Taxpayer Wins Refund Despite Using Wrong Form

Let’s look at a case that comes out of Cincinnati.

E. John Rewwer (Rewwer) had a professional practice which he reported on Schedule C (proprietorship/disregarded entity) of his personal return.

He got audited for years 2007 through 2009.

The IRS disallowed expenses and assessed the following in taxes, interest and penalties:

           2007            $  15,041

           2008            $137,718

           2009            $ 55,299

Rewwer paid the assessments.

He then filed a claim for refund for those years. More specifically his attorney filed and signed the refund claims, including the following explanation:

The IRS did not properly consider documentation of my expenses during my income tax audit. I would ask that the IRS reopen the audit, reconsider my documentation, and refund the amounts paid as a result of the erroneous audit adjustments, including any penalty and interest that may have accrued.”

I am not certain which expense categories the IRS denied, but I get it. I have a similar (enough) client who got audited for 2016. IRS Holtsville disallowed virtually every significant expense despite being provided a phonebook of Excel schedules, receipts and other documentation.  We took the matter to Appeals and then to Tax Court. I could see some expenses being disallowed (for example, travel and entertainment expenses are notoriously difficult to document), but not entire categories of expenses. That told me loud and clear that someone at IRS Holtsville could care less about doing their job properly.

Wouldn’t you know that our client is being examined again for 2018? Despite taking the better part of a day faxing audit documentation to IRS Holtsville, we are back in Tax Court.  And I feel the same way about 2018 as I did about 2016: someone at the IRS has been assigned work above their skill level.

Back to Rewwer.

The attorney:

(1)  Sent in claims for refund on Form 843, and

(2)  Signed the claims for refunds.

Let’s take these points in reverse order.

An attorney or CPA cannot sign a return for you without having a power of attorney accompanying the claim. Our standard powers here at Galactic Command, for example, do not authorize me/us to sign returns for a client. We would have to customize the power to permit such authority, and I will rarely agree to do so. The last time I remember doing this was for nonresident clients with U.S. filing requirements. Mail time to and from could approach the ridiculous, and some of the international forms are not cleared for electronic filing.

Rewwer’s claims were not valid until the signature and/or power of attorney matter was resolved.

Look at this Code section for the second point:

§ 301.6402-3 Special rules applicable to income tax.

(a) The following rules apply to a claim for credit or refund of income tax: -

(1) In general, in the case of an overpayment of income taxes, a claim for credit or refund of such overpayment shall be made on the appropriate income tax return.

(2) In the case of an overpayment of income taxes for a taxable year of an individual for which a Form 1040 or 1040A has been filed, a claim for refund shall be made on Form 1040X (“Amended U.S. Individual Income Tax Return”).

Yep, there is actually a Code section for which form one is supposed to use. The attorney used the wrong form.

For some reason, the IRS allowed 2008 but denied the other two years.

The IRS delayed for a couple of years. The attorney, realizing that the statute of limitations was about to expire, filed suit.

This presented a window to correct the signature/power of attorney issue as part of the trial process.

To which the IRS cried foul: the taxpayer had not filed a valid refund claim (i.e., wrong form), so the claim was invalid and could not be later perfected. Without a valid claim, the IRS claimed sovereign immunity (the king cannot be sued without agreement and the king did not so agree).

The IRS had a point.

But the taxpayer argued that he had met the “informal claim” requirements and should be allowed to perfect his claim.

The Supreme Court has allowed imperfect claims to be treated as informal claims when:

(1) The claim is written

(2)  The claim adequately tells the IRS why a refund is sought, and

(3)  The claim adequately tells the IRS for what year(s) the claim is sought.

The point to an informal claim is that technical deficiencies with the claim can be remedied – even after the normal statute of limitations - as long as the informal claim is filed before the statute expires.

As part of the litigation, Rewwer refiled years 2007 and 2009 on Forms 1040X, as the Regulations require. This also provided opportunity to sign the returns (and power of attorney, for that matter), thereby perfecting the earlier-filed claims.

Question: did the Court accept Rewwer’s informal claim argument?

Answer: the Court did.

