Don’t Be A Jerk

 

I am looking at a case containing one of my favorite slams so far this year.

Granted, it is 2020 COVID, so the bar is lower than usual.

The case caught my attention as it begins with the following:

The Johnsons brought this suit seeking refunds of $373,316, $192,299, and $114,500 ….”

Why, yes, I would want a refund too.

What is steering this boat?

… the IRS determined that the Johnsons were liable for claimed Schedule E losses related to real estate and to Dr. Johnson’s business investments.”

Got it. The first side of Schedule E is for rental real estate, so I gather the doctor is landlording. The second side reports Schedules K-1 from passthroughs, so the doctor must be invested in a business or two.

There is a certain predictability that comes from reviewing tax cases over the years. We have rental real estate and a doctor.

COMMENT: Me guesses that we have a case involving real estate professional status. Why? Because you can claim losses without the passive activity restrictions if you are a real estate pro.

It is almost impossible to win a real estate professional case if you have a full-time gig outside of real estate.  Why? Because the test involves a couple of hurdles:

·      You have to spend at least 750 hours during the year in real estate activities, and

·      Those hours have to be more than ½ of hours in all activities.

One might make that first one, but one is almost certain to fail the second test if one has a full-time non-real-estate gig. Here we have a doctor, so I am thinking ….

Wait. It is Mrs. Johnson who is claiming real estate professional status.

That might work. Her status would impute to him, being married and all.

What real estate do they own?

They have properties near Big Bear, California.

These were not rented out. Scratch those.

There was another one near Big Bear, but they used a property management company to help manage it. One year they used the property personally.

Problem: how much is there to do if you hired a property management company? You are unlikely to rack-up a lot of hours, assuming that you are even actively involved to begin with.

Then there were properties near Las Vegas, but those also had management companies. For some reason these properties had minimal paperwork trails.

Toss up these softballs and the IRS will likely grind you into the dirt. They will scrutinize your time logs for any and every. Guess what, they found some discrepancies. For example, Mrs. Johnson had counted over 80 hours studying for the real estate exam.

Can’t do that. Those hours might be real-estate related, but the they are not considered operational hours - getting your hands dirty in the garage, so to speak. That hurt. Toss out 80-something hours and …. well, let’s just say she failed the 750-hour test.

No real estate professional status for her.

So much for those losses.

Let’s flip to the second side of the Schedule E, the one where the doctor reported Schedules K-1.

There can be all kinds of tax issues on the second side. The IRS will probably want to see the K-1s. The IRS might next inquire whether you are actually working in the business or just an investor – the distinction means something if there are losses. If there are losses, the IRS might also want to review whether you have enough money tied-up – that is, “basis” - to claim the loss. If you have had losses over several years, they may want to see a calculation whether any of that “basis” remains to absorb the current year loss.

 Let’s start easy, OK? Let’s see the K-1s.

The Johnson’s pointed to a 1000-plus page Freedom of Information request.

Here is the Court:

The Johnsons never provide specific citations to any information within this voluminous exhibit and instead invite the court to peruse it in its entirety to substantiate their arguments.”

Whoa there, guys! Just provide the K-1s. We are not here to make enemies.

Here is the Court:

It behooves litigants, particularly in a case with a record of this magnitude, to resist the temptation to treat judges as if they were pigs sniffing for truffles.”

That was a top-of-the-ropes body slam and one of the best lines of 2020.

The Johnsons lost across the board.

Is there a moral to this story?

Yes. Don’t be a jerk.

Our case this time was Johnson DC-Nevada, No 2:19-CV-674.

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?

Pouring Concrete In Phoenix

I read the tax literature differently than I did early in my career. There is certainly more of “been there, read that,” but there is also more consideration of why the IRS decided to pursue an issue.

I am convinced that sometimes the IRS just walks in face-first, as there is no upside for them. Our recent blog about the college student and her education credit was an example. Other times I can see them backfilling an area of tax law, perhaps signaling future scrutiny. I believe that is what the IRS is doing with IRAs-owning-businesses (ROBS).

A third category is when the IRS goes after an issue even though the field has been tilled for many years. They are signaling that they are still paying attention.

I am looking at a reasonable compensation case.  I believe it is type (3), although it sure looks a lot like type (1).

To set up the issue, a company deducts someone’s compensation – a sizeable bonus, for example. In almost all cases, that someone is going to be an owner of the company or a relation thereto. 

