An Accounting Firm Gets Sued

I just saw that Baker Tilly has acquired Seiler LLP, a CPA firm located in San Francisco and practicing for well over half a century.

There is nothing unusual here. Many older CPAs are looking to retire. In some cases, the firm may have planned for transition and brought in, developed, and retained a pipeline of ownership-interested younger CPAs.  The older CPAs retire, the younger CPAs step up and the firm continues.

In other cases, there is no such pipeline, and the older CPA’s exit plan is a sale to another firm.

The matter caught my eye because a client is suing Seiler for negligence. The matter is still in court. I thought the grounds for negligence was … different.

It is not our usual brew of java, but let’s talk about it.

It starts with a married couple: Eric Freidenrich and Amy Macartney. They hired Seiler to prepare their 2019 joint tax return. The return was filed in December 2020.

COMMENT: You may be thinking that the return was filed late (that is, after October 15) and penalties and interest would be due. That is not true here, as the return showed an overpayment of almost $450 grand. There normally will be no interest and penalties on refund-due returns, as penalties and refunds normally apply only when balances are due the IRS. The risk to a refund return is waiting too long to file a return. Remember, the statute of limitations on filing is three years. Wait past those three years and you will lose your refund.

For some reason, Eric and Amy did not use a home address on their return. They instead used their financial advisor’s address, a practice they had followed for years.

Now, a couple of things happened after 2019 and during 2020 before Seiler filed the return:

·       Eric and Amy divorced.

·       The financial advisor moved.

On first blush, I would be concerned about the divorce. A CPA (or his/her firm) should think long and hard about representing a divorcing couple. The reason is simple: which one of the two is the client? Representing both can create a conflict of interest, and a CPA is supposed to maintain independence and avoid such conflicts. Failure to do so can result in a hearing before a State Board of Accountancy.

The refund arrived in April 2022.

The two had signed their separation agreement in June 2021.

The separation agreement included language that Eric would be responsible for additional taxes due during the term of marriage, but - to be fair - he would also be entitled to any refunds.

Amy did not know that the IRS refund got held up. The couple’s routine was to deposit in the couple’s Fidelity account, and the separation agreement had Amy receiving 60% of the Fidelity account.

The refund was almost $450 grand, and 60% of that – approximately $270 grand – would have gone to Amy.

She was not amused.

I would not be either.

She sued Seiler for negligence.

Notice that she did not sue her ex-husband.

Where is the negligence?

Seiler – as a firm – knew that that advisor had moved. It should have used the new address.

Did the tax team – a subset of Seiler – also know that the advisor had moved? Information moves well enough in a CPA firm, but it would be false to say that it moves flawlessly. It is possible that the tax department did not know, but Amy is suing Seiler, not the tax department.

Seiler (or rather, their attorney) tried to get the motion dismissed.

And there is a quick lesson here about torts. Torts are civil law. Think of torts as suing someone. You bring suit, not the government. It is conduct between private parties.

The idea behind a tort is to restore the injured party (as much as possible in the circumstance) to where he/she would have been had the other party not acted or failed to act. A goal of tort law is to see the world as it could have been, not as the world is now.

Well, under that description Amy would have received 60% of the IRS refund. Seiler injured her. Her ex did not injure her, as he stated in the divorce decree that he would keep any tax refunds relating to the marriage term.

The Court therefore saw reason for tort action and would not grant summary motion for dismissal.

What does this mean? It means that the Court will hear the case against Seiler for negligence.

As a tax CPA, it bothers me that I could get my firm sued for something I did not even know. That said, I get it. The firm knew. However, Eric and Amy saw the address on the return. Their attorneys would also have seen the address. Do we know if the financial advisor timely filed a change of address with the IRS? Seiler might not be the only party with some measure of fault. 

Firing A Client

We fired a client.

Nice enough fellow, but he would not listen. To us, to the IRS, to getting out of harm’s way.

He brought us an examination that started with the following:

We filed in Tax Court. I was optimistic that we could resolve the matter when the file returned to Appeals. There was Thanos-level dumb there, but there was no intentional underreporting or anything like that.

It may have been one of the most demanding audits of my career. The demanding part was the client.

