Sometimes the IRS Just Doesn't Believe You

I was reading the following recently, and we will use it as a springboard for our discussion today:

In its continued assault on real estate investors, the Court held in Jafarpour and Prang v. Commissioner, …, the taxpayers were not actively involved in a real estate trade or business nor was she a real estate professional ….

Prang is just one more taxpayer to fall under the IRS’s aggressive assault on real estate investors.

That writer and I do not agree on Jafarpour and Prang (“Prang”).

We are talking today about the taxation of real estate activities. Ever since 1986 we have had the passive activity rules, which Congress used to address the problem of tax shelters. The overall concept is simple: if an activity is considered to be passive, then losses from the activity cannot be subtracted from income considered nonpassive. Here is an example: you will not be allowed to claim losses or tax credits from an Alpaca investment against your W-2 income and bonus.

There are exceptions for real estate activities. This is not surprising, considering how significant real estate is to the national economy. The exception that Prang wanted was the “real estate professional” exception. If she could attain that, then her real estate activities would be nonpassive. She could subtract losses to her heart’s content.

There are two basic requirements to being a real estate pro:

(1)   More than one-half of your work hours have to be real-estate related, and

(2)   You have to work more than 750 hours in real estate

We have several real estate pro clients. A builder or broker qualifies, for example. These guys work real estate full-time, so they are easy to identify. What if you mix real estate with non-real estate activities? Further, what if the total hours are close?  You had better keep good records. That gets us to Prang.

Jafarpour was the husband. He sold stock options in 2006.

Prang was the wife. She was a chiropractor. Unfortunately she got injured and sold her practice during the middle of 2006.

So Prang and her husband came into cash and were looking for something to do. They have some experience in real estate. They have rented a former residence in California for a decade, for example. She attended seminars on real estate investing, including a course at the community college. The community college instructor explained the additional depreciation available for Katrina-affected areas (referred to as the GO Zone).

Mrs. Prang liked the idea and they snapped up three properties in Louisiana and Alabama. They almost immediately signed contracts with management companies to handle the properties. After all, they live almost 2,000 miles away. They returned to California.

They claimed over $271,000 in real estate losses on their 2006 tax return. Surprisingly, this caught the IRS’ attention. They were audited.

Jafapour immediately admitted that he was not a real estate pro for 2006. Not a problem, as Mrs. Prang claimed that she was the real estate pro. The IRS said: let’s go through the math: how many hours did you work and how many hours were in real estate?

The way to prove this is to show a record or log, preferably kept contemporaneously, showing what you did and how long it took. Mrs. Prang had an appointment book at the chiropractic office, so that should establish the chiropractic hours. The IRS looked at it and had questions. Daily visits were often illegible. There were daily totals, but the IRS was unable to determine what the totals represented. The totals frequently did not coincide with the number of patients filled-in for the day or the hours Mrs. Prang was supposedly working. Prang deepened the hole by attesting that she left the practice after selling in June. However there were e-mails and notations that she was still involved.

The IRS moved over to the real estate logs. The log was divided into sections. Immediately they were curious because she wrote her activities in pen but the number of hours in pencil. Mrs. Prang explained that she did this so she could cross-reference her time with phone records and make adjustments. Flipping through, the IRS saw several times the same task recorded in multiple sections. More than once the amount of time seemed excessive for the task. For example, Prang noted that she spent one hour on November 8, 2006 reading the following e-mail:

Hi Lecia, I'm your loan processor and will be your main contact person from this point on. I received the FedEx package you sent back. I will review it and prepare the file for my underwriter to review. I will update you with the status within 3 business days."

So she was a slow reader. The IRS pressed on. They spotted several days where she said he worked 17 or more hours, which was impressive. Problem is that she noted the same tasks on more than one day. She described doing something while she was actually on a plane back to California, which would have been a Copperfield-worthy trick. Some of the e-mails she claimed to have sent were from her husband’s e-mail account - and electronically signed by her husband.

