The IRS Goes Rounds With Cohan

 

The decision begins with the IRS seeking taxes of $805,149, $1,145,104, $1,161,864, and $831,771 for years 2013 through 2016. The penalties were unsurprisingly also enormous.

I want to know what happened here.

The taxpayer was Mohammad Nasser Aboui, and he was the sole shareholder of an S corporation called HPPO. He owned several used vehicle lots, and in 2009 he put them into HPPO as its initial corporate capitalization.

It sounds like a tough business:

·       Most of HPPO customers had bad credit.

·       Many did not have a checking account and instead paid HPPO in cash.

·       HPPO financed between 90% and 95% of its sales.

·       Customers repaid their loans less than 10% of the time.

·       HPPO repossessed approximately 25% of the cars it sold within 3 or 4 months.

·       HPPO had quite the barter system going with its mechanics: the mechanic would work on HPPO cars in exchange for rent of HPPO’s garage space.

Around 2014 Aboui decided to close the business. There were serious family health issues and HPPO was not making any money.

The IRS started its audit in September 2015.

HPPO’s accountant was ill at the time and later died.

To its credit, the IRS waited.

More than 3 years later HPPO engaged another accountant to represent the audit.

The second accountant made immediate mistakes, such as getting HPPO’s accounting method wrong when dealing with the IRS Revenue Agent (RA).

COMMENT: More specifically, the accountant told the RA that HPPO used the overall cash basis of accounting. HPPO did not. In fact, it could not because inventory was a material income-producing factor.

The RA wanted HPPO’s books and records, including access to its accounting software. HPPO could provide much but not the software. Its software license expired when it left the vehicle business in 2018.

This is a nightmare.

HPPO did eventually reactivate the software, but it was too late to help with the RA.

The RA – being told by the second accountant that HPPO used the cash basis of accounting – decided to use bank statements to reconstruct gross income.

BTW HPPO wound up dismissing the second accountant.

The results were odd: HPPO had reported more sales for 2013 through 2015 – nearly $3.25 million - than was deposited at the bank.

The pattern reversed in 2016 when HPPO deposited approximately $539 grand more than it reported in sales.

COMMENT: I have an idea what happened.

The RA also saw following bad debt expense:

          2013             $1,069,739

          2014             $ 668,537

          2015             $ 902,967

          2016             $ 436,738    

Here is something about the cash basis of accounting: you cannot have bad debt expense. It makes sense when you remember that gross income is reported as monies are deposited. Bad debts are receivables that are never collected, meaning there is nothing to deposit. One never leaves home plate.

So, the RA disallowed the bad debt expense entirely.

I am pretty sure about my earlier hunch.

The RA also determined that HPPO had distributed the following monies to Aboui, one way or another:

          2013             $2,476,301

          2014             $1,704,329

          2015             $1,406,893

2016             $1,934,033

There were other issues too.

Off they went to Tax Court.

Remember what I said about reactivating the accounting software license? Aboui now presented thousands of pages to document cost of sales and other expenses. The Court encouraged the IRS to accept and review the new records.

The IRS said, “nah, we’re good.”

COMMENT: Strike one.

The Court started its opinion with HPPO’s sales.

The RA stated to the Court that HPPO used the overall cash basis of accounting.

Don’t think so, said the Court. The Court saw HPPO using the accrual basis of accounting for sales and the cash basis of accounting for everything else.

COMMENT: This is referred to as a hybrid method: a pinch of this, a sprinkle of that. If one is consistent – and the results are not misleading – a hybrid is an acceptable method of accounting.

The Court asked Treasury why it thought that HPPO used the cash basis of accounting.

Treasury replied that it had never said that.

The Court pointed out that the RA had said that she understood HPPO to be a cash basis taxpayer. To be fair, that is what the second accountant had told her.

Nope, never used the cash method insisted Treasury.

