The Hosbrook Road Terrible Tax Tale

Let's talk about S corporations.

There are two types of corporations: C corporations and S corporations. Think Amazon or Apple and we are talking about "C" corporations: they file their own returns and pay their own taxes. Think of family-owned Schmidt Studebaker Carriage & Livery and we are talking about "S" corporations: only so many shareholders, do not normally pay tax, the numbers flow-through to the owners who pay the tax on their personal returns.

S corporations are almost the default tax structure for entrepreneurial and family-owned businesses, although in recent years LLCs have been giving them a run for their money. They are popular because the owner pays tax only once (normally), as contrasted to a C corporation with its two levels of tax.

But there are rules to observe.

For example, you have to keep track of your basis in your stock - that is, the amount of after-tax money you have invested in the stock. Your basis goes up as you put the business income on your personal return, but it also goes down as you take distributions (the S equivalent of dividends) from the company. You are allowed to take distributions tax-free as long as your basis does not go negative. Why? Because you paid tax on the business income, meaning you can take it out without a second tax.

Accountants keep permanent schedules to track this stuff.  Or rather, they should. I have been involved in more than one reconstruction project over the years. You have to present these schedules upon IRS audit.

I did not previously have a worse-case story to tell. Now I do. The best part is that the story takes place in Cincinnati.

Gregory Power is a commercial real estate broker with offices first on Montgomery Road and then on Hosbrook Road. He started his company (Power Realty Advisors, Inc.) in 1993. Somewhen in there he used Quicken for his accounting, and he would forward selected reports to his accountant for preparation of the returns.

COMMENT: Quicken is basically a check-register program. It tracks deposits and withdrawals, but it is not a general ledger - that is, the norm for a set of business books. It will not track your inventory or depreciable assets or uncollected invoices, for example.

There was chop in the preparation. For example, the numbers were separated between those Mr. Power reported as a proprietor (Schedule C) and those reported on the S return. Why? Who knows, but it created an accounting problem that would come back to haunt.

He lost money over several years, including the following selected years:

            1995              (191,044)

            1996              ( 70,325)

            2002              ( 99,813)

Nice thing about the S corporation as that he got to put these losses on his personal return. To the extent his return went negative, he had a net operating loss (NOL) which he could carry-over to another year. Mind you, he got to put those losses on his personal return to the extent he did not run out of basis - yet another reason to maintain permanent schedules.

He took distributions. In fact, he took distributions rather than taking a salary, which is a tax no-no. The IRS did not come after him on this issue because it had another angle of attack.

He had the corporation pay some of his personal and living expenses, which is another no-no. Accountants will reclassify these to distributions and tell you to stop.

Some of his S corporation returns did not show distributions. This is not possible, of course, as he was taking distributions rather than salary. That tells me that the accountant did not have numbers. It also tells me the accountant could not maintain the schedules - at least not accurately - that we talked about.

Sure enough, his big payday years came. There was tax to pay ... except for those NOLs that he was carrying-forward from his bad years. He told the IRS that he had over $500,000 of NOLs, which he could now put to good use.

Problem: He did not have those schedules.

Solution: He or his accountant went back and reconstructed those schedules.

Problem: The IRS said they were bogus.

Solution: You go to Tax Court.

COMMENT: It would have been cheaper to keep schedules all along.

Mr. Power ran into a very severe issue with the Court: it does not have to accept your tax returns as proof of the numbers.  The Court can request the underlying books and records: the journals, ledger and what-not that constitutes the accounting for a business.

The Court did so request.

He trotted out those Quicken reports and handwritten summaries.

The Court noted that Mr. Power was somehow splitting numbers between his proprietorship and the corporation, although it did not understand how he was doing so. This made it difficult for the Court to review a carryforward schedule when the Court could not first figure-out where the numbers for a given year were coming from.

Strike one.

The Court wanted to know what to do with those tax returns that did not show distributions, which it knew was wrong as he was taking distributions rather than a salary.

Strike two.

And there was the matter of personal expenses being paid through the company. It appears that in some years the corporation deducted these expenses, and in other years it did not. The Court wasn't even sure what the amounts were. It did not help when Mr. Power commingled business and personal funds when buying his house in Indian Hill.

Strike three.

His business accounting was so bad that the Court bounced the NOL carryforward. The whole thing.

He owed tax. He owed penalties.

And no one knows if he really had an NOL that he could use to sop-up his profitable years because he had neglected his accounting to an extreme degree. He could not prove his own numbers. 

