substance rules), but in 1986 Congress changed the playing field. One was to analyze an owner’s involvement in the business. If involvement was substantial, then one set of rules would apply. If involvement was not substantial, the another set of rules would.

The term for substantial was “material participation.”

And the key to the dichotomy was the handling of losses. After all, if the business was profitable, then the IRS was getting its vig whether there was material participation or not.

But if there were losses….

And the overall concept is that non-material participation losses would only be allowed to the extent one had non-material participation income. If one went net negative, then the net negative would be suspended and carryover to next year, to again await non-material participation income.

In truth, it has worked relatively well in addressing tax-shelter and related activities. It might in fact one argued that it has worked too well, sometimes pulling non-shelter activities into its wake.

The IRS argued that Fred was not materially participating in 2009, 2011 and 2012. I presume he made money in 2010.

Well, that would keep Fred from using the net losses in those respective years. The losses would suspend and carryover to the next year, and then the next.

Problem: Sounds to me like Fred is a one-man gang. He kept two employees in Chicago, but one was an accountant and the other the secretary.

The Tax Court observed that Fred worked at the office a little less than 6 hours per day while in Chicago. When in Florida he would call, fax, e-mail or whatever was required. The Court estimated he worked 460 hours in Chicago and 240 hours in Florida. I tally 700 hours between the two.

The IRS said that wasn’t enough.

Initially I presumed that Barney Fife was working this case for the IRS, as the answer seemed self-evident to me. Then I noticed that the IRS was using a relatively-unused Regulation in its challenge:

          Reg § 1.469-5T. Material participation (temporary).

(a)  (7)  Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

The common rules under this Regulation are the 500 hours test of (a)(1), the substantially-all-the-activity test of (a)(2) and 100-hours-and-not-less-than-anyone-else test of (a)(3). There are only so many cases under (a)(7).

Still, it was a bad call, IRS. There was never any question that Fred was the business, and the business was Fred. If Fred was not materially participating, then no one was. The business ran itself without human intervention. When looked at in such light, the absurdity of the IRS position becomes evident.

Our case this time was Barbara, TC Memo 2019-50.

Amos And Rodman

Do you remember Dennis Rodman?

He is more recently associated with traveling to North Korea and functioning as an off-the-record ambassador with Kim Jong-un, the dictator of that country. In the 1990s he was better known for playing with Michael Jordan and Scottie Pippen on the Chicago Bulls.

Early in 1997 the Bulls were playing the Minnesota Timberwolves. Rodman went after a loose ball, falling into a group of photographers on the sidelines. Rodman twisted his ankle. While getting back on his feet he kicked one of the photographers in the groin.

The photographer’s name was Eugene Amos. He went to a hospital, where he had difficulty walking and was in noticeable pain. The doctors offered pain medication but he refused, explaining that he was already taking medications for a preexisting back injury. Some dispute arose, and Amos left the hospital without being discharged.

He hired an attorney immediately upon leaving. 

The next day Amos went to another hospital. He complained about his groin, but the doctors did not notice anything other than the expected swelling. They were concerned about his back, though, and took a round of X-rays.

Before the lawsuit was filed, Rodman paid him $200,000 to go away.

Oh, and Amos had to sign a confidentiality provision to not discuss the matter. Standard stuff, but given that we are talking about it the agreement did not hold up as expected.

There is a Code section that addresses physical injuries:

          § 104 Compensation for injuries or sickness.

(a)  In general.

Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include-

(1)   amounts received under workmen's compensation acts as compensation for personal injuries or sickness;

(2)  the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;

Relying upon Section 104(a)(2), Amos excluded the $200,000 from his 1997 tax return.

Wouldn’t you know the IRS pulled his return for audit?

And they disagreed with his exclusion of the $200,000 from taxable income. Why? As far as they were concerned, Rodman paid Amos all but $1 of the $200,000 to keep his mouth shut. The IRS was, however, willing to exclude the $1 from income.

Amos disagreed. He took one in the orchestra, after all.

Off to Tax Court they went.

The IRS argued that Amos had not proven his physical injuries, and that Mr. Rodman himself was skeptical that Amos sustained any injuries to speak of. The IRS further argued that Amos was required to pay $200,000 in damages to Rodman should he violate the confidentiality agreement, clearly indicating that Rodman did not intend to pay anything for alleged physical injuries.

The Court immediately dismissed the first argument, noting that if an action has its origin in a physical injury, then damages therefrom are treated as payments received on account of the injury.

