How Much Paperwork Does the IRS Want?

Sometimes practitioners disagree on how much supporting paperwork – if any – should go with a tax return.

The issue can take on a keener edge when one is working with amended returns or claims for refunds.

COMMENT: For the nerds, an amended return can technically be a claim for refund – if the amended return shows a refund.

It also can vary with the tax issue at play.

I am looking at two cases – the first being the initial hearing and the second the appeal – involving a research tax credit.

The research credit is easier to understand if we think of companies such as Johnson & Johnson or Pfizer. Lab coats, scientific equipment, people wearing safety glasses and so forth. The image screams research.

Mind you, there are accounting and recordkeeping issues that go with this credit.

A routine accounting system would capture functional costs (think payroll, rent, utilities), departmental costs (think auto parts versus auto service at a car dealership) and divisional costs (consumer and industrial, for example). The research credit wants even more detail from the accounting system. It wants detail at the research activity level.

What is a research activity?

You could be an activity. Say that you are an engineer. You work in manufacturing, but a portion of your time is spent on activities that might qualify for the credit. What would be an example? Let’s say improving a product or the process to manufacture that product.  

The accounting system easily captures your payroll as a functional cost.

The system also captures your payroll as a manufacturing cost.

What the system perhaps doesn’t do – at least without upgrades – is break-down your lab time into specific projects, some of which might qualify for the credit and others which might not. Yep, your time sheets going forward are going to be a bear.

Let’s be clear: if you are Pfizer, you likely have tweaked-out your accounting and reporting system to capture 360 degrees of data, including whatever is needed for the research credit. Our discussion here concerns more routine companies.

The Harpers owned a company that specializes in military design build projects. They initially filed returns not claiming a research tax credit.

Now pause and consider what they do.

Chances are that some of what they do has an element of uncertainty: what to, how to do it, what order to do it and so on. Depending upon, that uncertainty might trigger the research credit.

There are four principal requirements to the research credit:

(1)  There must be a reduction in uncertainty about the development or improvement of a product or process.

(2)  That development or improvement in turn involves experimentation – that is, there are different ways to get there from here. The experimentation involves determining which ways work and which ways do not.

(3)  The experimentation must involve hard sciences: engineering, chemistry and so forth. Experimenting with tax law, for example, will not work (sadly).

(4)  The purpose of the activity must be a new or improved product or process: performance, function, quality, reliability, that kind of thing.

The Harpers reviewed what they did and determined that the company had research activities qualifying for the credit. They amended their returns for 2008 and 2010. The credit amount was impressive:

         2008                    $437,632

         2010                    $388,325

The IRS reviewed the amended returns and denied the credit.

Off to Court they went. The first case was in California district court.

The IRS position was both straightforward and cynical:

The claim must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof.”

Let me rephrase the position: we (the IRS) decide when we have enough facts and in any event the facts you submit are not sufficient to apprise us of anything until we say that they are sufficient.

The district court agreed with the IRS.  The taxpayer was required to establish all facts and details for its refund claim. The IRS said that the taxpayer had not, and the Court said that was all it needed to know.

Wow. Let me think how can this standard can possibly be abused….

The Harpers appealed the case to the 9^th Circuit Court of Appeals.

Their argument?

• The IRS has the right to notice of a claim and its underlying facts so it can make an informed and appropriate determination. This is referred to as the “specificity” requirement.
• The IRS can always ask one more question. This makes attaching ALL possible paperwork to a claim virtually impossible.
• In practice, the IRS can review a claim with a taxpayer. One way is to audit the claim, of course. This act is considered a waiver of the specificity requirement.
• Why would the IRS review a claim and thereby waive anything? Consider the alternative. Tax practitioners would attach so much documentation to the research tax credit that the IRS would have to lease additional storage to house it all.  It is in both parties’ mutual interest to go along and get along.

The Harpers argued that the IRS had waived the specificity requirement.

How did the IRS do this?

By auditing the claim.

The IRS spent four years auditing the amended returns. The Harpers provided over 100,000 pages of supporting documentation. At no point in time did the IRS tell the Harpers that they had not provided ENOUGH documentation.

I am trying to be fair, but I am distressed by the IRS behavior.

It is common professional knowledge that the IRS can always ask for additional information. One can provide it and still get turned down, but the give and take allows the system – the IRS and tax practitioners - to function and not be overwhelmed.

Is that what happened here?

Nope.

