Divorced Parents And A Dependent Child

 It is one of my least favorite issues in tax practice.

Who is entitled to a dependent?

Granted, there is no longer a dependency exemption available, but there are other tax items, such as the child tax credit, that require a dependent.

The issue can go off-the-rails if the parents are (a) divorced and (b) combative.

It occurs when both parents claim the same child for the same year.

One of the parents is going to lose the dependency, of course, but how the Code determines which one may surprise you.

The Code wants to know which is the custodial parent – that is, which parent did the child live with for the majority of the year. Granted, in some cases the answer may be razor close, but most of the time there is a clear answer.

The Code anticipates that the custodial parent will claim the child.

What if the noncustodial parent provides most of the child’s support?

The Code (for the most part) does not care.

How does the noncustodial parent get to claim the child?

If the parents get along, then there is no issue. Everyone follows the rules and there is no tax controversy.

If the parents do not get along and both claim the same child, the IRS is going to get involved. It will want to know: who is the custodial parent?

But the divorce decree says ….

You might be surprised how little the IRS cares about that divorce decree.

What it is interested in is whether a certain form was filed with the noncustodial parent’s return: Form 8332.

This form has to be signed by the custodial parent. If the parents do not get along, you can see the problem.

What happens if the noncustodial parent does not attach this form and both parents claim the child?

Let’s take a look at the DeMar case.

The divorce decree said that Mr Demar (Dad) was to claim the son in odd-numbered years. Dad claimed the son for 2015.

Mrs DeMar (Mom) also claimed the son.

The IRS came in. There (of course) was no Form 8332. The IRS could care less what that divorce decree had to say, so off to Tax Court they went.

Dad is going to lose this all day every day, except ….

Would you believe that – before the Tax Court hearing – Mom signed Form 8332?  

That doesn’t happen much.

There is a proposed Regulation on this point:

A noncustodial parent may submit a copy of the written declaration to the IRS during an examination to substantiate a claim to a dependency exemption for the child.

Did that save Dad?

Let’s keep reading:

A copy of a written declaration attached to an amended return, or provided during an examination, will not meet the requirement of this paragraph … if the custodial parent … has not filed an amended return to remove that claim to a dependency exemption for the child.

So one can file the 8832 late but one also has to prove that the other parent amended his/her return to remove the dependency for the child.

Guess what?

Mom did not amend her return.

Dad lost.

The IRS did not care about that divorce decree and the odd-numbered year.

I get it. The IRS has no intention of playing family court, so it established mechanical rules for the dependency. The average person focuses on the divorce decree – understandably – but the IRS does not.  Procedure is everything in this area.

Our case this time was DeMar v Commissioner T.C. Memo 2019-91.

Abatement Versus Refund

 

I was contacted recently to inquire about my interest in a proceduralist opportunity.

That raises the question: what is a proceduralist?

Think about navigating the IRS: notices, audits, payment plans, innocent spouse claims, liens and so on.  One should include state tax agencies too. During my career, I have seen states become increasingly aggressive. Especially after COVID – and its drain on state coffers - I suspect this trend will only continue.

I refer to procedure as “working the machine.” This is not about planning for a transaction, researching a tax consequence or preparing a tax return. That part is done. You have moved on to something else concerning that tax return.

Less glamorously, it means that I usually get all the notices.

Let’s go procedural this time.

Let’s talk about the difference between an abatement and a refund.

Mr Porporato (Mr P) filed a return for 2009. He owed approximately $10 grand in taxes.

He did not file for 2010 or 2011. The IRS prepared returns for him (called a Substitute Return), and he again owed approximately $10 grand for each year.

COMMENT: He had withholding but he still owed tax for each year. He probably showed have adjusted his withholding, but, then again, he went a couple of years without even filing. I doubt he cared.

The IRS came a-calling for the money, and Mr P requested a Collection Due Process hearing.

COMMENT: I agree, and that is what a CDP hearing is about. Mind you, the IRS wants to hear about payment plans, but at least you have a chance to consolidate the years and work-out a payment schedule.

There was chop in the water that we will not get into, other than Mr P’s claim that he had a refund for 2005 that was being ignored.

So what happened with 2005?

Mr P and his (ex) wife filed a joint 2005 return on June 15, 2006.

Then came a separation, then a divorce, then an innocent spouse claim.

Yeeessshhh.