The Court decided that the “dominant” reason for the settlement was to compensate Amos for his claimed injuries. However, the settlement also indicated that Rodman was paying some portion for Amos not to:

(1)   Defame Rodman

(2)   Disclose either the existence or amount of the settlement

(3)   Publicize facts relating to the incident, and

(4)   Assist in criminal prosecution against Rodman

Problem is, the agreement did not separate how much was paid for what.

The Court did what it had done many times before: it came up with a number.

The Court decided that $120,000 was payable for physical injuries and $80,000 was paid for confidentiality terms. Therefore $120,000 could be excluded under Section 104(a)(2). The $80,000 could not.

The Amos decision changed how personal injury attorneys draft documents. It is now expected that the injured party will not want to sign any confidentiality agreement. If there is one, anticipate the injured party to stipulate a nominal amount to the agreement and to request indemnification for any resulting taxes, penalties, interest, attorney fees and court costs.

And that is how Dennis Rodman contributed to the tax literature.

The IRS Did Not Like This Bonus

Let’s say that you own 100% of a company. Let’s say your company is quite profitable, and that you take out massive bonuses at year-end. The bonuses serve two purposes: first: why not? You took risk, borrowed money and worked hard. If the thing folded, you would have sunk with it. If it succeeds, why shouldn’t you succeed with it? After all, no politician built it for you. Second, bonuses help reduce taxes the company has to pay. Granted, they increase the taxes the shareholder has to pay, but that is a conversation for another day.

Let’s say the IRS questions the bonus.  They think your bonus is unreasonable.

Let’s discuss the Midwest Eye Center case.

Dr. Afzal Ahmad was the sole shareholder of Midwest Eye Center (Midwest), a multi-location ophthalmology and eye care center in Chicagoland. This is a pretty large practice, with approximately 50 employees, five surgeons, three optometrists and so on. Dr. Ahmad was doing well, receiving a salary of $30,000 every two weeks. At the end of the year he would also draw a sizeable bonus, which coincidently reduced corporate taxable income to zero. In 2007 he took a bonus of $2,000,000.   

Dr. Afzal Ahmad

There were reasons for the bonus. One of his busier surgeons quit unexpectedly in June, 2007. That surgeon was generating approximately $750,000 in revenues, and Dr. Ahmad took over the additional patients. Then there was another doctor who was reducing her workload as she established her own practice. Dr Ahmad starting absorbing some of these patients too.

Busy year for the doctor.

One more fact: Midwest filed taxes as a C corporation, which means it paid its own taxes.

The IRS came in and disallowed $1,000,000 of the bonus. Why $1,000,000 exactly? Who knows, except that (1) it is an impressive amount, and (2) it is close enough for government work.

As Midwest was a professional services corporation, its tax rate was the maximum, so there immediately was additional tax of $340,000.  The IRS also assessed penalties of over $62,000.

This was a nice audit for the IRS: limited issues and big bucks.

So how did the tax advisor defend Midwest?

There is standard text that any tax practitioner (at least, one who follows tax cases) has read a thousand times:

“Deductions are a matter of legislative grace and are allowed only as specifically provided by statute.”

Basically the tax Code says that everything is taxable and nothing is deductible – unless the Code says otherwise.  IRC Section 162 allows us to deduct “reasonable and necessary expenses.” So far, so good. Salaries have to be deductible, right? Hold up. The Code says that a “reasonable allowance for salaries or other compensation” is deductible.

We have to show the “reasonableness” of the salary.

The first way is to show that an “independent investor” would have paid the salary. Midwest decided not to use this line of defense, as no dividends were paid and no profits were left in the company. You have to leave some crumbs on the plate so the investor does not starve. Granted, Warren Buffett does not pay dividends, but he always leaves profit in Berkshire Hathaway.

OBSERVATION: The lack of dividends does not have to be fatal, but it does complicate the argument. For example, if I owned an NFL team, I might be willing to operate it at a loss. The value of my team (if I were to sell it) would likely be increasing more than enough to offset that operating loss.

The next way is by comparison to other businesses. Think professional athletes. If a team is willing to pay the salary, the player must then be worth it. Therefore if someone somewhere with your job duties has a similar salary, there is a prima facie argument that your salary is reasonable. This is more difficult to do with closely-helds than publicly-tradeds, as closely-helds do not tend to publish profitability data.  

