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 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.

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).

Keeping Records For More Than Three Years

 

How long should you keep tax records?

We have heard that one should keep records for at least three years, as the IRS has three years to examine your return.

There is a lot of wiggle room there, however.

Let’s look at a wiggle that repeats with some frequency: a net operating loss (NOL) carryover.

An NOL occurs when a business’ tax deductions exceed its tax revenues.

I include the word “business” intentionally. Nonbusiness income - think interest, dividends, royalties – will not generate NOLs, unless you happen to own a bank or something. That would be rare, but it could happen.

An NOL is a negative (net) number from a business.

How does this negative number get on your personal return?

Several ways. Here is one: you own a piece of a passthrough business and receive a Schedule K-1.  

A passthrough normally does not pay taxes on its own power. Its owners do. If that passthrough had a big enough loss, your share of its loss might wipe out all the other income on your personal return. It happens. I have seen it.

You would go negative. Bingo, you have an NOL.

But what do you do with it?

The tax law has varied all over the place on what to do with it. Sometimes you could take it back five years. Sometimes two. Sometimes you could not take it back at all. What you could not take back you could take forward to future years. How many future years? That too has varied. Sometimes it has been fifteen years. Sometimes twenty. Right now, it is to infinity and beyond.

Let’s introduce Betty Amos.

Betty was a Miami CPA and restaurateur.  In the early 1980s she teamed up with two retired NFL players to own and operate Fuddruckers restaurants in Florida.

She wound up running 15 restaurants over the next 27 years.

She was honored in 1993 by the National Association of Women Business Owners. She was named to the University of Miami board of trustees, where she served as chair of the audit and compliance committee.

I am seeing some professional chops.

In 1999 her share of Fudddruckers generated a taxable loss. She filed a joint tax return with her husband showing an NOL of approximately $1.5 million.

In 2000 she went negative again. Her combined NOL over the two years was pushing $1.9 million.

Let’s fast forward a bit.

On her 2014 tax return she showed an NOL carryforward of $4.2 million.

We have gone from $1.9 to $4.2 million. Something is sinking somewhere.

On her 2015 tax return she showed an NOL carryforward of $4.1 million.

That tells me there was a positive $100 grand in 2014, as the NOL carryforward went down by a hundred grand.

Sure enough, the IRS audited her 2014 and 2015 tax years.

More specifically, the IRS was looking at the big negative number on those returns.

Prove it, said the IRS.

Think about this for a moment. This thing started in 1999. We are now talking 2014 and 2015. We are well outside that three-year period, and the IRS wants us to prove … what, specifically?

Just showing the IRS a copy of your 1999 return will probably be insufficient. Yes, that would show you claiming the loss, but it would not prove that you were entitled to the loss. If a K-1 triggered the loss, then substantiation might be simple: just give the IRS a copy of the K-1. If the loss was elsewhere – maybe gig work reported on Schedule C, for example - then substantiation might be more challenging. Hopefully you kept a bankers box containing bank statements, invoices, and other records for that gig activity.

But this happened 15 years ago. Should you hold onto records for 15 years?

Yep, in this case that is the wise thing to do.

Let me bring up one more thing. In truth, I think it is the thing that got Betty in hot water.

When you have an NOL, you are supposed to attach a schedule to your tax return every year that NOL is alive. The schedule shows the year the NOL occurred, its starting amount, how much has been absorbed during intervening years, and its remaining amount. The IRS likes to see this schedule. Granted, one could fudge the numbers and lie, but the fact that a schedule exists gives hope that one is correctly accounting for the NOL.

Betty did not do this.

Betty knew better.

Betty was a CPA. 

The IRS holds tax professionals to a higher standard.

BTW, are you wondering how the IRS reconciles its Indiana-Jones-like stance on Betty’s NOL with a three-year-statute-of-limitations?

Easy. The IRS cannot reach back to 1999 or 2020; that is agreed.

Back it can reach 2014 and 2015.

The IRS will not permit an NOL deduction for 2014 or 2015. Same effect as reaching back to 1999 or 2000, but it gets around the pesky statute-of-limitations issue.

And in the spirit of bayoneting-the-dead, the IRS also wanted penalties.