He amended his 2005 return on March 29, 2010. The amended return changed matters from tax due to a tax overpayment. The IRS abated his 2005 liability.

There you have the first of our key words: abatement.

Let’s review the statute of limitations (SOL). You generally have three years to file a tax return and claim your refund, if any. Go past the three years and the IRS keeps your refund. There are modifiers in there, but that is the general picture. We also know the flip side of the SOL: the IRS has three years to examine your return. Go past three years and the IRS cannot look at that year (again, with modifiers). Why is this? It mostly has to do with administration. Somewhere in there you have to close the matter and move on.

Let’s point out that Mr P amended his 2005 return after more than three years. The IRS still reversed his tax due.

Can the IRS do that?

Yep.

Why?

An IRS can abate at any time. Abatement is not subject to the restrictions of the SOL.

Abatement means that the IRS reducing what it wants to collect from you.

But the result was an overpayment.

Mr P wanted the IRS to refund his 2005 overpayment – more specifically, to refund via application of the overpayment to later tax years with balances due.

This is not the IRS reducing what it wants to collect. This is in fact going the other way: think of it as the IRS writing a check.

Wanting the IRS to write a check ran Mr P full-face into the statute of limitations. He filed the 2005 amended outside the three-year window, meaning that the SOL on the refund was triggered.

I get where Mr P was coming from. The IRS cut him slack on 2005, so he figured he was entitled to the rest of the slack.

He was wrong.

And there you have the procedural difference between an abatement and a refund. The IRS has the authority to reduce the amount it considers due from you, without regard to the SOL. The IRS however does not have the authority to write you a check after the SOL has expired.

Another way to say this is: you left money on the table.

Our case this time was Porporato v Commissioner (TC Summary Opinion 2020-24).

The IRS Cryptocurrency Letter

Do you Bitcoin?

The issue actually involves all cryptocurrencies, which would include Ethereum, Dash and so forth.

A couple of years ago the IRS won a case against Coinbase, one of the largest Bitcoin exchanges. The IRS wasn’t going after Coinbase per se; rather, the IRS wanted something Coinbase had: information. The IRS won, although Coinbase also scored a small victory.

·       The IRS got names, addresses, social security numbers, birthdates, and account activity.

·       Coinbase however provided this information only for customers with cryptocurrency sales totaling at least $20,000 for years 2013 to 2015.

What happens next?

You got it: the IRS started sending out letters late last month- approximately 10,000 of them. 

Why is the IRS chasing this?

The IRS considers cryptocurrencies to be property, not money. In general, when you sell property at a gain, the IRS wants its cut. Sell it at a loss and the IRS becomes more discerning. Is the property held for profit or gain or is it personal? If profit or gain, the IRS will allow a loss. If personal, then tough luck; the IRS will not allow the loss.

The IRS believes there is unreported income here.

Yep, probably is.

The tax issue is easier to understand if you bought, held and then sold the crypto like you would a stock or mutual fund. One buy, one sell. You made a profit or you didn’t.

It gets more complicated if you used the crypto as money. Say, for example, that you took your car to a garage and paid with crypto. The following weekend you drove the car to an out-of-town baseball game, paying for the tickets, hotel and dinner with crypto. Is there a tax issue?

The tax issue is that you have four possible tax events:

(1)  The garage

(2)  The tickets

(3)  The hotel

(4)  The dinner

I suspect that are many who would be surprised that the IRS sees four possible triggers there. After all, you used crypto as money ….

Yes, you did, but the IRS says crypto is not money.

And it raises another tax issue. Let’s use the tickets, hotel and dinner for our example.

Let’s say that you bought cryptos at several points in time. You used an older holding for the tickets. 

You had a gain on that trade.

You used a newer holding for the hotel and dinner.

You had losses on those trades.

Can you offset the gains and losses?

Remember: the IRS always participates in your gains, but it participates in your losses only if the transaction was for profit or gain and was not personal.

One could argue that the hotel and dinner are about as personal as you can get.

What if you get one of these letters?

I have two answers, depending on how much money we are talking about.

·       If we are talking normal-folk money, then contact your tax preparer. There will probably be an amended return. I might ask for penalty abatement on the grounds that this is a nascent area of tax law, especially if we are talking about our tickets, hotel and dinner scenario.

·       If crazy money, talk first to an attorney. Not because you are expecting jail; no, because you want the most robust confidentiality standard available. That standard is with an attorney. The attorney will hire the tax preparer, thereby extending his/her confidentiality to the preparer.