Folks, staring down a $700 grand-plus assessment from the IRS is not the time to rage against the machine.  An audit requires documentation: of receipts, of expenses. Yes, it is bothersome (if not embarrassing) to contact a supplier for their paperwork on your purchases in a prior year. Consider it an incentive to improve your recordkeeping.

At one point we drew a very harsh rebuke from the Appeals Officer over difficulties in providing documentation and adhering to schedules. This behavior, especially if repetitive, could be seen as the bob and weave of a tax protester, and the practitioner involved could also be seen as enabling said protestor.

As said practitioner I was not amused.

We offered to provide a cash roll to the AO. There was oddball cash movement between the client and a related family company, and one did not need a psychology degree to read  that the AO was uncomfortable. The roll would show that all numbers had been included on the return. I wanted the client to do the heavy lifting here, especially since he knew the transactions and I did not. There were a lot of transactions, and I had a remaining book of clients requiring attention. We needed to soothe the AO somehow.

He did not take my request well at all.

I in turn did not take his response well.

Voices may have been raised.

Wouldn’t you know that the roll showed that the client had missed several expenses?

Eventually we settled with the IRS for about 4 percent of the above total. I knew he would have to pay something, even if only interest and penalties on taxes he had paid late. 

And that deal was threatened near the very end.

IRS counsel did not care for the condition of taxpayer’s signature on a signoff. I get it: at one point there was live ink, but that did not survive the copy/scan/PDF cycle all too well. Counsel wanted a fresh signature, meaning the AO wanted it and then I wanted it too.

Taxpayer was on a cruise.

I left a message: “Call me immediately upon return. There is a wobble with the IRS audit. It is easily resolved, but we have time pressure.”

He returned. He did not call immediately. Meanwhile the attorneys are calling the AO. The AO is calling me. She could tell that I was beyond annoyed with him, which noticeably changed her tone and interaction. We were both suffering by this point.

The client finally surfaced, complaining about having to stop everything when the IRS popped up.

Not so. The IRS reduced its preliminary assessment by 96%. We probably could have cut that remaining 4% in half had we done a better job responding and providing information. Some of that 2% was stupid tax.”

And second, you did not stop everything. You had been in town a week before calling me.”

We had a frank conversation about upping his accounting game. I understand that he does not make money doing accounting. I am not interested in repeating that audit. Perhaps  we could use a public bookkeeper. Perhaps we could use our accountants. Perhaps he (or someone working for him) could keep a bare-boned QuickBooks and our accountants would review and scrub it two or three times a year.

Would not listen.

We fired a client.

Some Thoughts After The Tax Filing Deadline(s)

 

There is something happening in the public accounting profession. The profession itself is aging. The AICPA expected 75% of practicing CPAs to reach retirement age by 2020 – which was four years ago. Many smaller firms do not have succession plans, meaning that an owner’s retirement plan likely involves being acquired by another firm. Fewer college students are pursuing accounting majors, placing stress on recruiting and retaining accountants in the early years of their career. We see firms releasing clients and sometimes entire lines of practice. I know of one which released its trust work, which surprised me. I contributed to this several years ago when we released our inbound (that is, international) work. These clients still need professional advice, but fewer CPAs are providing these services.

On the flip side, it is a great time for someone to start (or grow) an accounting practice. A challenge here is step growth – that is, growth that requires hiring. One circles back to the issue of the talent shortage. A bad hire is damaging, perhaps even more so in a small firm.

Even the IRS is not immune to the talent shortage. In 2019 the IRS employed approximately 75,000 people. The Inflation Reduction Act supposedly provided funds to hire an additional 87,000 people through the year 2031. It hasn’t, of course, as the IRS is competing with every other employer in the market.

I suspect the profession has done much of the damage to itself. One can easily point to the 150-hour requirement for a CPA license. That may have made sense years ago, but with today’s exorbitant college costs that additional year of class, books and housing might be difficult to justify.

And then we have the toxicity of the profession itself. I cannot recall the last time that a CPA my age has not shared his/her “horror” stories: the stress, hours, near-impossible deadlines, psychopathic personalities, power dynamics and whatnot. I remember a managing partner bringing cigars so we could “talk”; we sat outside, and he explained how infeasible it was for me to visit my ailing grandmother in Florida. My grandmother died that year. I also left the firm that year. I suspect Gen Z will not tolerate this behavior as passively, and rightfully so.   