COMMENT: An explanation is in order here. Treasury Department attorneys take over when the matter goes to Court. Perhaps the attorneys meant “direct” Treasury. The RA – while working for the IRS which itself is part of the Treasury – would then be “indirect” Treasury. I am only speculating, as this unforced error makes no sense. Clearly it bothered the Court.

Strike two.

The Court then reasoned why HPPO was reporting more sales than it deposited in the bank: it was reporting the total vehicle sale price in revenues at the time of sale. That also explained the bad debt expense: HPPO financed most of its sales and most of those loans went sour.

But why the reversal in 2016?

Aboui explained to the Court that by 2016 he was closing the vehicle business. He would have slowed and eventually stopped selling cars, with the result that he would be depositing more in the bank than he currently sold.

The Court decided that HPPO had correctly recorded its sales for the years at issue.

Next came the cost of vehicles sold.

This accounting was complicated because so much cash was running through the business. Sometimes cash was used to immediately pay expenses without first being deposited into a bank account – NOT a recommended accounting practice.

The RA had also identified certain debits to HPPO’s bank account that were either distributions or otherwise nondeductible.

The Court could find no evidence that those identified debits had been deducted on the tax returns.

The RA – and by extension, the … Treasury – was losing credibility.

Aboui meanwhile provided extensive documentation of HPPO’s expenses at trial. Some of these were records the Court had asked the IRS to accept and review – and which the IRS passed on.

Here is the Court:

Petitioners provided extensive documentation at trial to substantiate the COGS and business expenses. Mr. Aboui testified that HPPO was unprofitable. Given the record in its entirety, we find that petitioners have substantiated HPPO’s COGS and business expenses as reported on HPPO’s returns for each year at issue, except for meal and entertainment expenses of …..”

COMMENT: Strike three.

The Court went to the bad debts.

Mr. Aboui credibly testified that he was unable to repossess approximately 250 cars during the years at issue. The loss of these cars adequately substantiates the amount of HPPO’s bad debt deductions for the years at issue under the Cohan rule.”

The Court went to the distributions.

Respondent determined that petitioners failed to report approximately $7.5 million in taxable distributions from HPPO during the years at issue.”

COMMENT: Remember that HPPO is an S corporation, and Aboui would be able to withdraw his invested capital – plus any business income he had paid taxes on personally but left in the business – without further tax. This amount is Aboui’s “basis” in his S corporation stock.

Here is the Court:

Respondent argues that petitioners have not established Mr. Aboui’s basis in HPPO during the years at issue. We disagree and that the record and Mr. Aboui’s credible testimony provides sufficient evidence for us to reasonably estimate his basis under the Cohan rule.”

The IRS won a partial victory with the distributions. The Court thought Aboui’s basis in HPPO was approximately $5.1 million.

The IRS had wanted zero basis.

The effect was to reduce the excess distributions to $$2.4 million ($7.5 minus $5.1).

Still, it was a rare win for the IRS.

Excess distributions are taxable. Aboui had taxable distributions of $2.4 million. Yes, it is a lot, but it is also a lot less than the IRS wanted.

COMMENT: The nerd part of me wonders how the Court arrived at an estimate of $5.1 million for Aboui’s basis. Unfortunately, there is no further explanation on this point.

Oh, one more thing from the Court:

… we hold that petitioners are not liable for any penalties.”

While not contained within the four corners of this decision, I am curious why the Court repetitively went to the Cohan rule. I have followed this literature for years, and this result is not normal. Courts generally expect a business to maintain an accounting system that produces reliable numbers. Yes, every now and then there may be a leak in the numbers, and the court may use Cohan to plug said leak. That is not what we have here, though. This boat was sinking.

Perhaps Aboui presented his case well.

Mr. Aboui was incredibly forthright in his testimony.”

And perhaps the IRS should not have argued that an RA – an IRS employee – is not the IRS.

Our case this time was Aboui and Mizani v Commissioner, T.C. Memo 2024-106.

