File A Return, Especially If You Have Carryovers

 

Please file a tax return when you have significant carryovers.

Let’s look at the Mosley case.

In 2003 Sonji Mosley bought four residential properties in North Carolina.

In 2007 she bought undeveloped land in South Carolina.

In 2009 all the properties were foreclosed.

On her 2009 return she reported approximately $20 grand of net rental expenses and a capital loss of approximately $182 grand.

On her 2014 return she claimed an (approximately) $17 thousand loss from one of the 2009 foreclosures.

On her 2015 return she claimed an (approximately) $28 thousand loss from one of the 2009 foreclosures.

On to n 2018.

It seemed an ordinary year. She worked for the city of Charlotte. She also broke two retirement accounts. The numbers were as follows: 

            Wages                                                $ 40,656

            Retirement plan distributions              $216,871

The retirement plan distributions were going to hurt as she was under 59 ½ years of age. There would be a 10% penalty for early distribution on top of ordinary income taxes.

Well, there would have been - had she filed a return.

The IRS prepared one for her. The IRS already had her W-2 and 1099s through computer matching, so they prepared something called a Substitute for Return (SFR). Taxes, penalties, and interest added to almost $60 grand. The implicit bias in the SFR is transparent: everything is taxable, nothing is deductible. The IRS wants you to see the SFR, clutch your chest and file an actual return.

To her credit, she did reply. She did not file a return, though; she replied with a letter.

COMMENT: She should have sent a return.

She explained that - yes – she should have filed a return, but the IRS was not giving her credit for prior year carryovers. If anything, she still had a credit with the IRS. She also requested the IRS to remove all penalties and interest.

COMMENT: She definitely should have sent a return.

The IRS could not understand her letter any more than you or I. They sent a Notice of Deficiency, also called a “NOD,” “SNOD,” or “90-day letter.” It is the ticket to Tax Court, as we have discussed before.

Off to Court they went.

Mosley next submitted four handwritten calculations to the IRS.

• The first showed a net operating loss (NOL) of $444,600 and a capital loss of $206,494, both originating in 2009.
• The second and third ones broke down those numbers between South and North Carolina.
• The fourth one was an updated calculation of her 2018 taxes. According to her numbers, she had a remaining NOL of $211,308 going into 2018. Since the total of her 2019 income was approximately $257 grand, she had very much separated the thorn from the stalk.

The IRS had questions. The tax impact of a foreclosure can be nonintuitive, but – in general – there are two tax pieces to a foreclosure:

(1)  The borrower may have income from the cancellation of income. That part makes sense: if the bank settles a $150,000 debt for $100 grand, one can see the $50 grand entering the conversation. Then follows a bramble of tax possibilities – one is insolvent, for example – which might further affect the final tax answer but which we will leave alone for this discussion.

(2)   Believe it or not, the foreclosure is also considered a sale of the property. There might be gain or loss, and the gain might be taxable (or not), and the loss might be deductible (or not). Again, we will avoid this bramble for this discussion.

The IRS looked at her calculations. She had calculated a 2009 NOL of $444,600 and $78,025 capital loss from her North Carolina properties. The IRS recalculated North Carolina and arrived at taxable gain of $55,575.

Not even close.

You can anticipate the skepticism the Tax Court brought to bear:

(1)  She did not file a 2009 return, yet she asserted that there were carryovers from 2009 that affected her 2018 return.

(2)  She reported the same transactions in 2009, 2014 and 2019.

(3)  The tax reporting for foreclosures can be complicated enough, but her situation was further complicated by involving rental properties. Rentals allow for depreciation, which would affect her basis in the property and thereby her gain or loss on the foreclosure of the property.

(4)  The IRS recalculations were brutal.

The Court pointed out the obvious: Mosley had to prove it. The Court did not necessarily want her to recreate the wheel, but it did want to see a wheel.

Here is the Court’s sniff at the net operating loss carryover:

It is apparent that the record is devoid of evidence to properly establish both the existence and the amount of petitioner’s NOLs in 2009.”

Here is the Court on the capital loss carryover:

“ … petitioner initially reported the foreclosure on the South Carolina land resulted in $182,343 of net long-term capital losses, and for each of 2009-17, she claimed $3,000 of that amount as a long-term capital loss deduction pursuant to section 1211(b). But on the 2015 return … petitioner also improperly claimed an ordinary loss deduction of 110,257 from the sale or exchange of the South Carolina land despite the foreclosure on that land in 2009. Thus, petitioner effectively double counted the loss …."

Mosley lost on every count, She owed tax, penalty, and interest.