Congress has greatly exacerbated the problem with its never-ending and wildly metastasizing tax changes. It used to be that accountants would spread their tax work over the course of the year by placing their business clients on a fiscal year – that is, a tax year ending other than December 31. This allowed work to be distributed more sanely over the year. Congress changed this in 1986 by requiring almost everyone to use the calendar year. Yes, there was an “out,” and the out was for the business to pay a “deposit” for taxes it would have paid had it changed to a calendar year. I suspect that – even if not a CPA – you can guess how well those client conversations went. Combine that with Congress’ recent-enough 1099 reporting fetish and you have a crippling steamroller than begins in January and ends … well, who know when.  

I think we overstretched ourselves here at Galactic Command this year. Potential clients are calling for appointments, and it can be hard (for some of us) to say no. After the just-concluded September and October extension deadlines, however, we must learn to say no. We do not have the resources, and we are burning the resources – including me – that we do have.    

Then there is AI – will artificial intelligence replace any/some/much of what a CPA does? Depending on what the accountant does, I suppose it is possible. First year audit work, for example, scarcely requires a 150-hour degree. That might be a viable onramp for AI. Then again, I remember when QuickBooks was going to put accounting services departments out of business. It didn’t, and accounting services is one of the most sought-after practice areas in accounting firms today. Will AI take away much of my 1040 workload? 

I hope so.

A Bad Idea

I am reading an abstract for an upcoming article in the Southern California Law Review.

When an electricity provider wants customers to pay their bills monthly, it sends them a bill each month. Yet this is not how the tax system works, at least for independent contractors. Their taxes are due quarterly, but they receive a tax statement (Form 1099) only one time a year. It is up to the individual, then, to know when their taxes are due and how to pay them, and it is on that individual to estimate how much they owe each quarter. As a result, compliance for independent contractors – particularly for online platform workers–tends to be lacking. Failure to pay their estimated taxes subjects these taxpayers to potential penalties and causes the government to collect less tax revenue.

Yep, quarterly taxes for the self-employed. I know a lot about the topic.

There is a simple, yet entirely overlooked, reform that could vastly improve compliance when it comes to paying estimated taxes: third-party information returns (Form 1099s) should be issued to taxpayers on a quarterly basis. The idea is straightforward and intuitive. If the government wants people to pay taxes four times per year, it needs to effectively “bill” them four times per year. This idea is supported by social science research showing that, the more taxpayers are reminded to pay their taxes, the more likely they are to do so.

Sigh.

If only it were so simple.

Unspoken is an arrogance that accounting is just pushing a button. Everything is automated, right, so what is the issue?

Much is automated. More so today than when I started, and it will be more so again when I eventually retire. But much is not all. Much is not necessarily even much.

The presumption that Fortune 500 accounting departments are the norm for businesses will lead to erroneous conclusions, including the one above. There are over 30 million companies in the United States. Less than 1 percent of those are publicly traded, and the Fortune 1000 constitutes a fraction of that fraction. There is an entire economic sector - the self-employeds, the small- and mid-market companies - that are unlikely to have an accountant - much less an accounting department - available to respond to the whims of nonserious minds. Most CPAs - including me – advise that market. When we meet with ownership, we meet with the owner or owners, not an assemblage at an annual shareholder meeting.  When decisions are required, the number of decision makers is few; in many cases, it is only one.

Somehow this overlooked sector represents roughly half of all economic activity and approximately two-thirds of all jobs created in the United States since the 1990s. This sector employs tens of millions, allowing them home ownership, EV purchases, private schools, higher education, smart phones, streaming services, and perhaps an occasional vacation to Disney World.

Can this sector push a button to generate quarterly 1099s because a professor thinks the idea has been “entirely overlooked?” Maybe, but probably not. More likely, they will call their CPA – assuming they have one.

That quarterly 1099 is somehow now in my court.

CPAs want to go home, too.

Then there is the issue of who will prepare these 1099s. I know that accounting literature is not a thing, but glance at the following:

Statistics from the AICPA suggest that 75 percent of current CPAs will retire in the next 15 years.

