A CPA Draws A Fraud Penalty

I see that a CPA drew a fraud penalty.

There is something you don’t see every day.

The CPA is Curtis Ankerberg. He practices in Oregon, which means that I could not have met him. I however am certain that I have met his acolytes.

He graduated in 1994 and did the CPA firm route until 2005, when he went out on his own.

Good for him.

The IRS pulled his personal 2012, 2013 and 2014 returns.

Should be easy for a practicing CPA.

During those years he prepared 50 to over 70 individual returns for clients. It doesn’t sound like a lot, but those are just individual returns. It does not include business returns or any accounting he may also have done.

He maintained an office-in-home, which meant that the IRS examiner came to his house. The audit started off on a bad foot. The auditor added up his 1099s for one year and found that the sum exceeded what Ankerberg had reported as income. Needless to say, the auditor immediately recorded a write-up.

Comment: Folks, if you want to chum the waters for an IRA auditor, this is a good way to do so. I am – if anything – surprised that the IRS computers did not catch this before the auditor even showed up.

Emboldened, the auditor now presented a list of documents he wanted to review.

Our CPA said sure, but he never followed up. He was creative with his excuses, though:

·      He had cataract surgery coming up.

·      He was awaiting the outcome of a complaint he filed with the Treasury Inspector General for Tax Administration.

·      He lost his records.

·      The auditor was messing around with one of the years, as the CPA had already agreed he had underreported income.

·      He had not attached necessary forms to his tax returns because to attach them was a “red flag.”

·      He had bank statements but he could not turn them over because he could not see well.

Alrighty then.

That last one cost him and big.

If the IRS wants your bank statements, they will get your bank statements. You can play it nice and provide copies yourself, or you can stick it to the man and have the IRS subpoena them from the bank. The latter may give you a momentary rush of I-am-a-bad-dude, but you have hacked off an auditor.

What is the first reason that comes to mind if one refuses to provide bank statements?

Exactly.

The IRS agent poured over those bank statements like they were winning lottery tickets. Our CPA had again underreported income. In each year.

Can you feel the penalty coming? Oh, it is going to be a biggun.

What more can a disgruntled agent do?

The agent disallowed the following expenses:

·      Insurance

·      Taxes and licenses

·      Office expenses

·      Repairs and maintenance

·      Utilities

·      Interest

·      Vehicle expenses

·      Office in home

·      And others

This is not fatal. Just provide the documents.

Which Ankerberg did not do.

Our CPA is before the Tax Court explaining how he got into this mess. I imagine the conversation as follows:

“Your honor,” he said, “I had serious medical issues, and those issues constitute reasonable cause. I had cataract surgery, and before then I was really a mess. This auditor caught me at a bad time.”

“Really?” asked the Court. “We are curious then how you prepared all those tax returns for all those clients.”

“Braille,” replied our CPA.

“You continued to drive a car,” continued the Court.

“Self-driving,” explained our CPA. “It is a Google car.”

“Interesting,” noted the Court. “How about that 2014 return, the one after your cataract surgery?”

“Phantom blindness,” offered the CPA generously.

“Let us see. Too little income. Too many deductions. A tax professional who knew the tax ropes. Someone who never provided bank statements or other documentation requested by the auditor. What does this sound like? Let us think… let us think...”

“Aha! We remember now: they sound like badges of fraud.”

Bam!

BTW the fraud penalty is 75%.

Just provide the bank statements, Barney.

A Divorce Decree And Past Taxes

Let’s say that a couple divorces. The divorce decree stipulates that liability for previous federal taxes will be split 50:50. They had always filed jointly The IRS audits one or more of those earlier years and assesses additional taxes.

Question: what is each spouse’s liability?

Your first thought might be 50:50, as that is what the divorce decree says.

Our protagonists this time would find out.

Mae Asad and Sam Akel filed joint returns for 2008 and 2009. The IRS audited those years, looking at rental losses. They disallowed the losses and assessed over $30,000 in taxes and penalties.

Mae filed for innocent spouse.

