Navigating The Tax Code On Your Own

 

I received a phone call recently from the married daughter of a client. I spoke with the couple – mostly the son-in-law – about needing an accountant. They had bought property, converted property to rental status and were selling property the following (that is, this) year.

It sounds like a lot. It really isn’t. It was clear during our conversation that they were well-versed in the tax issues.

I told them: “you don’t need me.”

They were surprised to hear this.

Why would I say that?

They knew more than they gave themselves credit for. Why pay me? Let them put the money to better use.

Let’s take an aside before continuing our story.

We - like many firms - are facing staffing pressure. The profession has brought much of this upon itself – public accounting has a blemished past – and today’s graduates appear to be aware of the sweatshop mentality that has preceded them. Lose a talented accountant. Experience futility in hiring new talent. Ask those who remain to work even harder to make up the shortfall. Be surprised when they eventually leave because of overwork. Unchecked, this problem can be a death spiral for a firm.

Firms are addressing this in different ways. Many firms are dismissing clients or not accepting new ones. Many (if not most) have increased minimum fees for new clients. Some have released entire lines of business. There is a firm nearby, for example, which has released all or nearly all of its fiduciary tax practice.

We too are taking steps, one of which is to increase our minimum fee for new individual tax clients.

Back to the young couple.

I explained that I did not want to charge them that minimum fee, especially since it appeared they could prepare their return as well as I could. 

They explained they wanted certainty that it was done right.

Yeah, I want that for them too. We will work something out.

But I think there is a larger issue here.

The tax Code keeps becoming increasingly complex. That is fine if we are talking about Apple or Microsoft, as they can afford to hire teams of accountants and attorneys. It is not fine for ordinary people, hopefully experiencing some success in life, but unable – or fearful - to prepare their own returns. Couple this with an overburdened accounting profession, a sclerotic IRS, and a Congress that may be brewing a toxic stew with its never-ending disfigurement of the tax Code to solve all perceived ills since the days of Hammurabi.

How are people supposed to know that they do not know?

Let’s look at the Lucas case.

Robert Lucas was a software engineer who lost his job in 2017. He was assisting his son and daughter, and he withdrew approximately $20 grand from his 401(k) toward that end.

Problem: Lucas was not age 59 ½.

Generally speaking, that means one has taxable income.

One may also have a penalty for early distribution. While that may seem like double jeopardy, such is the law.

Sure enough, the plan administrator issued a Form 1099 showing the distribution as taxable to Lucas with no known penalty exception.

Lucas should have paid the tax and penalty. He did not, which is why we are talking about this.

The IRS computers caught the omission, of course, and off to Tax Court they went.

Lucas argued that he had been diagnosed with diabetes a couple of years earlier. He had read on a website that diabetes would make the distribution nontaxable.

Sigh. He had misread – or someone had written something wildly inaccurate about – being “unable to engage in any substantial gainful activity.”

That is a no.

Since he thought the distribution nontaxable, he also thought the early distribution penalty would not apply.

No … again.

Lucas tried.

He thought he knew, but he did not know.

He could have used a competent tax preparer.

But how was he to know that?

Our case this time was Robert B. Lucas v Commissioner T.C.M. 2023-009.

Deducting a Divorce

I am looking at two points on a case:

(1)  The IRS wanted $1,760,709; and

(2)  The only issue before the Court was a deduction for legal and professional fees.

That is one serious legal bill.

The taxpayer was a hedge fund manager. The firm had three partners who provided investment advisory services to several funds. For this they received 1.5% of assets under management as well as 20% of the profits (that is, the “carry”). The firm decided to defer payment of the investment and performance fees from a particular fund for 2006, 2007 and 2008.

2008 brought us the Great Recession and taxpayer’s spouse filing for divorce.

By 2009 the firm was liquidating.

The divorce was granted in 2011.

Between the date of filing and the date the divorce was granted, taxpayer received over $47 million in partnership distributions from the firm.

You know that point came up during divorce negotiations.

To be fair, not all of the $47 million can be at play. Seems to me the only reachable part would be the amount “accrued” as of the date of divorce filing.

He hired lawyers. He hired a valuation expert.

Turns out that approximately $4.7 million of the $47 million represented deferred compensation and was therefore a marital asset. That put the marital estate at slightly over $15 million.

Upon division, the former spouse received a Florida house and over $6.6 million in cash.

He in turn paid approximately $3 million in professional fees. Seems expensive, but they helped keep over $42 million out of the marital estate.

He deducted the $3 million.

Which the IRS bounced.

What do you think is going on here?

The issue is whether the professional fees are business related (in which case they are deductible) or personal (in which case they are not). Taxpayer argued that the fees were deductible because he was defending a claim against his distributions and deferred compensation from the hedge fund. He was a virtual poster boy for a business purpose.

He has a point.

The IRS fired back: except for her marriage to taxpayer, the spouse would have no claim to the deferred compensation. Her claim stemmed entirely because of her marriage to him. The cause of those professional fees was the marriage, which is about as personal as an event can be. The tax Code does not allow for the deduction of personal expenses.

The IRS has a point.

The tax doctrine the IRS argued is called origin-of-the-claim. It has many permutations, but the point is to identify what caused the mess in the first place. If the cause was business or income-producing, you may have a deduction. If the cause was personal, well, thanks for playing.

But a divorce can have a business component. For example, there is a tax case involving control over a dividend-paying corporation; there is another where the soon-to-be-ex kept interfering in the business. In those cases, the fees were deductible, as there was enough linkage to the business activity.

The Court looked, but it could not find similar linkage in this case.

In the divorce action at issue, petitioner was neither pursuing alimony from Ms [ ] nor resisting an attempt to interfere with his ongoing business activities.

Petitioner has not established that Ms [ ] claim related to the winding down of [the hedge fund]. Nor has petitioner established that the fees he incurred were “ordinary and necessary” to his trade or business.

While the hedge fund fueled the cash flow, the divorce action did not otherwise involve the fund. There was no challenge to his interest in the fund; he was not defending against improper interference in fund operations; there was no showing that her action led to his winding down of the fund.

Finding no business link, the Court determined that the origin of the claim was personal.

Meaning no deduction for the professional fees.

NOTE: While this case did not involve alimony, let us point out that the taxation of alimony is changing in 2019. For many years, alimony – as long as the magic tax words were in the agreement – was deductible by the payor and taxable to the recipient. It has been that way for my entire professional career, but that is changing. Beginning in 2019, only grandfathered alimony agreements will be deductible/taxable, with “grandfathered” meaning the alimony agreement was in place by December 31, 2018.

Mind you, this does not mean that there will be no alimony for new divorces. What it does mean is that one will not get a deduction for paying alimony if one divorces in 2019 or later. Conversely, one will not be taxed upon receiving alimony if one divorces in 2019 or later.

The Congressional committee reports accompanying the tax change noted that alimony is frequently paid from a higher-income to a lower -income taxpayer, resulting in a net loss to the Treasury. Changing the tax treatment would allow the Treasury to claw back to the payor’s higher tax rate. Possible, but I suspect it more likely that alimony payments will eventually decrease by approximately 35% - the maximum federal tax rate – as folks adjust to the new law.

Our case this time was Sky M Lucas v Commissioner.