But Mr. Power has attained tax fame.

Deducting Everything - The Tanzi Doctrine

I admit: I got a chuckle from reading the case.

The taxpayers (Tanzi's) are married, and for the year in question they were employed by Seminole State College, which is Sanford, Florida. I remember a conversation with a Sanford CPA a year or two ago lamenting that there no longer was separation between Orlando and Sanford. I was in Orlando this year, and he is right - there isn't.

Our taxpayer was an adjunct instructor teaching communications, and his wife worked at the campus library. Although an adjunct, he held a PhD in communications, so we can presume he was hoping for a permanent full-time position.

On their 2011 return they deducted the following as employee expenses:

            (1) 100% of their telephone, internet and television

            (2) depreciation

            (3) books, CDs and DVDs

            (4) computer expenses

The IRS bounced the employee expenses and sent them a notice for approximately $3,000.

Employee expenses are a subset of "miscellaneous deductions." One has to itemize to get to miscellaneous deductions, and even then these miscellaneous deductions are not what they used to be. The common itemized deductions are mortgage interest, real estate taxes and contributions. Living in Florida, our taxpayers did not have to concern themselves with another common itemized deduction - state income taxes. Chances are the first three got them into itemized deduction range, and their miscellaneous deductions then became usable. It is rare that miscellaneous deductions by themselves will be enough to get you to itemize.

Miscellaneous deductions are not tax-efficient, though. The Code requires that you reduce your miscellaneous deductions by 2% of your adjusted gross income, so that portion is immediately forfeited.

EXAMPLE: You and your spouse make a combined $150,000. You would have to immediately reduce your miscellaneous deductions by $3,000 (i.e., $150,000 times 2%). If your miscellaneous deductions totaled $3,500, only $500 would be deductible. And yes, it is intentional. It is a way for Congress to pry a few more tax dollars from everyone who incurs employee expenses.

COMMENT: My daughter is working before returning to graduate school. She is required to use her car for work. Although reimbursed something for mileage, it is not the full rate permitted by the IRS. Her employer explained to her that she could deduct the difference come tax time. As her dad and tax advisor, I explained that this was not true. She would not have enough to itemize, and her unreimbursed mileage would be deductible only if she itemized.

By the way, you forfeit all miscellaneous deductions if you are subject to the AMT (alternative minimum tax). As I said, they are not efficient.

The Tanzi's were deducting employee business expenses. The IRS was questioning how 100% of their telephone and internet - just to start - became business. There is a long-standing doctrine that an employee is "in the business" of being an employee, but one still has to show some nexus between the expenses and being an employee. I receive a W-2, for example, but I cannot deduct my Starbucks tab solely for the reason that I am an employee. I would have a business nexus if I met a client there, but not because I was picking up coffee for my commute to the office.

The IRS wanted to know what that nexus was.

The Tanzi's argued that they must constantly expand their "general knowledge" to be effective at their jobs. Mr Tanzi explained that individuals holding terminal degrees - such as himself, coincidently - especially bear a lifelong burden of "developing knowledge, exploring [and] essentially self-educating."   Mr. Tanzi insisted that all expenses paid in pursuing his general knowledge should be deductible as unreimbursed business expenses.

COMMENT: If Mr Tanzi won this argument, I would immediately try to expand the Tanzi doctrine to include tax CPAs with Masters degrees who also maintain a tax blog. Our burdened ranks must constantly expand our general knowledge to be effective at our jobs. I for example sometimes work with and write about international tax matters. Seems to me that a trip overseas to visit my wife's family should be deductible, as it expands my knowledge of being overseas, or some reasoning along those lines.

The tax Code recognizes that some expenses are simply personal in nature. There is even a Code section that says this out loud:

  Section 262 - Personal, living, and family expenses

      (a) General rule

Except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses.

Here is the Court:

While we find credible the Tanzi's testimony that they spent significant time and resources educating themselves, we do not believe the expenses are ordinary and necessary for the trades of being a professor or a campus librarian but rather are personal, living or family expenses nondeductible under section 262(a)."

No surprise for the Tanzi's, but I am a bit disappointed. Looks like I won't be able to deduct my life expenses as ordinary and necessary to the business of being a tax CPA and blogger. Those tax refunds would have been sweet.

IRS Fires Revenue Agent Who Lost Own Case in Tax Court

Would you be aggressive on your taxes if your job was on the line?