Later Sam filed for innocent spouse.

NOTE: Filing for innocent spouse status means that a spouse (probably an ex-spouse, but I had a client who was still married) has been assessed taxes for which he/she does not believe he/she is responsible. The classic case is the stay-at-home spouse, the other self-employed spouse, and the stay-at-home has no participation in or knowledge of the other’s business. Think Carmela Soprano.

The IRS bounced both requests for innocent spouse.

Both ex-spouses filed with the Tax Court.

Before the hearing, the IRS conceded that Mae was responsible for 28% of the 2008 tax and 41% of the 2009 tax. Sam of course was responsible for the balance.

Seems to me that Sam might not like this deal.

I do not know how, but Mae agreed to a 50:50 split. She did not have to, mind you.

The courts have been consistent that a divorce decree is not binding on the IRS, as the IRS is not party to the divorce.  A joint return means that both spouses are liable, and the IRS can go after one … or both, to the extent the IRS desires. The decree may provide for a former spouse to seek restitution against the other, but it has no impact on the IRS.

The Court accepted the IRS previous concession to Mae of 28% and 41%. It did not have to observe the divorce decree and it did not.

Then the Court reviewed the penalties of over $5,000.

But there had been a fatal flaw,

You see, Mae and Sam had filed pro se with the Tax Court. Pro se means one is going in without professional representation (not exactly correct, but close enough). It happens with small tax cases. The paperwork to get to Court and the procedural rules once there are more lenient for small cases.

Sam and Mae had not included the penalty in their petition to the Court.

The Court did not have authority to review the penalties.

But it did provide us a clear example of the downside to representing oneself pro se.

How Often Can The IRS Audit You For The Same Thing?

How often can the IRS audit you for the same thing?

I would have to ask two more questions before answering:

(1) Is the IRS auditing the same year?

(2) Is the IRS auditing the same issue?

Here is the relevant Code section:

            IRC Section 7605(b):

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.

Focus in on the lawyered wording:

            “unnecessary examination or investigations”

            “an additional inspection is necessary”

If I were the IRS, I would argue that all examinations and inspections are “necessary” and be done with the matter.

Fortunately, it does not work that way.

Let say that you are self-employed and deducted a bad debt – a sizeable one – in 2014. The IRS takes a look at it and raises some questions, as bad debts are a notorious area of contention with the IRS. After some back and forth the IRS agrees to the deduction.

Question: Can the IRS audit your 2014 tax return again?

Answer: Of course it can, at least until the statute of limitations expires. What it cannot do is audit your 2014 bad debt again. It already looked at that issue and did not propose an audit adjustment. There is only one bite at the apple.

This does not mean that you are untouchable, however.

Let’s say that you incur a huge net operating loss in 2016. You decide, after meeting with your tax advisor, to carryback the loss to 2014 and get a tax refund. You could really use the cash, with that loss and all.

Question: Can the IRS audit your 2014 bad debt again?

The answer may surprise you: Yes.

Here is the Court:

This is not a case where the IRS is subjecting the Taxpayer to onerous and unnecessarily frequent examinations and investigations. The reexamination of Year 1 is not a unilateral action on the part of the IRS, but in response to the Taxpayer’s election to carry back net operating losses and claim a refund.”

In other words, you started it.

Let me give you a second scenario: 

You have a large donation in 2014 and another large donation in 2015. You were audited for 2014. The IRS made no change to your return.

Question: Can the IRS audit your 2015 for the donation? 

Here is Internal Revenue Manual 4.10.2.13:

(1) Repetitive audit procedures apply to individual tax returns without a Schedule C or Schedule F, when the following criteria are met:

·        a. An examination of one or both of the two preceding tax years resulted in a no change or a small tax change (deficiency or overassessment), and

·        b. The issues examined in either of the two preceding tax years are the same as the issues selected for examination in the current year.  

Answer: You should be able to stop this audit. The IRS looked at the same issue in the preceding year and found nothing.