An IRS Employee And Unreported Income

 

You may have heard that Congress is tightening the 1099 reporting requirements for third party payment entities such as PayPal and Venmo. The ultimate goal is to report cumulative payments exceeding $600. Because of implementation issues, the IRS has adjusted this threshold to $5,000 for 2024.

Many, I suspect, will be caught by surprise.

Receiving a 1099-K does not necessarily mean that you have taxable income. It does mean that you were paid by one of the reporting organizations, and that payment will be presumed business-related. This is of concern with Venmo, for example, as a common use is payment of group-incurred personal expenses, such as the cost of dining out. Venmo will request one to identify a transaction as business or personal, using that as the criterion for IRS reporting  

What you cannot do, however, is ignore the matter. This IRS matching is wholly computerized; the notice does not pass by human eyes before being mailed. In fact, the first time the IRS reviews the notice is when you (or your tax preparer) respond to it. Ignore the notice however and you may wind up in Collections, wondering what happened.

The IRS adjusted the 2004 and 2005 returns for Andrea Orellana.

The IRS had spotted unreported income from eBay. Orellana had reported no eBay sales, so the computer match was easy.

There was a problem, though: Orellana worked for the IRS as a revenue officer.

COMMENT: A revenue officer is primarily concerned with Collections. A revenue agent, on the other hand, is the person who audits you.

Someone working at the IRS is expected to know and comply with his/her tax reporting obligations. As a revenue officer, she should have known about 1099-Ks and computer matching.

It started as a criminal tax investigation.

Way to give the benefit of the doubt there, IRS.

There were issues with identifying the cost of the items sold, so the criminal case was closed and a civil case opened in its place.

The agent requested and obtained copies of bank statements and some PayPal records. A best guess analysis indicated that over $36 thousand had been omitted over the two years.

Orellana was having none of this. She requested that the case be forwarded to Appeals.

Orellana hired an attorney. She was advised to document as many expenses as possible. The IRS meanwhile subpoenaed PayPal for relevant records.

Orellana did prepare a summary of expenses. She did not include much in the way of documentation, however.

The agent meanwhile was matching records from PayPal to her bank deposits. This proved an unexpected challenge, as there were numerous duplicates and Orellana had multiple accounts under different names with PayPal.

The agent also needed Orellana’s help with the expenses. She was selling dresses and shoes and makeup and the like. It was difficult to identify which purchases were for personal use and which were for sale on eBay.

Orellana walked out of the meeting with the agent.

COMMENT: I would think this a fireable offense if one works for the IRS.

This placed the agent in a tough spot. Without Orellana’s assistance, the best she could do was assume that all purchases were for personal use.

Off they went to Tax Court.

Orellana introduced a chart of deposits under dispute. She did not try to trace deposits to specific bank accounts nor did she try to explain – with one exception - why certain deposits were nontaxable.

Her chart of expenses was no better. She explained that any documents she used to prepare the chart had been lost.

Orellana maintained that she was not in business and that any eBay activity was akin to a garage sale. No one makes a “profit” from a garage sale, as nothing is sold for more than its purchase price.

The IRS pointed out that many items she bought were marketed as “new." Some still had tags attached.

Orellana explained that she liked to shop. In addition, she had health issues affecting her weight, so she always had stuff to sell.

As for “new”: just a marketing gimmick, she explained.

I always advertise as new only because you can get a better price for that.” 

… I document them as new if it appears new.”

Alright then.

If she can show that there was no profit, then there is no tax due.

Orellana submitted records of purchases from PayPal.

… but they could not be connected or traced to her.

She used a PayPal debit card.

The agent worked with that. She separated charges between those clearly business and those clearly personal. She requested Orellana’s help for those in between. We already know how that turned out.

How about receipts?

She testified that she purchased personal items and never kept receipts.

That would be ridiculous, unheard of. Unless there was some really bizarre reason why I keep a receipt, there were no receipts.”

The IRS spotted her expenses that were clearly business. They were not enough to create a loss. Orellana had unreported income.

And the Court wanted to know why an IRS Revenue Officer would have unreported income.