There are two primary reasons the IRS goes after reasonable compensation:

(1)  If the taxpayer is a C corporation (meaning it pays its own tax), the deduction means that the compensation is being taxed only once (deducted by the corporation; taxed once to the recipient). The IRS wants to tax it twice. In a C environment, the IRS will argue that you are paying too much compensation. It wants to move that bonus to dividends paid, as there is no tax deduction for paying dividends.

(2) If the taxpayer is an S corporation (and its one level of tax), the IRS will argue that you are paying too little compensation. There is no income tax here for the IRS to chase. What it is chasing instead is social security tax. And penalties. Some of the worst penalties in the tax Code revolve around payroll.

There is a world of literature on how to determine “reasonable.” The common judicial tests have you run a gauntlet of five factors:

(1) The employee’s role in the company

(2) Comparison to compensation paid others for similar services

(3) Character and condition of the company

(4) Potential conflict of interest

(5) Internal consistency of compensation

Let’s look at the Johnson case as an example.

Mom and dad started a concrete company way back when. They had two sons, each of which came into the business. They specialized in Arizona residential development. As time went on, the brothers wound up owning 49% of the stock; mom owned the remainder. The family was there at the right time to ride the Phoenix housing boom, and the company prospered.

A downside to the boom was periodic concrete shortages. The company did not produce its own concrete, and the brothers came to believe it to be a business necessity. They presented an investment opportunity in a concrete supplier to mom. Mom wanted nothing to do with it; she argued that the company was a contractor, not a supplier. This was how companies overextend and eventually fail, she reasoned.

The brothers went ahead and did it on their own. They invested personally, and mom stayed out. They even guaranteed some of the supplier’s bank debt.

Who would have thought that concrete had so many problems? For example, did you know that concrete becomes unusable after 

(1) 90 minutes or

(2) If it reaches 90 degrees.

I am not sure what to do with that second issue when you are in Phoenix. 

The brothers figured out how to do it. They developed a reputation for specialized work. They worked 10 or 12 hours a day, managed divisions of 100 employees each, were hands-on in the field and often ran job equipment themselves. Sometimes they even designed equipment for a given job, having their fabrication foreman put it together.

Not surprisingly, the developers and contractors loved them.

That concrete supplier decision paid off. They always had concrete when others would not. They could even charge themselves a “friendly” price now and then.

We get to tax years June 30, 2003 and 2004 and they paid themselves a nice bonus. The brothers pulled over $4 million in 2003 and over $7 million in 2004.

COMMENT: I really missed the boat back in college.

The brothers were well-advised. They maintained a cumulative bonus pool utilizing a long-time profit-sharing formula, and they had the company pay annual dividends.

The IRS disallowed a lot of the bonus. You know why: they were a C corporation and the government was smelling money.

The Court went through the five tests:

(1) The brothers ran the show and were instrumental in the business success. Give this one to the taxpayer.

(2) The IRS argued that compensation was above the average for the industry. Taxpayer responded that they were more profitable than the industry average. Each side had a point. Having nothing more to go on, however, the Court considered this one a push.

(3) Company sales and profitability were on a multi-year uptrend. This one went to the taxpayer.

(4) The IRS appears to have wagered all on this test. It brought in an expert who testified that an “independent investor” would not have paid so much compensation and bonus, because the result was to drop the company’s profitability below average.

Oh, oh. This was a good argument.

The idea is that someone – say Warren Buffett – wants to buy the company but not work there. That investor’s return would be limited to dividends and any increase in the stock price. Enough profitability has to be left in the company to make Warren happy.

This usually becomes a statistical fight between opposing experts.

It did here.

And the Court thought that the brothers’ expert did a better job than the government’s expert.

COMMENT: One can tell that the Court liked the brothers. It was not overly concerned that one or two years’ profitability was mildly compromised, especially when the company had been successful for a long time. The Court decided there was enough profitability over enough years that an independent investor would seriously consider the company. 

Give this one to the taxpayer.

(5) The company had a cumulative bonus program going back years and years. The formula did not change.

This one went to the taxpayers.

By my count the IRS won zero of the tests.

Why then did the IRS even pursue this?

They pursued it because for years they have been emphasizing test (4) – conflict of interest and its “independent investor.” They have had significant wins with it, too, although some wins came from taxpayers reaching too far. I have seen taxpayers draining all profit from the company, for example, or changing the bonus formula whimsically. There was one case where the taxpayer took so much money out of the company that he could not even cash the bonus check. That is silly stuff and low-hanging fruit for the IRS.

This time the IRS ran into someone who was on top of their game.