OBSERVATION: How did the Court skip over the fact that the claims – informal or not – were not properly signed? The IRS did that to itself. At no time did the IRS deny the claims for of lack of signatures or an incomplete power of attorney. The Court refused to allow the IRS to raise this argument after-the-fact to the taxpayer’s disadvantage: a legal principle referred to as “estoppel.”  

Look however at the work it took to get the IRS to consider/reconsider Rewwer’s exam documentation for 2007 and 2009. Seems excessive, I think.

Our case this time was E. John Rewwer v United States, U.S. District Court, S.D. Ohio. 

COMMENT: If you are wondering why the “United States” rather than the usual “Commissioner, IRS,” the reason is that tax refund litigation in federal district courts is handled by the Tax Division of the Department of Justice.

A Rant On IRS Penalties

I am reading that the number one most-litigated tax issue is the accuracy-related penalty, and it has been so for the last four years.

The issue starts off innocently enough:

You may qualify for relief from penalties if you made an effort to comply with the requirements of the law, but were unable to meet your tax obligations, due to circumstances beyond your control.

I see three immediate points:

(1)  You were unable to file, file correctly, pay, or pay in full

(2)  You did legitimately try

(3)  And it was all beyond your control

That last one has become problematic, as the IRS has come to think that all the tremolos of the universe are under your control.

One of the ways to abate a penalty is to present reasonable cause. Here is the IRS:

Reasonable cause is based on all the facts and circumstances in your situation. The IRS will consider any reason which establishes that you used all ordinary business care and prudence to meet your federal tax obligations but were nevertheless unable to do so.

How about some examples?

·       Death

Something less … permanent, please.

·       Advice from the IRS

·       Advice from a tax advisor

That second one is not what you might think. Let’s say that I am your tax advisor. We decide to extend your tax return, as we are waiting for additional information. We however fail to do so. It got overlooked, or maybe someone mistakenly thought it had already been filed. Whatever. You trusted us, and we let you down.

There is a Supreme Court case called Boyle. It separated tax responsibilities between those that are substantive/technical (and reasonable cause is possible) and those which are administrative/magisterial (and reasonable cause is not). Having taken a wrong first step, the Court then goes on to reason that the administrative/magisterial tasks were not likely candidates for reasonable cause. Why? Because the taxpayer could have done a little research and realized that something – an extension, for example - was required. That level of responsibility cannot be delegated. The fact that the taxpayer paid a professional to take care of it was beside the point.

So you go to a dentist who uses the wrong technique to repair your broken tooth. Had you spent a little time on YouTube, you would have found a video from the UK College of Dentistry that discussed your exact procedure. Do you think this invites a Boyle-level distinction?

Of course not. You went to a dentist so that you did not have to go to dental school. You go to a tax CPA so that do not have to obtain a degree, sit for the exam and then spend years learning the ropes.      

·     

• Fire, casualty, natural disaster or other disturbances
• Inability to obtain records
• Serious illness, incapacitation or unavoidable absence of the taxpayer or a member of the taxpayer’s immediate family

I am noticing something here: you are not in control of your life. Some outside force acted upon you, and like a Kansas song you were just dust in the wind.

How about this one: you forgot, you flubbed, you missed departure time at the dock of the bay? Forgive you for being human.

This gets us to back to those initially innocuous string of words:

          … due to circumstances beyond your control.”

When one does what I do, one might be unimpressed with what the IRS considers to be under your control.

Let me give you an example of a penalty appeal I have in right now. I will tweak the details, but the gist is there.

·   You changed jobs in 2015 

·   You had a 401(k) loan when you left

·   Nobody told you that you had to repay that loan within 60 days or it would be considered a taxable distribution to you. 

·   You received and reviewed your 2015 year-end plan statement. Sure enough, it still showed the loan.  

·   You got quarterly statements in 2016. They also continued to show the loan. 

·    Ditto for quarter one, 2017. 

·   The plan then changed third-party administrators. The new TPA noticed what happened, removed the loan and sent a 1099 to the IRS.

o   Mind you, this is a 1099 sent in 2017 for 2015.

o   To make it worse, the TPA did not send you a 1099.     