BTW, note the references to Schedule “C” and “F” in para 1 above. Schedule C means that someone is self-employed, and Schedule F means that someone is a farmer. Those are two situations where a tax advisor would love to have this IRM protection. The IRS knows that too, which is why the IRS left out self-employeds and farmers.  

Question: What if the IRS audits you in 2014 for mileage and in 2015 for office-in-home expenses?  

Answer: You being are audited for two different things. What we are talking about is the IRS looking at the same thing, either more than once for the same year or more than once over a three-year period.

Let’s clarify a crucial point: what halts the second audit is NOT that you were previously audited on the same issue. What halts it is that you were audited and there was no change or an insignificant change. If you owed big bucks on the audit then you are fair game. 

A word of advice: you will have to let the examiner know. My experience is that he/she will be unaware until you bring it up. Address this issue early – for example, when the examiner is trying to schedule the visit – and you can stop the audit altogether. 

A CPA Goes Into Personal Audit

Folks, if you wind up before the Tax Court, please do not say the following:

… petitioner testified that allocating some of the expenses between his personal and business use required more time than he was willing to spend on the activity.”

Our protagonist this time is Ivan Levine, a retired CPA who was trying to get a financial service as well as a marketing business going. He worked from home. He used personal credit cards and bank accounts, as well as a family cellular plan. He also drove two vehicles – a Porsche 911 and a Chevrolet Suburban – for both personal and business reasons. All pretty standard stuff.

The IRS came down like a sack of bricks on his 2011 return. They challenged the following:

(1) Advertising

(2) Vehicle expenses

(3) Depreciation, including the vehicles

(4) Insurance (other than health)

(5) Professional fees

(6) Office expenses

(7) Supplies

(8) Utilities

(9) Cell phone

(10)       Office-in-home

Whoa! It seems to me that some of these expenses are straight-forward – advertising, for example. You show a check, hopefully an invoice and you are done. Same for professional fees, office expenses and supplies. How hard can it be?

It turns out that he was deducting the same expense in two categories. He was also confusing tax years – currently deducting payments made in the preceding year.

The office-in-home brings some strict requirements. One of them is that an office-in-home deduction cannot cause or increase an operating loss. If that happens, the offending deductions carryover to the subsequent year. It happens a lot.

It happened to Mr. Irvine. He had a carryover from 2010 to 2011, the year under audit. The IRS requested a copy of Form 8829 (that is, the office-in-home form) from 2010. They also requested documentation for the 2010 expenses.

COMMENT: Why would the IRS request a copy of a form? They have your complete tax return already, right? This occurs because the IRS machinery is awkward and cumbersome and it is easier for the revenue agent to get a copy from you.

Mr. Irvine refused to do either. The decision does not state why, but I suspect he thought the carryover was safe, as the IRS was auditing 2011 and not 2010. That is not so. Since the carryover is “live” in 2011, the IRS can lookback to the year the carryover was created. Dig in your heels and the IRS will disallow the carryover altogether.

The vehicles introduce a different tax technicality. There are certain expenses that Congress felt were too easily subject to abuse. For those, Congress required a certain level of documentation before allowing any deduction. Meals and entertainment are one of those, as are vehicle expenses.

Trust me on this, go into audit without backup for vehicle expenses and the IRS will just goose-egg you. You do not need to keep a meticulous log, but you need something. I have gotten the IRS to allow vehicle expenses when the taxpayer drives a repeating route; all we had to do was document one route. I have gotten the IRS to accept reconstructions from Outlook or Google calendar. The calendar itself is “contemporaneous,” a requirement for this type of deduction.

BTW the tricky thing about using Outlook this way is remembering to back-up Outlook at year-end. I am just saying.

You know Mr. Irvine did not do any of this.

Why?

Because it would have required “… more time than he was willing to spend on the activity.”

This from a CPA?

Being a CPA does not mean that one practices tax, or practices it extensively. I work tax exclusively, but down the hall is a CPA who has careered in auditing. He can exclaim about myriad issues surrounding financial statements, but do not ask him to do a tax return. There are also nouveau practice niches, such as forensic accountants or valuation specialists. One is still within the CPA tent, but likely far away from its tax corner.