If the IRS follows the same game plan as they did with overseas bank accounts, anticipate that they are looking for strong cases involving big fish with millions of dollars left unreported.

In other words, tax fraud.

You and I are not talking fraud. We are talking about paying Starbucks with crypto and forgetting to include it on your tax return.

Just don’t blow off the letter.

Do You File An Accurate Return Or A Timely Return?

I have alerted the staff here at CTG command center that I prefer and expect to file all business returns, especially passthrough returns, on a timely basis, irrespective of whether we have all required information. Granted, there is some freeplay – we cannot file if we have no information, for example, or if so much information is missing that a filing would not be construed as substantially correct.

The reason?

Penalties for late filing.

Let’s say that you and a partner have an LLC. The return is due in March and can be extended to September. You file an extension but, for whatever reason, do not file the partnership return until December.

What just happened?

(1)  You might think that the return is only 2 months late, as it was extended until September. That is incorrect. You have until September 15 to file the return. Fail to do so, and it is as if you never filed an extension. That return is now late beginning March 16.

(2)  So what? Here is so what: the penalty is $195 per K-1 per month. There are two K-1s: you and a partner. The penalty is $390 per month. Multiply that by the number of months, and you can see how this gets expensive fast.

(3)  You might be able to get out of this penalty. Revenue Procedure 84-35 allows an avenue for small partnerships with 10 or fewer partners, for example. Depending on the facts, however, there may be no easy out. Like fire, you do not want to be playing with this.

There are a hundred variations on the theme. Let me give you one. This one involves an estate tax return. Let’s review the key points, and you decide whether there is cause for a late-filing penalty. 

• The decedent died February 24, 1986.
• On May 6, 1986 the estate was admitted to probate.
• The wife was appointed executrix.
• The estate hired an attorney.
• The estate tax return was due November 24, 1986 (nine months after death). No extension was filed.
• In January, 1987 the executrix filed an inventory with the probate court. Four assets were listed but given no value. One of those assets was an interest in a trust, which asset took on a life of its own. 
• The assets which were valued - that is, excluding the four which were unvalued - were enough the require the filing of a federal estate tax return.
• In 1991 (five years later) the estate filed suit concerning the trust.
• In 1994 the common pleas court entered judgement.
• In 1996 the executrix filed a revised and final accounting with the probate court.
•  In 1997 the estate finally filed a federal estate tax return. 

     The IRS immediately went after late filing penalties. Why wouldn’t it? The tax return was filed more than 10 years after the decedent died.

The gross estate was over $2 million. Those items that could not initially be valued came in around $200 grand.

The IRS charged in and chanted its standard wash-rinse-repeat hymn: the taxpayer cannot escape penalties for the non-extension or late filing of a return pursuant to the Supreme Court’s Boyle decision.

But the estate punched back with reasonable cause: the executrix did not have values for some of the assets that were eventually distributable from the estate. Heck, they had to sue to even get to some of those assets!

What do you think? Is there reasonable cause?

Let me give you a clue: the disputed assets were about 10% of the final estate.

And we come back to a phrase I used early on: “substantially correct.” Tax Regulations require only that the estate return be “as complete as possible.” There are numerous cases where pending litigation – even if the outcome is expected to materially affect the estate’s final tax liability – has not been considered reasonable cause for not filing a return.

The Court pointed out two things:

(1)  The executrix knew (or should have known) early on that the estate was large enough – even excluding the disputed items – to require filing a return.

(2)  She could have paid at least the tax on that amount, or estimated and also included tax on the disputed items.

a.     The Court pointed out that disputed assets were only 10% of the estate.

The executrix did not have reasonable cause. She should have filed and paid something, even if she later had to amend the estate tax return.

My thoughts?

I agree with the Court. I believe the estate was ill-advised. 

There is a sub-story in here concerning the attorney (who thought the accountant was taking care of the estate tax return) and the CPA (who was never told to prepare an estate tax return, at least not until years after the return would have been due). Why didn’t the attorney reach out earlier to the CPA, at least for peace of mind? Who knows? Why didn’t the long-standing CPA – who would have known the decedent - ask about an estate return? Again, who knows?

Our case this time was Estate of Thomas v Commissioner.