Frankly, so would I.

Petitioner testified that she ‘had prepared 1040s since she was 16’ and that she ‘would ‘never look at the instructions.’”

Good grief.

The IRS also asked for an accuracy penalty.

The Court agreed.

Our case this time was Orellana v Commissioner, T.C. Summary Opinion 2010-51.

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 4% 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.

Paying Personal Expenses Through A Business

I am looking at a tax case.

It reminds me of something.

There is a too-common belief that paying an expense through a business can somehow transmute an otherwise personal expenditure into a tax deduction.

Here are common ways I have heard the question:

(1)  My spouse is going to replace her car. Should we buy it through the business?

(2)  I run my business from my home. That makes my home a “headquarters,” right? Can’t I deduct all the expenses related to my business headquarters?

(3)  I am going to borrow money to [go on vacation/pay college tuition/buy a boat I’ve been wanting]. Should I have the business borrow the money to make it deductible?

Do not misunderstand, many times there is a more tax-efficient way to accomplish something. There may still be some tax though, and the goal is to minimize the tax. Making it disappear may not be an option, at least for a responsible practitioner.

Let’s look at the above questions.

(1) Realistically, if there is no business use of the vehicle, you are not allowed to deduct any of the ownership or operating expenses of a vehicle. Despite that, does it happen routinely? Of course. Practitioners do what they can, but it is like fighting the tide.

(2)  I consider this quackery, but it is a true story. No, working from home does not make your house fully deductible. You might get a home office deduction out of it, but that is a fraction of some – and not all – expenses. No, your house is not Proctor and Gamble. Get over it.

(3) This one might have traction, but in general the answer is no. Even if the interest is deductible, how is the company getting you the money? Is it going to lend it to you? If so, you will have to pay interest to the company, although you may be able to arbitrage the rate. Will the company bonus you the money? If so, I see FICA and income taxes in your future. Explain to me the win condition here.

Let’s look at Justin Maderia (JM).

JM lived in Florida and owned 50% of Lindy Inc (Lindy).

Lindy must be a C corporation, which is the type that pays its own taxes. I say this because the Court refers to earnings and profits (E&P), which is a C corporation concept. The purpose of E&P is to track a corporation’s ability to pay dividends. When it pays dividends, a corporation is sharing its accumulated profits with its shareholders. The corporation has already paid taxes on these profits (remember: a C corporation pays taxes). When it pays dividends, you are personally taxed on that previously taxed profit. This is the reason for “qualified dividends” in the tax Code: to cut you a break on that second round of taxation.

The IRS was looking at JM’s 2018 personal return. It was also looking at Lindy’s 2018 business return.

COMMENT: It is not unusual to include a closely held company with the audit of an individual tax return.

The IRS wanted to increase JM’s 2018 income by $192 grand of “stuff” that Lindy paid on his behalf.

COMMENT:  Sounds to me like Lindy was paying for EVERYTHING.

Let’s talk procedure here.

The IRS identified personal transactions in Lindy. Lindy was the type of corporation that could pay dividends, and the IRS argument was – to the extent Lindy paid for personal stuff – that such payments represented constructive dividends to JM.

Fair. Consider that the serve.

JM gets to return.

He would argue that the payments were not personal because … well, who knows why.

JM did nothing.

Huh?

JM did nothing because he had a previous audit, and the IRS never pursued the issue of Lindy payments. JM believed he was immunized.

Mind you, there is a kernel of truth here, but JM has googled the concept beyond all recognition.

IF the IRS looks at an issue AND makes no change to your tax return for that issue, you can challenge a later proposed assessment based on that same issue. You might not win, mind you, but you have grounds for the challenge.

Is this what happened to JM?

Let’s look at it.

The IRS examined his prior year return.

Score one for JM.

The IRS never looked at Lindy.

We are done.

There is no immunity. JM cannot challenge a proposed 2018 assessment on an issue the IRS did not examine in a prior year.