The IRS came to the conclusion that she manufactured the logs after-the-fact, which greatly weakened their credibility. She worked the logs to get the answer she wanted. The IRS trusted none of it, denied her real estate professional status and disallowed her loss.

Prang went to Tax Court. Here is the Court:

We would have to engage in complete guesswork to determine how much time Ms. Prang spent at her chiropractic business on a particular day during 2006, let alone the entire year. We decline to engage in such dubious speculation.”

We are not convinced that Ms. Prang contemporaneously recorded her actions in the real estate log. Petitioners' unreasonable assertions are so pervasive that the entire log is tainted with incredibility. Moreover, petitioners' appointment book is frequently illegible and generally ambiguous. While Ms. Prang may have invested a considerable amount of time in real estate activities during 2006, petitioners' records are simply too unreliable for us to draw any sound conclusion.”

The Tax Court found the logs unreliable. With them she couldn’t prove her real estate pro status. Without that status she could not claim losses. Without the losses she owed the IRS a lot of money. And she owed a big penalty.

My Take:  I have had a real estate pro audit before, and the IRS challenged the logs directly. I was younger and working under a partner at another firm. In that case, I felt that the examining agent and supervisor were being unreasonable. The client had maintained but had not assembled the data into a usable, calendar form.  The agent felt that fact impugned the log, whereas my argument was that the log was little more than an administrative compilation of existing data. The agent disallowed pro status, the group manager sided with the agent, we appealed and won in Appeals. Quite a hassle - and we had better facts than Prang. For all that the client fired us. It did not go as smoothly as he would have liked. I wasn’t too thrilled about it either.

I try to be blunter with clients these days about the hazards of tax representation. Lose the examiner’s trust, for example, and you may not convince him/her that the sun came up this morning. Catch the examiner on a pet peeve and he/she may raise the body more often than a Living Dead episode. You may have an examiner too green to realize that classroom examples rarely occur outside the classroom. You may run into a coordinated exam, in which a specialized group – not necessarily the examiner - is calling the shots.  A lot can go wrong.

Was Prang an “aggressive assault” on real estate investors? I do not see it. What I do see is someone gaming the system. They got caught. That’s all.

Do Tax Preparers Get Penalized On Their Own Returns?

Do tax preparers ever get penalized by the IRS on their own returns?

We are going to look at one today: Joyce Anne Linzy (JAL). She is party to a Tax Court Memorandum Decision issued on November 7, 2011.

JAL is a tax preparer with more than 15 years’ experience. During 2007 she operated an income tax return preparation business. She owned an apartment building in which she both lived and worked: the business was on the first floor and she lived on the second floor. She also rented out second-floor space that she did not use as a residence.

There were a number of proposed IRS adjustments for the Court to consider:

1.    JAL omitted $2,500 of gambling income.

This is actually the least of her problems.

2.    JAL claimed almost $35,000 of contract labor.

There is no problem with claiming this deduction, but the IRS expects one to maintain documentation to substantiate the deduction upon examination. Here is the Court’s language on this matter:

“Petitioner presented canceled checks, bank account statements, receipts and invoices purporting to substantiate various items claimed as business expenses deductions. These records are not well organized, and have not been submitted to the Court in a fashion that allows for easy association with the portions of the deductions that remain in dispute. Nonetheless, we make what sense we can with what we have to work with…”

The Court is trying to work with JAL. They are referring to the Cohan rule: if the Court knows that a taxpayer incurred an expense, it can (with some statutory exceptions) allow estimates of the actual expenses. JAL must be quite the tax adept, though, as the Court goes on…

“None of the numerous receipts petitioner offered in support of her claimed contract labor expense were for contract labor.”

“The checks are photocopied such that the dates are missing or incomplete, and the full amount cannot be determined…”

Oh, oh.

“These records are incomplete, and there is not enough information to permit a reasonable estimate. Accordingly, respondent’s complete disallowance of petitioner’s … deduction for contract labor is sustained.”

3.    Mortgage interest

JAL used one-third of the building for her tax return business. She deducted one-half of the mortgage interest as a business expenses.

Seems like simple math.