Although a CPA, Mr. Irvine could have used a good tax practitioner. 

Issuing 1099s In Anger

Several years ago, I received an angry call from another CPA.

He had lost a couple of key partners, to which he responded with an almost Game-of-Thrones vindictiveness. He had been charged with issuing false Form 1099s to his former partners.

They dragged him into Court for this and other reasons.

I had looked into the 1099 matter. It is not every day a CPA is charged with issuing false tax forms.

Why would somebody do this: issue false 1099s?

Because chum in the water.

Let’s talk about the Petrunak case.

Petrunak was a pyrotechnician.

This guy made fireworks. He owned a company called Abyss Special FX, Inc. (Abyss), and he could do both indoor and outdoor fireworks displays.

This also meant that he was under regulation by the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF).

A couple of ATF agents conducted a mandatory inspection and found a number of violations. Petrunak challenged their findings and had his day in administrative court. I do not know what the details were, but the judge revoked Petrunak’s fireworks license.

So much for Abyss and his paycheck.

Petrunak reckoned he lost a lot of money – both as real-money losses and as money he would have made except for the ATF agents.

He had time to think about it. He thought about it for five years.

He had Abyss send each of them a Form 1099-MISC for $250,000.

Half a million. He figured that was about what they had cost him.

Abyss deducted that half million. As Abyss was an S corporation, there was a big loss passed-through to Petrunak to use on his individual return.

Needless to say, both ATF agents omitted that 1099 from his/her individual tax return.

One agent however got pulled for audit.

The IRS wanted taxes of over $100 grand. She spent a lot of time contesting and unraveling that mess.

Exactly what Petrunak wanted. Forms 1099 are chum in the water to the IRS.

Problem is, the IRS pursued Petrunak after the ATF agent’s audit. He admitted to filing those 1099s, but he was right in doing so and those two had lied – to a judge, unbelievable! – and an IRS person told him that he might be able to issue 1099s for his business costs. He estimated his costs to be half a million.

The IRS charged him with three counts of making false and fraudulent IRS forms.

He fought back, going to the Seventh Circuit Court of Appeals.

How did it turn out?

Petrunak is going to prison for 24 months.

His accounting was fantastical, but I get his anger.

Circling back, the accountant who called me was angry because I did not agree with him.

To be kind, let’s say his side of story was … creative.

But then, have a CPA play in a field with accounts receivable, deferred compensation, cash transfers, buyout agreements and whatnot and a talented – and motivated - practitioner can get creative.

He did.

Problem was: he picked a fight with tax CPAs. Two of them.

Bad call. 

It cost him a few bucks.

An Attorney, A CPA and Confidentiality

Do you have privacy protection if you tell me something as your CPA?

Your first thought might be yes, as your CPA might be the financial doppelganger to an attorney.

Then again, the answer might be no, as your CPA is not in fact an attorney – unless he/she is one of those rare birds that pairs-up a JD/CPA.

What got me thinking along these lines is the recent case US v Galloway.

Let’s travel to 2006. The IRS notifies Galloway that his 2003 return has been pulled for audit.

Audit starts.

In the middle of the audit Galloway’s CPA fires him. Why? Galloway did not pay his fees.

In 2008 Galloway gets sent to CID (Criminal Investigation Division), the part of the IRS that carries badges and guns.

As a heads-up: you NEVER want to deal with CID. It is one thing to argue with regular IRS, appeal penalties, stretch out a payment plan and so on. All that crowd wants is your money. CID investigates criminal conduct and they have a different goal: to put you in jail.

CID agents went to his business offices in Bakersfield, California. Upon their approach, a man in the office locked the door and called the police.

The CID agents also called the police and informed them there were two plain clothed and armed federal agents waiting for them to arrive.

The man stepped out of the building and provided them with the name of an attorney. The CID agents cleared out before the police arrived.

Nothing. Suspicious. There.