COMMENT: I am looking (translation: I printed but have not yet read) a case where a taxpayer did use estimates but still got nailed with penalties. We may come back to that one in the near future.

CTG University: Part One

Let's discuss a famous tax case, and then I will ask you how you would decide a second case based on the decision in the first.

We are going back to 1944, and Lewis received a $22 thousand bonus.  He reported it on his 1944 tax return. It turns out that the bonus had been calculated incorrectly, and he returned $11,000 in 1946. Lewis argued that the $11,000 was mistake, and as a mistake it should not have been taxed to him in 1944. He should be able to amend his 1944 return and get his taxes back. This had an extra meaning since his tax rate in 1946 was lower (remember: post-war), so if he could not amend 1944 he would never get all his taxes back.

The IRS took a very different stand. It pointed out that the tax Code measures income annually. While arbitrary, it is a necessary convention otherwise one could not calculate income or the tax thereon, as there would (almost) always be one or more transactions not resolving by the end of the year. Think for example of writing a check to the church on December 31 but the check not clearing until the following year. The Code therefore taxes income on a "period" concept and not a "transactional" concept. With that backdrop, Lewis would have a deduction in 1946, when he returned the excess bonus.

The case went to the Supreme Court, which found that the full bonus was taxable in 1944. The Court reasoned that Lewis had a "claim of right," a phrase which has now entered the tax literature. It means that income is taxable when received, if there are no restrictions on its disposition. This is true even if later one has to return the income. The reasoning is that there are no limits on one's ability to spend the money, and there is also no immediate belief that it has to be repaid. Lewis had a deduction in 1946.

Looks like the claim of right is a subset of "every tax year stands on its own."

Let's roll into the 1950s. There was a company by the name of Skelly Oil. During the years 1952 through 1957 it overcharged customers approximately $500 thousand. In 1958 it refunded the $500 thousand.

You can pretty much see the Lewis and claim-of-right issue.

But there was one more fact.

Skelly Oil had deducted depletion of 27.5%. Depletion is a concept similar to depreciation, but it does not have to be tied to cost. Say you bought a machine for $100,000. You would depreciate the machine by immediately expensing, allocating expense over time or whatever, but you would have to stop at $100,000. You cannot depreciate more than what you spent. Depletion is a similar concept, but without that limitation. One would deplete (not depreciate) an oil field, for example. One would continue depleting even if one had fully recovered the cost of the field. It is a nice tax gimmick.

Skelly Oil had claimed 27.5% depletion against its $500,000 thousand or so, meaning that it had paid tax on a net of $366,000.

Skelly Oil deducted the $505,000 thousand.

Skelly Oil had a leg up after the Burnet v. Sanford & Brooks and Lewis decisions, as every tax year was to stand on its own. It refunded $505,000, meaning it had a deduction of $505,000. Seemed a slam dunk.

The IRS said no way. The $505,000 had a trailer attached - that 27.5% depletion - and wherever it went that 27.5% went. The most Skelly Oil could deduct was the $366,000.

But the IRS had a problem: the tax Code was based on period reporting and not transactional reporting. The 27.5% trailer analogy was stunning on the big screen and all, but it was not tax law. There was no ball hitch on the $505,000 dragging depletion in its wake.

Here is the Supreme Court: 

[T]he Code should not be interpreted to allow respondent 'the practical equivalent of double deduction,' *** absent a clear declaration of intent by Congress."

The dissent argued (in my words):           

So what? Every year stands on its own. Since when is the Code concerned with the proper measurement of income?

Odd thing, though: the dissent was right. The Lewis decision does indicate that Skelly Oil had a $505,000 deduction, even though it might not have seemed fair. The Court reached instead for another concept - the Arrowsmith concept. 

[T]he annual accounting concept does not require us to close our eyes to what happened in prior years."

There is your ball hitch. The concept of "net items" would drag the 27.5% depletion into 1958. "Net items" would include revenues and deductions so closely related as to be inseparable. Like oil revenues and its related depletion deduction.

The Court gave us the following famous quote: 

In other situations when the taxes on a receipt do not equal the tax benefits of a repayment, either the taxpayer or the Government may, depending on circumstances, be the beneficiary. Here, the taxpayer always wins and the Government always loses."

And over time the Skelly Oil case has come to be interpreted as disallowing a tax treatment where "the taxpayer always wins and the Government always loses." The reverse, however, is and has always been acceptable to the Government.