And there is a lesson. If you have significant tax carryovers spilling over several years, you should file even if the result is no taxable income. The IRS wants to see the numbers play out. Get yourself in hot water and the Tax Court will want to see them play out also.

You might even catch mistakes, like double-counting things.

Our case this time was Mosely v Commissioner, T.C. Memo 2025-7.  

When A Tax Audit Is Not An Audit

 

I am cleaning-up files here at Galactic Command. I saw an e-mail from earlier this year chastising someone for running business deposits through a personal account.

I remember.

He wanted to know why his extension payment came in higher than expected.

Umm, dude, you ran umpteen thousands of dollars through your personal account. I am a CPA, not a psychic.

Let’s spend some time in this yard.

If you are self-employed – think gig worker – and are audited, the IRS is almost certain to ask for copies of your bank accounts. Not just the business account(s), mind you, but all your accounts, business and personal.

I have standard advice for gig workers: open a separate business account. Make all business deposits to that account. Pay all business expenses from that account. When you need personal money, draw the needed amount from the business account and deposit to your personal account.

This gives the accountant a starting point: all deposits are income until shown otherwise. Expenses are trickier because of depreciation, mileage, and other factors.

Is it necessary?

No, but it is best practice.

I stopped counting how many audits I have represented over the years. I may not win the examiner’s trust with my record-keeping, but I assure you that I will win their distrust without it.

Does the examiner want to pry money from you? You bet. Examiners do not like to return to their managers with a no-change.

Will the examiner back-off if all the “i’s” are dotted? That varies per person, of course, but the odds are with you.

And sometimes unexpected things happen.

Let’s look at the Showalter case.

Richard Showalter (RS) owned a single-member LLC. The LLC in turn had one bank account with Wells Fargo.

This should be easy, I am thinking.

RS did not file a tax return for 2013.

Yep, horror stories often start with that line.

The IRS prepared a substitute for return (SFR) for 2013.

COMMENT: The IRS prepares the SFR with information available to it. It will add the 1099s for your interest and dividends, the sales price for any securities trades, any 1099s for your gig, and so forth. It considers the sum to be taxable income.

         Where is the issue?

Here’s one: the IRS does not spot you any cost for securities you sold. Your stock may have gone through the roof, but the odds that it has no cost is astronomical.

Here is another. You have a gig. You have gig expenses. Guess what the IRS does not include in its SFR? Yep, you get no gig expenses.

You may be thinking this has to be the worst tax return ever. It is leaving out obvious numbers.

Except that the IRS is not trying to prepare your tax return. It is trying to get your attention. The IRS throws an inflated number out there and hopes that you have enough savvy to finally file a tax return.

So, RS caught an SFR. The IRS sent him a 90-day notice (also known as a statutory notice of deficiency or SNOD), which is the procedure by which the IRS can move your file to Collections. You already know the tender mercies of IRS Collections.

RS responded to the SNOD by filing with the Tax Court. He wanted his business expenses.

Well, yeah.

RS provided bank statements. The IRS went through and – sure enough – found about $250 grand of deductions, either business or itemized.

That turned out rather well for RS. He should have done this up-front and spared himself the headache.

Then the IRS looked at his deposits. Lo and behold, they found another hundred grand or so that RS did not report as income.

It is not taxable, said RS.

Prove it, said the IRS.

RS did not.

COMMENT: It is unclear to me whether this disputed deposit was fully or partially taxable or wholly nontaxable. The deposit came from a closing statement. Maybe I am being pedantic, but I expect a cost for every sale. The closing statement for the sale is not going to show cost. Still, RS did not argue the point, so ….  

Now think about what RS did by getting into IRS dispute.

RS filed with the Tax Court because he wanted his deductions. Mind you, he could have gotten them by filing a return when required. But no, he did this the hard way.

He now submitted invoices and bank statements to support his deductions.

However, using bank statements is an audit procedure. Why is the IRS using an audit procedure?

Well, he is in Tax Court and all. He picked the battleground.

Had RS filed a return, the IRS might have processed the return without examination or further hassle. Since bank statements are an examination step, the IRS would never have seen them.

Just saying.

Was this this fair play by the IRS?

The Court thought so. The IRS cannot run wild. There must be a “minimal evidentiary showing” tying the taxpayer to potential income. The IRS added up his deposits; that exceeded what he reported as income. Seems to me the IRS cleared the required “minimal” hurdle.

By my reckoning, RS should still come out ahead. The IRS bumped his income by a smidgeon less than a hundred grand, but they also spotted him around a quarter million in business and itemized deductions. Unless there is crazy in that return, this should have improved his tax compared to the SFR.

Our case this time was Richard Showalter v Commissioner, T.C. Memo 2022-114.