Does this seem like an appropriate time to further add to the problems of accounting? Many already see a profession facing future demands exceeding its ability to supply.

No, I don’t think that quarterly 1099s are a bright idea.

In fact, maybe the Congressional effort in 1986 to move almost all taxable year-ends to December 31, further compressing our work schedule was – in retrospect – not such a bright idea.  

Notices are the bane of tax practice. One may be a gifted practitioner but send enough penalty notices and even a loyal client begins to question. Maybe the decades of Congress “balancing” budget bills by increasing tax penalties on virtually anything that moves was not such a bright idea.

Maybe the relentless introduction of arbitrary, inconsistent if not preposterous – other than as blatant money grabs - tax laws was not such a bright idea.

Maybe passing tax laws late in the year when there is no time for advisors to react – or even better, passing those laws the following year but with retroactive effect – was not such a bright idea.

Maybe the hubris that just one more surtax, deduction or tax credit will somehow solve the enduring difficulties of the species and pave the highway to heaven was not such a bright idea. 

We are showered by sententious minds bringing bright ideas.

They should be entirely overlooked.

A Penalty Against A Tax Preparer

 

Did you know that the IRS can assess penalties against a tax preparer as well as a taxpayer?

I am looking at an IRS Chief Counsel Memorandum recommending a preparer be penalized for a deduction on a client return.

You do not see that every day.

Let’s talk about it.

As is our way, we will streamline the issue so that it is something you might want to read and something I might want to write.

A taxpayer accrued expenses on its books for customer early payment discounts and estimated write-offs for disputed billing and shipping charges.

Sure, easy for a CPA to say.

Let’s clarify. The company sold stuff. It allowed discounts if a customer paid early. It also had routine billing disputes – for quantity, quality, price, damage and so on. As part of its general accounting, it estimated these charges and recorded them as expenses when the related sale was recorded.

Makes sense to me. Generally accepted accounting wants one to record all related expenses when the sale is recorded. This is called the “timing principle,” and the idea is to present net profit from a sales transaction as well as reasonably possible. What if all the expenses are not known at that precise moment - say, for example - the amount of product that will be returned because of damage in shipping? Generally accepted accounting will allow one to estimate that number, normally by statistical analysis of historical experience.

BTW you better do this if you expect to have your financial statements audited. Part of an audit is a review of your accounting method, and the “estimate that number” described above is considered a best-of-breed.

Generally accepted accounting might not work when you get to your tax return, however. Why? Well, generally accepted accounting is trying to get to the “best” number in an economic sense. Tax accounting is not trying to get to the “best” number; rather, it is trying to measure your ability to pay. Pay what? Taxes, of course.

Let’s go back to our taxpayer. They estimated a bunch of expenses when they recorded a sale. They included those numbers on their financial statements. They then wanted to deduct those same numbers on their tax return.

Problem:

The taxpayer utilized statistics to record the expenses for the two items. The courts held that statistics were not a valid method to record the amounts.”

Their CPA firm had to review the accounting method and decide whether it was acceptable for tax purposes.

There is even a Code section and Regulations:

           Reg § 1.461-1. General rules for taxable year of deduction

(a)(2) Taxpayer using an accrual method.

(i) In general. Under an accrual method of accounting, a liability (as defined in §1.446-1(c)(1)(ii)(B)) is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. 

 

You see that last sentence and its reference to “economic performance?”

 

For generally accepted accounting, one must:

        

·      Establish the fact of the liability.

·      Measure the amount of the liability with reasonable accuracy.

 

Tax then adds one more requirement:

        

·      Economic performance on the liability must have occurred.

 

That third requirement is what slows down the tax deduction.

 

What is an example of economic performance?

 

Say that you record expenses for services related to the sale. Economic performance wants to see those services performed before allowing the deduction. What if you know - because it has happened millions of times before and can be calculated with near-arithmetic certainty – that the services will occur? Tax doesn’t care.  

 

But the auditors signed-off on the financial statements, you say. Doesn’t that mean that experts agreed that the accounting method was valid?      

A taxpayer’s conformity with its accrual method used for financial accounting purposes does not create a presumption that its tax accrual method clearly reflects income.”

And there you have a brief introduction to why a company’s financial statements and its tax return might show different numbers. Financial statement accounting and tax accounting serve different purposes, and those differences have real-world consequences.