But you can see something about the evolution of tax law: you don't really know the law until the Court decides the law. Both Lewis and Skelly Oil could have gone either way.

Now think of the tax law, rulings and Regulations being published every year. Do we really know what this law means, or are we just waiting our turn, like Lewis and Skelly Oil?

Can the IRS Disallow Your Net Operating Loss Carryback?

Here is a quiz question:

            Can the IRS reopen a tax year if you file an NOL carryback?

Most tax accountants will remember the intent of IRC Section 7605(b), even if they may not remember the specific citation:

No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.

This language entered the Code in 1921, and its intent was and is to relieve taxpayers from unnecessary annoyance.

The question is whether it is the original year that is being reopened or whether it is the carryback from a later year that is being reviewed.

The IRS expounded on IRC Section 7605 in Rev Procedure 2005-32. The wording we are after is “reopening.” Section 2.04 of the Rev Procedure informs us that new section 4.02 is being added to define the “reopening” of a closed tax case.

The new section 4.02 states:

A reopening of a closed case involves an examination of a taxpayer’s liability that may result in an adjustment to liability unfavorable to the taxpayer for the same taxable period as the closed case, with exceptions, some of which are noted below. The Service’s review, including an inspection of books of account, of a taxpayer’s claim for a refund on an amended excise or income tax return, as well as the Service’s review of a Form 843, Claim for Refund and Request for Abatement, claiming a refund for an overpayment reported on a return, is not a reopening.

Someone ran face-first into this in FAA 20114701F. Here are the facts:

Taxpayer deducted a bad debt loss in Year 1. It was audited and the IRS allowed the loss. Enough time goes by that the statute of limitations for Year 1 expires. In a later year Taxpayer has an NOL, which it carries-back to Year 1. The IRS however was still churlish about that bad debt deduction in Year 1.

The FAA goes on to reason that the IRS did not pick this fight. Rather the Taxpayer did by electing to carryback its net operating loss and claiming a refund. The Taxpayer’s action allowed the IRS to “reopen” the closed year.

There was some saving grace, thankfully. The IRS decided it could deny Taxpayer’s claim for refund dollar-for-dollar – but only to the extent of the refund. The worst that could happen is that the Taxpayer would not receive any refund, resulting of course in a total waste of the net operating loss carryback. But hey, at least the Taxpayer did not have to write a check to the IRS for the audacity of claiming a tax refund.

United States v. Michael F. Schiavo

Let’s look at the matter of Michael Schiavo (United States v. Michael F. Schiavo). He was a bank director in Boston and had invested in a medical device partnership. This partnership had monies overseas. Schiavo decided to tuck the money (approximately $100,000) away and not tell anyone. He did not report the income and certainly did not file the Foreign Bank and Financial Accounts report (FBAR) with the Treasury on or before June 30 every year.

The partnership gave him about $100,000 in Bermuda to play with. He failed to file the FBARs for 2003 through 2008, so he was playing for a while.

He notices what the government was doing with UBS, meets with his advisor and decides to do a “quiet disclosure.” This means that he either amends his income tax return, files the FBAR, or both, without otherwise bringing attention to it. That is, it’s “quiet.”

The IRS had offered an amnesty program for foreign-account taxpayers back in 2009. The advantage was that the government would not prosecute. The downside was that there would be income taxes, penalties and a special 20% penalty for not having reported the monies originally. This program expired in October, 2009. Schiavo decided this was not for him.

The IRS has introduced another amnesty program in 2011, again allowing foreign-account taxpayers to come clean. This time the program covers two more years, and the penalties have been increased to 25% (with some exceptions). The IRS wants to increase the burden to the taxpayer so as not to reward the earlier act of noncompliance.

So Schiavo prepares and files FBARs for 2003 through 2008 but does not participate in the amnesty. That is, he is “quiet.” An IRS special agent then contacts him, whereupon Schiavo amends his income tax return to include the unreported income he just reported to the IRS via the FBAR.

You read this right. He made a quiet disclosure to the IRS but did not amend his income tax return to include the income he had just alerted them to.

The IRS estimates that the taxes at play were about $40,000.

Schiavo was convicted. He now faces a fine and possible jail time.

You are going to take this kind of risk for $40,000 in tax? Are you kidding me? You cannot retire on $40,000. Heck, one can barely send a kid to two years of college for $40,000. What was this guy thinking?