•  The IRS computers whirl and sent you a notice.
•  You sent it to me. You amended. You paid tax and interest.
•  The IRS now wants a belt-tightening accuracy-related penalty because ….

Granted, I am a taxpayer-oriented practitioner, but I see reasonable cause here. Should you have known the tax consequence when you changed jobs in 2015? I disagree. You are a normal person. As a normal you are not in thrall to the government to review, understand and recall every iota of regulatory nonsense they rain down like confetti at the end of a Super Bowl. Granted, you might have known, as the 401(k)-loan tax trap is somewhat well-known, but that is not the same as saying that you are expected to know.  

I know, but you never received a 1099 to give me. We never discussed it, the same as we never discussed Tigris-Euphrates basin pottery. Why would we?

Not everything you and I do daily comes out with WWE-synchronized choreography. It happens. Welcome to adulthood. I recently had IRS Covington send me someone else’s tax information. I left two messages and one fax for the responsible IRS employee – you know, in case she wanted the information back and process the file correctly – and all I have heard since is crickets. Is that reasonable? How dare the IRS hold you to a standard they themselves cannot meet?

I have several penalty appeals in to the IRS, so I guess I am one of those practitioners clogging up the system. I have gotten to the point that I am drafting my initial penalty abatement requests with an eye towards appeal, as the IRS has  convinced me that they will not allow reasonable cause on first pass - no matter what, unless you are willing to die or be permanently injured. 

I have practiced long enough that I remember when the IRS was more reasonable on such matters. But that was before political misadventures and the resulting Congressional budget muzzle. The IRS then seemed to view penalties as a relief valve on its budget pressures. Automatically assess. Tie up a tax advisor’s time. Implement a penalty review software package in the name of uniformity, but that package's name is “No.” The IRS has become an addict.

Cincinnati Reds, Tax And Bobbleheads

Did you hear about the recent tax case concerning the Cincinnati Reds?

It has to do with sales and use tax. This area is considered dull, even by tax pros, who tend to have a fairly high tolerance for dull. But it involves the Reds, so let’s look at it.

The Reds bought promotional items - think bobbleheads - to give away. They claimed a sales tax exemption for resale, so the vendor did not charge them sales tax.

Ohio now wants the Reds to pay use tax on the promotional items.

COMMENT: Sales tax and use tax are (basically) the same thing, varying only by who is remitting the tax. If you go to an Allen Edmunds store and buy dress shoes, they will charge you sales tax and remit it to Ohio on your behalf. Let’s say that you buy the shoes online and are not charged sales tax. You are supposed to remit the sales tax you would have paid Allen Edmunds to Ohio, except that now it is called a use tax. 

The amount is not insignificant: about $88 grand to the Reds, although that covers 2008 through 2010.

What are the rules of the sales tax game?

The basic presumption is that every sale of tangible personal property and certain services within Ohio is taxable, although there are exemptions and exceptions. Those exemptions and exceptions had better be a tight fit, as they are to be strictly construed.

The Reds argued the following:

·      They budget their games for a forthcoming season in determining ticket prices.

·      All costs are thrown into a barrel: player payroll, stadium lease, Marty Brennaman, advertising, promotional items, etc.

·      They sell tickets to the games. Consequently, the costs – including the promotional items – have been resold, as their cost was incorporated in the ticket price.

·      Since there is a subsequent sale via a game ticket, the promotional items were purchased for resale and qualify for an exemption.

Ohio took a different tack:

·      The sale of tangible personal property is not subject to sales tax only if the buyer’s purpose is to resell the item to another buyer. Think Kroger’s, for example. Their sole purpose is to resell to you.

·      The purpose of the exemption is meant to delay sales taxation until that final sale, not to exempt the transaction from sales tax forever. There has to be another buyer.

·      The bobbleheads and other promotions were not meant for resale, as evidenced by the following:

o   Ticket prices remain the same throughout the season, irrespective of whether there is or isn’t a promotional giveaway.

o   Fans are not guaranteed to receive a bobblehead, as there is normally a limited supply.

o   Fans may not even know that they are purchasing a bobblehead, as the announcement may occur after purchase of the ticket.