Since that visit went so well, CID next issued a summons for production of documents to the former CPA.

The CPA met with them, explained his relationship with Galloway and answered questions on how he prepared Galloway’s 2003 return. No great surprise: Galloway had forwarded QuickBooks information; the CPA asked a few questions, massaged a few numbers and produced a tax return. Happens in a thousand CPA offices every day.

There was a smidgeon of a problem, though.

Remember that the CPA had started the Galloway audit. As part of the audit, Galloway had provided him more paperwork, including additional and replacement QuickBooks runs. No big deal - usually.

What was unusual was that the new QuickBooks runs did not match-up to the earlier run the CPA used for the tax return.  

Galloway was charged with four counts of attempting to evade tax.

What to do?

Galloway sought to suppress all evidence obtained from his prior CPA. Why? Code Section 7609. The AICPA Code of Professional Conduct. Equitable authority. Applebee’s 2 for $20 menu.

You get it: kitchen sink. Galloway was throwing everything he had.

And this brings us to the Couch case from 1973. It was a Supreme Court case, so it is big-time precedent.

Couch owned a restaurant. At issue was unreported income. Cash. Pocket. Wink. You understand.

The IRS issued a subpoena to Couch’s accountant for books, records, bank statements, cancelled checks, deposit ticket copies, Sunday newspaper coupons and unexpired S&H green stamps.

Couch said: hold up. She had provided all that stuff to her accountant, so subpoenaing her accountant rather than her personally was nonetheless a violation of her Fifth Amendment right against self-incrimination.

I like her argument.

Ultimately – as Captain Picard would say – her argument was futile.

The Court was short and swift: Couch had no “legitimate expectation of privacy” upon providing information to a third-party with the goal of processing, straining and compressing that same information onto a government tax return.

Back to Galloway.

As you can see, he was taking a low-probability swing on a high-and-tight fastball.

He struck out. He could not make enough separation between his situation and Couch to avoid the precedent.

How do tax CPAs handle situations like Galloway in practice?

First of all: interaction with CID is rare. One can have a long career and never see the criminal side of the IRS.  

I have run into CID once or twice over 30+ years, most recently in connection with a fraudulent tax preparer in northern Kentucky. I also recently (enough) represented a client whose file was submitted by Exam to CID, but CID rejected the matter. The client was eye-rollingly negligent, but Exam hyperventilated (I thought then and now) and started seeing intent where only stupidity abounded.  

Anyway, here is what the CPA should recommend:

(1) Have the client hire an attorney

(2) Have the attorney hire the CPA

Under this arrangement, the CPA works for the attorney. He/she is protected under the attorney’s confidentiality privilege and cannot be compelled to testify unless the attorney releases him/her. The attorney will not – of course -  do any such thing.

This set-up is called a “Kovel,” by the way. Not surprisingly, it refers to a case by the same name.

What did Galloway’s accountant do wrong?

To be fair: nothing. Galloway was no longer a client. He was under no obligation to chase Galloway down.

Galloway really should have thought of that before stiffing the CPA for his fee.

Let’s however say Galloway was still a client. 

Folks, at the first hint or whiff of a criminal investigation I am (1) firing you or (2) you are providing me with a Kovel. Those are the only two options.

But it requires the accountant to recognize the danger signs.

Like a combined civil-criminal IRS examination, for example. Those are borderline unfair, as the IRS will pretend there is no criminal side to it. They introduce an unsettling miasma of entrapment, and they require the tax practitioner to realize that he/she is being played.

But that is not what happened with Galloway. CID went to his office, for goodness’ sake.

There was not a lot of subtlety there.

How To Hack Off An IRS Auditor

Let’s discuss an excellent way to anger a revenue agent auditing your tax return.

Eric and Mary Kahmann have owned a jewelry business for 45 years. They report the business on their personal return as a proprietorship (that is, a Schedule C). they primarily sell at shows throughout the United States, although they also sell through Amazon and PayPal.

PayPal introduces a tax variable: Form 1099-K.