4.    Depreciation

During 2007 she purchased several depreciable items. She did not depreciate the cost of these items but instead claimed the costs as contract labor expenses.

Some of these items could not be immediately expensed under Section 179 because they related to building improvements. These items included siding and tuck pointing. Buildings of course have a long depreciation life, so the swing between immediately expensing and depreciating over many years is magnified.

There was no fallback position here for JAL.

5.    Charitable contributions

You may be aware that you are required to get a timely statement from the charity describing the contribution and that you received nothing of monetary value in return, or to estimate the amount if there was monetary value. You are supposed to have this in hand before you file your return.

JAL seems to have forgotten this.

She deducted a $2,500 donation to Schneider School.

Here is the Court:

               

“Although petitioner received a receipt from the Chicago Public Schools, it does not qualify as a contemporaneous written acknowledgement because it does not state whether she received any goods or services in return for her contribution.”

She deducted a $7,500 donation to Faith Deliverance.

Again, here is the Court:

               

“The letter does not state whether petitioner received goods or services in exchange for contribution and was not received by the earlier of her return’s filing date or its due date…. Thus there is no contemporaneous written acknowledgement from the donee that would permit petitioner to deduct the contributions.”

6.    The substantial understatement penalty

This is a “super penalty” if you misstate your taxable income by too much. The IRS defines “too much” as more than 10% of the final tax but at least $5,000.

JAL had no problem leaping over this hurdle.

The IRS can waive this penalty if one has “reasonable cause.” There are a number of factors that constitute reasonable cause, but a common one is reliance on a tax professional. In fact, I drafted a letter this week requesting abatement of this very penalty, and the reason I gave was their reliance on a tax professional. What happens, however, when you are a tax professional and it is your OWN tax return?

Here is the Court:

“Petitioner’s records were insufficient to substantiate several of her claimed deductions, and she failed to keep adequate books and records. Furthermore, petitioner, a tax return preparer with more than 15 years experience, improperly deducted….Petitioner offered no evidence that she acted with reasonable cause and in good faith. Accordingly, we hold that petitioner is liable … due to negligence or disregard of rules or regulations.”

The penalty alone was over $3,100.

What can I say about JAL?

A lesson here is that the Tax Court is going to hold a professional preparer to a higher standard. Now, JAL was not an attorney, CPA or enrolled agent, but when she stepped into “professional preparer” shoes the Court was going to be less lenient. It is not unreasonable, as others pay you for knowing more about the tax system than the average person. It seems to me that JAL did not rise to the occasion.

A Tax CPA Not Filing Taxes

My daughter goes to the University of Tennessee. Perhaps it is because she is in Knoxville that the following story about Edgar H. Gee Jr. caught my eye.

Mr. Gee is a CPA and has (had?) a small accounting firm on the west side of Knoxville off Kingston Pike. He has been at this for a while, as he is going on 40 years of professional experience.  His resume is nothing to snicker at:

·    He has published articles in the Tax Adviser (a professional publication)

·    He has testified before the U.S. House of Representatives Subcommittee on   the Oversight of IRS Activities

·    He is co-author of PPC’s Guide to Worker Classification

·    He is the winner of the Max Block Award by NYSSCPAs for Distinguished Article of the Year 2000

·    He is a past president of the Knoxville Chapter of the Tennessee Society of Certified Public Accountants

·    He was the recipient of the Discussion Leader of the Year award from the Tennessee Society of CPAs in 2001

What did he do?

Well, the IRS Office of Professional Responsibility disbarred him because he did not pay taxes for tax years 1997 through 2005. The OPR said he had engaged in disreputable conduct by willfully evading his taxes for nine years. The amount of taxes, including interest and penalties, was approximately $340,000.

I guess he can continue lecturing, but he is not practicing before the IRS again.

What argument does a tax CPA present when he hasn’t filed taxes for almost a decade? I didn’t know? That kite is just not going to fly.

It’s just sad.

BTW I do not know Mr. Gee, but maybe I’ll run into him sometime. I do hope that he is not teaching tax at UTK.