The IRS did not go to Court arguing that it had reviewed 100,000 pages of supporting documentation and decided the Harpers did not qualify for the research credit.

The IRS argument was that the Harpers did not meet the specificity requirement – meaning the Harpers did not include enough paperwork.

The Appeals Court called out the IRS. It had waived the specificity requirement by auditing the amended returns.

The Appeals Court sent the case back to the district court. The case should never have been dismissed for the specificity requirement.

The Harpers may win or may lose, but they will have their day in court.

Our case this time for the home gamers was Harper v United States.

The Sale of "American Pie"

Did you see where Don McLean sold his original manuscript for “American Pie” at Christie’s? He sold the work for $1.2 million, and it included his handwritten notes and deletions from the 1971-72 hit that – at 8 ½ minutes – was the longest song to ever top the U.S. charts.

The song of course is famous for its allusions. The “day the music died” refers to the death of Buddy Holly, whereas “the king” supposedly refers to Elvis Presley while “the jester on the sidelines” refers to Bob Dylan after his motorcycle accident. It became an anthem to disillusionment, to the sense of our best days being behind us and the ennui and hopelessness of a society being carted off in the wrong direction.

Sounds eerily contemporary.

He explained that he had forgotten he had the manuscript. He found it in the proverbial old box that had survived several moves. The sale allowed him to provide for his family, now and into the future.

Yes, $1.2 million will do that.

So what are the tax consequences from the sale of his manuscript?

We are talking about intellectual property and a subset we will call creative properties.

For the most part, self-created properties cannot be a capital asset in the hands of its creator. This causes a problem, as one requires a capital asset if one wants capital gains.

Take it a step further. If someone else owns the asset but its tax basis (that is, its cost for purposes of calculating gain or loss) is determined by reference to the creator’s basis, then it cannot be a capital asset.  How can this happen? Easy. You could gift the property, for example, or you could contribute the property to a family limited partnership. In either case the recipient will “take over” your basis in the creative property. Since the basis remains the same, it cannot be a capital asset.

The vocabulary gets tricky when discussing creative property. For example, an author (say Stephen King) may receive a “royalty.” Coincidently, find oil in your backyard and chances are an oil company will also pay you a royalty. Since the word “royalty” is the same, are the tax consequences the same?

The answer is no. If you write a book or score a movie soundtrack, that royalty is probably ordinary income to you. In fact, it is reported on Schedule C of your individual tax return, the same as your self-employment income from Uber. The oil royalty, on the other hand, is reported on Schedule E, along with rents. The Schedule C royalty will trigger self-employment tax. The Schedule E will not. 

OBSERVATION: We have discussed before that sometimes a word will have different meanings as it travels through the tax Code. Here is an example.

As always, there are exceptions. Let’s say you write one book and never write again. The IRS will likely consider that to be ordinary income but not self-employment income. Why? Supposedly it takes two or more books to establish that you are in the trade or business of writing books.

OBSERVATION: I am curious how the IRS would apply this standard to Harper Lee. She published, you will recall, To Kill a Mockingbird in 1960. It was only this year that she published her second work (Go Set a Watchman) – 55 years later. What do you think: is this self-employment income or not?

Remember when Michael Jackson bought the catalog of Beatles music? He bought it as a non-alternative investment, akin to stocks and bonds. Like a stock or bond, Michael Jackson would have had capital gains had he sold the catalog.

This created a fuss among songwriters. If they sold their own compositions, they would have ordinary and self-employment income. Introduce Michael Jackson and the tax result transmuted to capital gains.

So Congress passed Section 1221(b)(3), which incorporated a provision from the Songwriter’s Capital Gains Equity Act, promoted by the Nashville Songwriters Association International (NASI). It extended capital gains to self-created music owned for more than one year. It requires an election, and the songwriter/creative can elect for one musical composition and not for another. It does require the transfer of a musical composition or a copyright in the same; transfer something less and the result defaults to ordinary income.

NASI argued that the industry had changed. By the 1990s many music artists were acting as their own publishers or co-publishers, meaning they had some control over the exploitation of their songs. Gone were the days of Hank Williams and Bill Monroe, when songwriters sold their songs outright to music publishers with no right to ongoing income.

Congress listened.

Don McLean now has a tax option that he did not have years ago when he recorded “American Pie.” I suppose that there could be a scenario where it would be more advantageous to recognize the $1.2 million as ordinary income rather than as capital gains, but I cannot easily think of any that do not require low-probability tax considerations.

I would say he is making the election.