JM had to return on different grounds. He did not. He - procedurally speaking - automatically lost.

JM had $192 grand of additional income.

The IRS next wanted the accuracy-related penalty.

Well, of course they did. If they were any more predictable, we could just put it on a calendar.

The Court said “no” to the penalty.

Why?

Because the IRS had looked at JM’s previous return. The IRS either did not bring up or dismissed the Lindy issue, so JM kept reporting the same way. While this would not protect him from a challenge of additional income, it did provide a “reasonable basis” defense against penalties.

Our case this time was Maderia v Commissioner, T.C. Summary 2024-5.

Can A Taxpayer Be Responsible For Tax Preparer Fraud?

 

We are familiar with the statute of limitations. In general, the SoL means that you have three years to file a return, information important to know if you are due a refund. Likewise, the IRS has three years to audit or otherwise adjust your return, important to them if you owe additional tax.

The reason for the SoL is simple: it has to end sometime, otherwise the system could not function.  Could it be four years instead of three? Of course, and some states use four years. Still, the concept stands: the ferris wheel must stop so all parties can dismount.

A huge exception to the SoL is fraud. File a fraudulent return and the SoL never starts.

Odds are, neither you nor I are too sympathetic to someone who files a fraudulent return. I will point out, however, that not all knuckleheaded returns are necessarily fraudulent. For example, I am representing an IRS audit of a 2020 Schedule C (think self-employed). It has been one of the most frustrating audits of my career, and much of it is self-inflicted. I know the examiner had wondered how close the client was to the f-word; I could hear it in her word selection, pausing and voice. We spoke again Friday, and I could tell that she had moved away from that thought. There is no need to look for fraud when being a knucklehead suffices.

Here is a question for you:

You do not commit fraud but your tax preparer does. It could be deductions or credits to which you are not entitled. You do not look at the return too closely; after all, that is why you pay someone. He/she however did manage to get you the refund he/she had promised. Can you be held liable for his/her fraud?

Let’s look at the Allen case.

Allen was a truck driver for UPS. He had timely filed his tax return for the years 1999 and 2000. He gave all his tax documents to his tax preparer (Goosby) and then filed the resulting return with the IRS.

Mr. Goosby however had been juicing Allen’s itemized deductions: contributions, meals, computer, and other expenses. He must have been doing quite a bit of this, as the Criminal Investigations Division (CID, pronounced “Sid”) got involved.

COMMENT: CID is the part of the IRS that carries a gun. You want nothing to do with those guys.

Allen was a good guy, and he agreed with the IRS that there were bogus numbers on his return.

He did not agree that the tax years were open, though. The IRS notice of deficiency was sent in 2005 – that is, outside the normal three years. Allen felt that the tax years had closed.

He had a point.

However, look at Section 6501(c):

§ 6501 Limitations on assessment and collection.

(c)  Exceptions.

(1)  False return.

In the case of a false or fraudulent return with the intent to evade tax, the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time.

The Court pointed out that the law mentions a “false or fraudulent return.” It does not say that the fraud must be the taxpayer’s.

The year was open, and Allen owed the additional tax.

I get it. There is enough burden on the IRS when fraud is involved, and the Court was not going to add to the burden by reading into tax law that fraud be exclusively the taxpayer’s responsibility.

The IRS had helped its case, by the way, and the Court noticed.

How?

The IRS had not assessed penalties. All it wanted was additional tax plus interest.

I wish we could see more of that IRS and less of the automatic penalty dispenser that it has unfortunately become.

Allen reminds us to be careful when selecting a tax preparer. It is not always about getting the “largest” refund. Let’s be honest: for many if not most of us, there is a “correct” tax number. It is not as though we have teams of attorneys and CPAs sifting through vast amounts of transactions, all housed in different companies and travelling through numerous foreign countries and treaties before returning home to us. Anything other than that “correct” number is … well, a wrong number.  

Our case this time was Allen v Commissioner, 128 T.C. 4 (U.S.T.C. 2007).