 

In this situation, I side with the IRS. Work in a CPA firm for any meaningful period and you will see tax people repetitively “tweak” the audit people’s numbers. It happens so often it has a term: “M-1.” Schedule M-1 is a tax schedule that reconciles the profit per the financial statements to the profit per the tax return. The possible list of differences is near endless:

 

·      Entertainment

·      Depreciation

·      Allowance for uncollectible receivables

·      Accrued bonuses

·      Reserve for warranties

·      Deferred rent

·      Controlled foreign corporation income

·      Opportunity zone income

 

And on and on. Knowing these differences is part of being a tax pro.

 

The Chief Counsel wanted to know why the tax pros at this particular CPA firm did not know that this generally accepted accounting method would not work for purposes of the tax return.

 

To be fair, methinks, because it is complicated …?

 

No dice, said the Counsel’s office. The preparer should have known.

 

The items deducted constituted a substantial part of the return. 

TRANSLATION: It was a big deduction.

And therefore the preparer penalty is appropriate.  

TRANSLATION: Someone has to pay.

Mind you, a Chief Counsel memorandum is internal to the IRS. The taxpayer – and by extension, its CPA firm – might appeal the matter to the Tax Court. I would expect them to, frankly. The memorandum is just the IRS’ side.

For the home gamers, today we have been discussing Chief Counsel Memorandum 20223301F.

 

Kentucky, Bourbon and Tax Accounting

I came across a proposed tax bill that caught my eye.

It has to do with bourbon.

Bourbon is closely associated with Kentucky, as the state produces approximately 95% of the world supply. I have heard that there are more barrels of bourbon aging in Kentucky than there are residents (of which I am one). I do not know if that is true, but it does summarize the importance of the industry to the commonwealth.

So Kentucky senators and representatives have introduced a tax bill to exempt bourbon producers from the interest capitalization rules.

This is relatively old tax law, having entered the Code in 1986. It caused practitioners quite a bit of problem at start-up (I was a young CPA), but for the most part it has settled down since.

The explanation for the law was to bring consistency to inventory tax accounting. By itself that was laudable, but the law went further. Congress also decided that certain costs associated with a manufacturing or production process were not being appropriately captured by generally accepted accounting principles (GAAP). To correct that accounting oversight, the tax Code would henceforth require the capitalization of costs not previously capitalized on financial statements.

In accounting-speak, “capitalizing” means removing an expense from net income by putting it (that is, by “capitalizing” it) on the balance sheet as an asset. It can remain there for six months, fifteen years or until the end of time, depending upon. The common result is that it is not an expense on the income statement. Extrapolate that and it probably is not a deduction on the tax return.

You can see Congress’ fascination with becoming tax accounting experts.

This tax provision is referred to as uniform capitalization, or - for the hard core – Section 263A, which is the Code section that houses it. Most of the accountants I have worked with consider uniform capitalization little more than a slight-of-hand (and other earthier words) to increase taxes on inventory-intensive businesses.

Let’s be blunt: if there were issues with the inventories of Kimberley-Clark or Proctor & Gamble, the resulting lawsuits would have self-corrected the matter years ago.

Interest expense is one of the costs that have to be capitalized under Section 263A.

A perfect tax trap would be an expensive inventory which takes many, many years to get to market. One would have to capitalize interest every year. Granted, there would be a tax deduction down the line when the inventory was sold, but the wait to get there could get expensive.

What would be an example of such an inventory?

Well, bourbon.

Some high-end bourbons are aged for a long time. Take a personal favorite – Pappy Van Winkle Family Reserve 15 Year. It has a 20-year brother, but many aficionados consider the 15 a better product. There are bourbons aged even longer. That is a lot of years to carry an inventory.

The problem is that many bourbon competitors do not have this tax issue. Consider rum or vodka, for example, with a short ageing process.  Scotch whisky would be comparable, but the UK does not have an equivalent to Section 263A. This means that scotch producers do not have the tax problem of their US bourbon counterparts. Wine production would be comparable. Perhaps the Kentucky delegation could join forces with their California peers on this matter.

But why exempt bourbon producers but not others adversely affected by interest capitalization?

It is a fair question.