Yep, another blasted 1099. This time Congress was concerned that people were selling stuff (through Amazon, for example) and not correctly reporting their income. Amazon will sell your stuff, but the cash is likely going through Pay Pal or its equivalent. Do enough business and PayPal will send you a 1099-K at the end of the year.

Issue number one.

In addition, Mr. Kahmann’s two brothers were also in the jewelry business. Whereas they did not work with or for him, they would use his two merchant accounts to process payments.

Issue number two.

The IRS audited the Kahmann’s 2011 year.

Why? Who knows. What did not help were the following numbers:

Gross sales reported by the Kahmanns     $128,070

Gross sales reported on the 1099-Ks         $151,834

Guess what? This happens quite a bit, and it does not necessarily mean shenanigans. I will give you one example:

Customer refunds

If one accounts for customer refunds by subtracting them from sales, one can have the above discrepancy. The 1099-K does not – of course – know about any refunds.

The revenue agent asked for bank statements.

COMMENT: This has become standard IRS procedure for a Schedule C audit. It means nothing. You can however flame it into roaring meaningfulness by …

The Kahmanns refused to provide the bank statements.

Brilliant!  

I would seriously consider firing a client who did that to me. Is it a pain? Yes. Will the bank charge you for the copies? Yep. Is it fair? Fair is beside the point. It is what it is.

The revenue agent issued a summons to the bank for the three accounts she knew about. 

COMMENT: Yes, the IRS can get to those accounts. In addition, now the agent has to question whether she knows about all your accounts. Your chances of getting her to believe anything you say are falling fast.

Let’s grade the Kahmanns’ conduct during this audit so far:

                  F

The agent got the bank statements and added up all the deposits. The total was $169,603.

Wait, it gets better.

She could not trace one of the 1099-Ks into the bank statements, so she added that number ($15,745) to the $169,603. She now calculated gross receipts as $188,073.

The Kahmanns have a problem.

They have to show that some of those deposits were not income. Could be. Perhaps they borrowed money. Perhaps they transferred monies between accounts. Perhaps they received family gifts.

Perhaps Mr. Kahmann deposited his brothers’ PayPal transactions, given that they were using his merchant accounts.

There are two technical issues here that a tax nerd would recognize:

(1) There is recourse to having the IRS add-in $15,745 from a 1099-K just because the agent could not figure-out how it was deposited. A taxpayer can shift the burden of proof back to the IRS, meaning that the IRS is going to need something more than a piece of paper with “1099-K” printed somewhere on it.

There is a catch: you must cooperate with the IRS during the exam. Guess who did not cooperate by refusing to provide bank statements?

Bingo!

(2) Alternatively, a taxpayer can show that the deposits are not income.

Say that a deposit belonged to Kahmann’s brother. You can have the brother (or his accountant, more likely) show that the deposit was included in gross sales reported on the brother’s tax return.

It’s a pain, but it is not brain surgery.

The Kahmanns provided letters from the brothers.

The IRS wanted to meet with the brothers.

The brothers did not want to meet with the IRS.

The Kahmanns submitted books and records to support their tax return. The handwriting appeared to have been written all at once rather than over the year. The ink was also the same throughout.

Unlikely. Suspicious. Dumb.

You can guess how this wound up.

The Court agreed with the IRS recalculation of income. The Kahmanns owed big bucks. There were penalties too. 

Normally I am quite pro-taxpayer.  Am I sympathetic this time?

Not a bit.

The Hosbrook Road Terrible Tax Tale

Let's talk about S corporations.

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

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

But there are rules to observe.

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

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

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

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

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

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

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

            1995              (191,044)

            1996              ( 70,325)

            2002              ( 99,813)

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

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

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

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

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

Problem: He did not have those schedules.

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

Problem: The IRS said they were bogus.

Solution: You go to Tax Court.

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

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

The Court did so request.

He trotted out those Quicken reports and handwritten summaries.

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

Strike one.

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

Strike two.

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

Strike three.

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

He owed tax. He owed penalties.

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

But Mr. Power has attained tax fame.