The Ohio Board of Appeals rejected the Reds argument.

The critical issue was “consideration.”

Let’s say that you went to a game but arrived too late to get a bobblehead. You paid the same price as someone who did get a bobblehead, so where is the consideration? Ohio argued and the Board agreed that the bobbleheads were not resold but were distributed for free. There was no consideration. Without consideration one could not have a resale.

Here is the Board:

The evidence in the record supports our conclusion that the cost of the subject promotional items is not included in the ticket price.”

The Reds join murky water on the issue of promotional items. The Kansas City Royals, for example, do not pay use tax on their promotional items, but the Milwaukee Brewers do. Sales tax varies state by state.

Then again perhaps the Reds will do as the Cavaliers did: charge higher ticket prices for promotional giveaway games.

This is (unsurprisingly) heading to the Ohio Supreme Court. We will hear of The Cincinnati Reds, LLC v Commissioner again.

Issuing 1099s In Anger

Several years ago, I received an angry call from another CPA.

He had lost a couple of key partners, to which he responded with an almost Game-of-Thrones vindictiveness. He had been charged with issuing false Form 1099s to his former partners.

They dragged him into Court for this and other reasons.

I had looked into the 1099 matter. It is not every day a CPA is charged with issuing false tax forms.

Why would somebody do this: issue false 1099s?

Because chum in the water.

Let’s talk about the Petrunak case.

Petrunak was a pyrotechnician.

This guy made fireworks. He owned a company called Abyss Special FX, Inc. (Abyss), and he could do both indoor and outdoor fireworks displays.

This also meant that he was under regulation by the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF).

A couple of ATF agents conducted a mandatory inspection and found a number of violations. Petrunak challenged their findings and had his day in administrative court. I do not know what the details were, but the judge revoked Petrunak’s fireworks license.

So much for Abyss and his paycheck.

Petrunak reckoned he lost a lot of money – both as real-money losses and as money he would have made except for the ATF agents.

He had time to think about it. He thought about it for five years.

He had Abyss send each of them a Form 1099-MISC for $250,000.

Half a million. He figured that was about what they had cost him.

Abyss deducted that half million. As Abyss was an S corporation, there was a big loss passed-through to Petrunak to use on his individual return.

Needless to say, both ATF agents omitted that 1099 from his/her individual tax return.

One agent however got pulled for audit.

The IRS wanted taxes of over $100 grand. She spent a lot of time contesting and unraveling that mess.

Exactly what Petrunak wanted. Forms 1099 are chum in the water to the IRS.

Problem is, the IRS pursued Petrunak after the ATF agent’s audit. He admitted to filing those 1099s, but he was right in doing so and those two had lied – to a judge, unbelievable! – and an IRS person told him that he might be able to issue 1099s for his business costs. He estimated his costs to be half a million.

The IRS charged him with three counts of making false and fraudulent IRS forms.

He fought back, going to the Seventh Circuit Court of Appeals.

How did it turn out?

Petrunak is going to prison for 24 months.

His accounting was fantastical, but I get his anger.

Circling back, the accountant who called me was angry because I did not agree with him.

To be kind, let’s say his side of story was … creative.

But then, have a CPA play in a field with accounts receivable, deferred compensation, cash transfers, buyout agreements and whatnot and a talented – and motivated - practitioner can get creative.

He did.

Problem was: he picked a fight with tax CPAs. Two of them.

Bad call. 

It cost him a few bucks.

The Hosbrook Road Terrible Tax Tale

Let's talk about S corporations.

There are two types of corporations: C corporations and S corporations. Think Amazon or Apple and we are talking about "C" corporations: they file their own returns and pay their own taxes. Think of family-owned Schmidt Studebaker Carriage & Livery and we are talking about "S" corporations: only so many shareholders, do not normally pay tax, the numbers flow-through to the owners who pay the tax on their personal returns.