Betty put up an immediate defense: she had reasonable cause. She had incurred those losses before Carter had liver pills. Things are lost to time. She was certain that she carried numbers correctly forward from year to year.

Remember what I said about tax professionals? Here is the Court:

More significantly, Ms. Amos is a longtime CPA who has worked for high-profile clients, owned her own accounting firm, and been involved with national and state CPA associations. It beggars belief that she would be unaware that each tax years stands alone and that it was her responsibility to demonstrate her entitlement to the deductions she claimed.”

Yep, she was liable for penalties too.

Our case this time was Betty Amos v Commissioner, T.C. Memo 2022-109.

You Received An IRS CP2000 Notice

I read a considerable amount on a routine basis. It might be fairer to say that I skim, changing it to a read if I think that something might apply here at Galactic Command.

I came across something recently that made me scoff out loud.

Somebody somewhere was talking about never receiving an IRS CP2000 notice again.

Yeah, right.

What is a CP2000?

You know it as the computer match. The IRS cross-checks your numbers against their numbers. If there is a difference – and the difference is more than the cost of a stamp – their computers will generate a CP2000 notice.

How does the IRS get its numbers?

Easy. Think of all the tax reporting forms that you have received over the years, such as:

W-2 (your job)   

1099-INT (interest from a bank)

1099-DIV (dividends from a mutual fund)

1099-SA (distribution from an HSA)

1099-B (proceeds from selling stock)

It is near endless, and every year or so Congress and/or the IRS requires additional reporting on something. There is already a new one for 2022: the minimum threshold for payment card reporting has been reduced from $20,000 to $600. Think Venmo or Pay Pal and you are there.

If the IRS has information you didn’t report: bam! Receive a CP2000.

It happens all the time. You closed a bank account but forgot about the part of the year that it did exist.  You traded on Robinhood for a couple of weeks, lost money and tried to forget about it. You reimbursed yourself medical expenses from your HSA.   

The common denominator: you forgot to tell your tax preparer.

We get a ton of these.

Then your tax preparer might have caused it.

Maybe you did a 60-day roll on an IRA. Your preparer needs to code the distribution a certain way. Flub it and get a CP2000.

These you try to never repeat, as you are just making work for yourself.

Is this thing an audit?

Technically no, but you might still wind-up owing money.

The notice is proposing to make changes to your return. It is giving you a chance to respond. It is not a bill, at least not yet, but ignore the notice and it will become a bill.

The thing about these notices is that no one at the IRS reviews them before they go out. Yours are the first set of eyes to look upon them, and your preparer the second when you send the notice to him or her. You there have one of the biggest frustrations many practitioners have: the IRS sends these things out like candy; many are wrong and would be detected if the IRS even bothered. Attach an explanation to your return in the hope of cutting-off a notice? Puhleeze.

You really need to respond to a CP2000. I have lost track of how many clients over the years have blown these notices off, coming to see me years later because some mysterious tax debt has been siphoning their tax refunds. Combine this with the statute of limitations – remember, three years to file or amend – and you can be digging a hole for yourself.

If you agree with the notice, then responding is easy: check the box that says you agree. The IRS will happily send you a bill. Heck, don’t even bother to reply. They will send you the same bill.

If you disagree, then it can be more complicated.

If the matter is relatively easy – say an HSA distribution – I might attach the required tax form to my written response, explaining that the form was overlooked when filing.

If the matter is more complicated – say different types of mismatches – then I might change my answer. My experience – especially in recent years – is that the IRS is doing a substandard job with correspondence requiring one to think. They have repetitively forced me into Appeals and unnecessary procedural work.  My response to more complicated CP2000 notices? I am increasingly filing amended returns. Mind you, the IRS DOES NOT want me to do this. Neither do I, truthfully, but the IRS must first give me reason to trust its work. I am not there right now.

You can fax your response, fortunately.

You might try to call the IRS, but I suspect that will turn out poorly. Shame, as that would be the easiest way to request additional time to reply to the CP2000.

Whatever you do, you have 30 days. The days start counting beginning with the date of the letter, so mail delays can cost you.

Is the IRS gunning for you?

Remember: no one at the IRS has even looked at the notice you received.