I am reading Agbaniyaka v Commissioner. Benjamin Agbaniyaka (Ben) started with the IRS in 1986. He received excellent evaluations, several promotions and a Master’s Degree in taxation from Long Island University. Between the years 1988 and 2006 Ben engaged in a side business selling African arts and crafts.  Here are the business results for selected years;

            2001    no sales and a loss of $5,661

            2002    sales of $3,216 and a loss of $15,232

            2003    sales of $1,372 and a loss of $7,624

            2004    sales of $200 and a loss of $6,383

He also claimed itemized deductions, including annual expenses for “Union Dues” and “Accounting Journals.”

He gets audited for 2001.

Let’s go over what the IRS expects when it sees that Schedule C on your return. It expects you to maintain records so that you can compile a tax return at the end of the year. Records can be as simple as a checkbook with a year-sheet recapping everything by category. The IRS also wants you to keep invoices and receipts, to allow a third party to trace a check to something. There are some expenses where Congress itself tells the IRS what documentation to review. Meals and car expenses are two of the most common examples. With those two, the IRS is somewhat limited in its flexibility because Congress called the tune.

Then we have the hobby loss rules. The idea here is that a business activity is expected to show a profit every so often. If the activity has always shown losses, it is difficult to buy-into the argument that it is a business. An actual business would eventually shut down and not throw good money after bad. There are exceptions, of course, but it is a good starting point.

The third point is that a revenue agent is going to be held to a higher standard. There is the education and training involved, as well as that whole working for the IRS thing.

The IRS audits 2001. It finds the following:

(1)   Ben deducted expenses for a course on trust and estates. He cannot provide any documentation, however. He also has other unsubstantiated education expenses, including his journals.

(2)   Ben claimed a deduction for union expenses. He cannot present any proof he paid the union.

(3)   Ben is hard-pressed to persuade the IRS that there was any profit intent to his arts and crafts activity. The problem is that Ben never reported a profit – ever. The IRS simply disallowed the loss.

(4)   The IRS is now miffed at Ben, especially since Ben is one of their own. They argue that the Ben’s failure to make any reasonable attempt to comply with the tax code is negligence. In fact, failure to keep records shows not only negligence but also Ben’s intentional disregard of the regulations. The IRS slapped Ben with a substantial understatement penalty.

The IRS expands the audit to 2002, 2003 and 2004, with similar results.

Can this get worse? You bet. The 1998 IRS Restructuring and Reform Act requires termination of an IRS employee found to have willfully understated his federal tax liability, unless such understatement is due to reasonable cause and not willful neglect.

Let’s go back to the substantial understatement penalty. One of the exceptions to the penalty is reasonable cause. Ben goes to Tax Court. He pretty much has to. He has to win, at least on the penalty issue. If he can get the court to see reasonable cause, he might be able to save his job.  

The Tax Court is unimpressed. Here are some comments:

We found Mr. Agbaniyaka’s testimony to be general, vague, conclusory, uncorroborated, self-serving and/or questionable in all material respects.”

During the years at issue, Mr [] was a trained revenue agent and was fully aware of the requirements imposed by …. Nonetheless, petitioners failed to maintain sufficient records for each of their taxable years 2001 through 2004 to establish their position with respect to any of the issues presented.”

On the record before us, we find that petitioners have failed to carry their burden of showing that they were not negligent and did not disregard rules and regulations, or otherwise did what a reasonable person would do, with respect to the underpayment for each of the years at issue.”

After the Tax Court’s decision, the IRS ended Ben’s employment effective April 15, 2008.

Ben appeals to the Federal Court of Appeals. That too fell on deaf ears:

“… he was undoubtedly aware that he had to substantiate his efforts to conduct a business in 2001 and beyond. Being an experienced and knowledgeable Agency employee, he had to have been aware that he could not substantiate his alleged business activities. By claiming deductions on Schedule C, he knowingly and willfully submitted tax filings to which he was not entitled.”

Ben next tried other channels. In the end, he lost and stayed fired.

How much money are we talking about? The court does not come out and specifically give a dollar amount, but there is enough to approximate the taxes as little more than $10,000.

I question the lack of documentation for some of these claimed expenses. The bank can provide cancelled checks for the subscriptions or seminars, and the union will provide a letter of membership and dues activity.  The court doesn’t elaborate, but it is clear that Ben wasn’t trying too hard.

Would you gamble your job for $10,000? Ben did.

I wouldn’t.