S corporations are almost the default tax structure for entrepreneurial and family-owned businesses, although in recent years LLCs have been giving them a run for their money. They are popular because the owner pays tax only once (normally), as contrasted to a C corporation with its two levels of tax.

But there are rules to observe.

For example, you have to keep track of your basis in your stock - that is, the amount of after-tax money you have invested in the stock. Your basis goes up as you put the business income on your personal return, but it also goes down as you take distributions (the S equivalent of dividends) from the company. You are allowed to take distributions tax-free as long as your basis does not go negative. Why? Because you paid tax on the business income, meaning you can take it out without a second tax.

Accountants keep permanent schedules to track this stuff.  Or rather, they should. I have been involved in more than one reconstruction project over the years. You have to present these schedules upon IRS audit.

I did not previously have a worse-case story to tell. Now I do. The best part is that the story takes place in Cincinnati.

Gregory Power is a commercial real estate broker with offices first on Montgomery Road and then on Hosbrook Road. He started his company (Power Realty Advisors, Inc.) in 1993. Somewhen in there he used Quicken for his accounting, and he would forward selected reports to his accountant for preparation of the returns.

COMMENT: Quicken is basically a check-register program. It tracks deposits and withdrawals, but it is not a general ledger - that is, the norm for a set of business books. It will not track your inventory or depreciable assets or uncollected invoices, for example.

There was chop in the preparation. For example, the numbers were separated between those Mr. Power reported as a proprietor (Schedule C) and those reported on the S return. Why? Who knows, but it created an accounting problem that would come back to haunt.

He lost money over several years, including the following selected years:

            1995              (191,044)

            1996              ( 70,325)

            2002              ( 99,813)

Nice thing about the S corporation as that he got to put these losses on his personal return. To the extent his return went negative, he had a net operating loss (NOL) which he could carry-over to another year. Mind you, he got to put those losses on his personal return to the extent he did not run out of basis - yet another reason to maintain permanent schedules.

He took distributions. In fact, he took distributions rather than taking a salary, which is a tax no-no. The IRS did not come after him on this issue because it had another angle of attack.

He had the corporation pay some of his personal and living expenses, which is another no-no. Accountants will reclassify these to distributions and tell you to stop.

Some of his S corporation returns did not show distributions. This is not possible, of course, as he was taking distributions rather than salary. That tells me that the accountant did not have numbers. It also tells me the accountant could not maintain the schedules - at least not accurately - that we talked about.

Sure enough, his big payday years came. There was tax to pay ... except for those NOLs that he was carrying-forward from his bad years. He told the IRS that he had over $500,000 of NOLs, which he could now put to good use.

Problem: He did not have those schedules.

Solution: He or his accountant went back and reconstructed those schedules.

Problem: The IRS said they were bogus.

Solution: You go to Tax Court.

COMMENT: It would have been cheaper to keep schedules all along.

Mr. Power ran into a very severe issue with the Court: it does not have to accept your tax returns as proof of the numbers.  The Court can request the underlying books and records: the journals, ledger and what-not that constitutes the accounting for a business.

The Court did so request.

He trotted out those Quicken reports and handwritten summaries.

The Court noted that Mr. Power was somehow splitting numbers between his proprietorship and the corporation, although it did not understand how he was doing so. This made it difficult for the Court to review a carryforward schedule when the Court could not first figure-out where the numbers for a given year were coming from.

Strike one.

The Court wanted to know what to do with those tax returns that did not show distributions, which it knew was wrong as he was taking distributions rather than a salary.

Strike two.

And there was the matter of personal expenses being paid through the company. It appears that in some years the corporation deducted these expenses, and in other years it did not. The Court wasn't even sure what the amounts were. It did not help when Mr. Power commingled business and personal funds when buying his house in Indian Hill.

Strike three.

His business accounting was so bad that the Court bounced the NOL carryforward. The whole thing.

He owed tax. He owed penalties.

And no one knows if he really had an NOL that he could use to sop-up his profitable years because he had neglected his accounting to an extreme degree. He could not prove his own numbers. 

But Mr. Power has attained tax fame.

It's Opening Day!

One does not need to be a baseball fan, just exhausted with winter.

Wish I could be there.