A third way involves profit-sharing and other incentive plans, hopefully written down and providing formulas should certain thresholds be met. It is important to establish the plan ahead of time and to be certain there is some rhyme or reason to the calculations. Examples include: 

1.  Documenting the doctor’s activities over the years, putting a value to it and keeping a running tally of how compensation is still due. This can be done to “reimburse” the shareholder for those start-up years when the money was not there to properly compensate the shareholder, for example.
2. Setting up a bonus formula and following it from year-to-year. If there isn’t enough cash to pay out the amount generated by the formula, then the business would accrue it as “compensation payable.” It is not deductible until paid, but it does indicate that there is a compensation plan in place.
3. Having an independent Board of Directors, who in turn decide the amount of compensation. This can be done on an annual basis, preferably earlier rather than later in the year. This technique is not often seen in practice. 
4. Valuing the company on a regular basis (perhaps as frequently as annually). The intent is to attribute the increase in the value of the business to the shareholder’s efforts. The business would then share some of that increase via a bonus.

So what did Midwest do?

They did nothing, that’s what they did.

And I am at a loss. Midwest had a professional tax preparer, but when push came to shove the preparer provided the Court … nothing.

On to the penalty. The IRS will reverse a penalty if the taxpayer can show that he/she relied upon professional advice. The insurance companies go apoplectic, but it is common (enough) practice for a CPA to fall on the sword to get the client out of a penalty. 

But Midwest’s tax preparer was nowhere to be found.

The IRS won on all fronts.

My thoughts?

My corporate clients have overwhelmingly shifted to S corporations over the years. S corporations have their own tax issues, but reasonable compensation is not one of them. It is rare for a tax practitioner to recommend a C corporation nowadays, unless that practitioner works with Fortune 500 companies.

Midwest is an example why. It is a second pocketbook for the IRS to pick.

A Wake for Flanagans

Have you got a restaurant to sell? If you do, you may want to hear the story of John Psihos (JP) and Flanagan’s Restaurant.

JP was a Greek immigrant who came to the U.S. in his 20s. He did very well and eventually owned three restaurants in the north Chicago area: Flanagan's, Cafe Oceana and Full Moon. Flanagan's was the most successful. He seemed to be a good employer, willing to help his employees. He was also generous in his charitable pursuits.

The problem was that JP was keeping a double set of books on Flanagan’s. He used the second set to prepare his tax returns, a ruse undetected until he tried to sell the restaurant. JP listed the restaurant through a broker, providing a fact sheet showing his average monthly receipts at $170,000 and average yearly operating profit at approximately $554,000. These numbers were from the first set of books.

This caught the IRS’s attention.

The IRS dispatched two special agents who posed as husband and wife. They met three times with JP, who explained how he kept track of the actual receipts at Flanagan’s. Each night at closing the managers would assemble envelopes with all of the money, as well as receipts, register tapes and payout sheets. Standard stuff for a restaurant. JP then provided this material to one of his managers, who prepared weekly summaries. JP, feeling brave, provided these summary sheets to the two “buyers,” stating further that he had these records going back to 2001 showing what he “really got” from Flanagan’s.

The two agents executed a search warrant on one of JP’s restaurants, seizing, among other things, the weekly summary sheets. They also seized records detailing Flanagan’s nightly sales and cash payouts. The IRS reviewed these records to recalculate the actual gross receipts for years 2001 through 2004. They determined that JP had underreported his receipts by over $3 million over the four years. He was indicted on felony charges by a federal grand jury.

One has to give JP credit for the chutzpah he displayed before the District Court. He argued that he had left out all kinds of expenses, such as:

·        Amounts paid to DJ’s

·        Cash wages

·        Complimentary food and drinks

·        Payments to Café Oceana for food supplied

He even prepared a chart which he presented to the Court. According to his analysis, the actual loss to the government was approximately $22 thousand. He argued that the Court had to give him credit for the expenses he didn’t claim because, well, you know, he hadn’t wanted to double dip. He had a conscience, after all. The Court was having none of this and observed that the expenses were undocumented except for his word and that his word was not credible. The Court ordered him to pay more than $800 grand and go to jail for a couple of years

My Take: JP could not have this both ways. Once he decided to underreport his gross receipts to the IRS, he then had to consistently underreport for all purposes, including any sale listing. I am not making a moral call here, just observing how this works.

Once caught, there was little hope that anyone would believe him about unclaimed expenses. How credible was he at that moment? 

And why would someone go to all this effort if the end result was only $22 thousand?

What does it tell you that the IRS became aware of (a) the sale listing and (b) correlated it to gross receipts on Flanagan’s tax return? Remember: tax information is supposed to be confidential. Returns are not supposed to be laying around on someone’s desk or kitchen table. Are you telling me that someone “remembered” Flanagan’s gross receipts? Could it be that JP was already under scrutiny? The court decision does not give us background on this point, although it is this point that I find chilling. I can almost hear JP saying “how would they ever know?” I agree: how did they know?