To which there is a fair answer: if international accounting firms are willing to be sued for the amount of inventory shown on audited financial statements, should we not presume that number is substantially correct? Why then does the Code require another calculation of inventory for the tax return?

We know why. It is the same as you losing a credit for your kid’s college tuition because you make enough money to send your kid to college. The tax Code is riddled with these things. Interest capitalization is a clever backdoor, however, as it dives into tax accounting itself. This area is arcane and boring and likely to keep someone from looking too closely. That is – of course – why it was done.

Taxing A Corvette

I came across an old case recently. It made me smile, as it reminded me of earlier – and skinnier – times.

Let’s set this up.

There are, broadly speaking, two accounting methods when deciding whether you have reportable income for a period: the cash method and the accrual method. There are a variety of sub, sorta- and who-actually-understands-this methods, but cash and accrual are enough for right now.

The cash method is easy: if you can deposit it at the bank you have income.  Maybe you decide not to deposit at the bank until next week, but it is still income today. Why? Because you can deposit it. The definition is “can” not “did.”

Accrual is trickier. Generally it means that you sent an invoice to someone. The act of invoicing means you have income, as someone owes you. What if you delay invoicing for a week or two? Well, then you have a variation on the above cash-basis reasoning: you could have but didn’t. Again, it is the “could,” not the “did,” that drives the test.

What if you are on the cash method and somebody pays you with property instead of cash? You have income. It makes sense when you remember that cash is a form of property. We have just gotten so used to it that we don’t think of cash that way. For tax purposes, though, someone paying you in asiago cheese and gluten-free crackers still represents income. Granted, we have to translate cheese-and-crackers into dollars, but income it is.

Let’s say that you played football. Not just any football, however. You were Vince Lombardi’s running back. It is December 31, and you and Lombardi and the Green Bay Packers are playing the New York Giants in the National Football League Championship.

COMMENT: NFL historians will immediately recognize that this was before the Super Bowl era. There was no game called the Super Bowl until the two leagues – the National Football League and the American Football League – merged in 1966. The first two Super Bowls were won tidily by Lombardi and the Packers. In Super Bowl 3 Joe Namath famously led the New York Jets over the Baltimore Colts.

So it is the championship game. You are the running back. It is December 31 and you are playing outside in Green Bay. I presume you are freezing. You run wild and score 19 points, establishing a league record. You are selected after the game by Sport Magazine as the most valuable player, which comes with the prize of a new Corvette. 

Sweet.

By the way, your Corvette is waiting for you in New York. It is now the evening of December 31, 1961.

Tax issue: Do you have income (the value of that Corvette) in 1961?

The IRS said you did.

But you throw the IRS a loop: the car is not income. No, siree. It was a gift. Alternatively, it is nontaxable to you as a prize or award.

I give you kudos, but the concept of a gift requires the presence of detached and disinterested generosity. While a creative argument, it could not be reasonably argued that a for-profit magazine was awarding an expensive car to the most valuable player of a televised sporting event out of a detached and disinterested generosity. It was much more likely that both Sport Magazine and General Motors were expecting publicity, advertising and social buzz from the award.

You still have your second argument, though.

Problem is, the prize or award exception requires you to receive it for an educational, artistic, scientific or civic achievement.

You argue your point: being a star football player “calls for a degree of artistry” requiring techniques based on “scientific” principles.

Seriously.

The Court decides:

We believe that petitioner should be caught behind the line of scrimmage on this particular offensive maneuver.”

You have income. And the Court gave us a great quote.

But when do you have income: 1961 or 1962?

The Court reasons through the obvious. You are in Green Bay. The car is in New York. You cannot get to that car - much less title it - unless you had Star Trek technology. However, it is 1961 and Star Trek is not on television yet. You have income in 1962, the following day.

Your tax case is seminal in developing the tax doctrine of constructive receipt. Normally constructive receipt accelerates when you have income, but it did not in your case.You could not have made it to the bank even if you wanted to.

So why did the IRS push the issue of 1961 versus 1962? They didn’t. Remember that you were arguing that the Corvette wasn’t taxable. The IRS had to fight back on that issue. The 1961 thing was a sidebar, albeit that is what the case is remembered for all these years later.

By the way, do you know which football player we have been talking about?