Another Runaway FBAR Case

 

Let’s talk about the FBAR (Report of Foreign Bank and Financial Accounts). It currently goes by the name “FinCen Form 114.”

This thing has been with us since 1970. It came to life as an effort to identify foreign financial transactions that might indicate money laundering or tax evasion. 

Sounds benign.

The filing requirement applies to a United States person, defined as

·      A citizen or resident of the U.S.

·      A domestic partnership

·      A domestic corporation

·      A domestic trust or estate

 We’ll come back that first one in a moment.

Next, one needs a financial interest or signature authority in a foreign financial account to trigger this thing.

A foreign financial account includes a bank account, which is easy enough to understand. It would also include a broker account (think Charles Schwab, but overseas). Some are not so intuitive, though.

·      A foreign insurance policy with cash value is reportable.

·      A foreign hedge fund is not.

·      A foreign annuity policy is reportable.

·      A foreign private equity fund is not.

·      A foreign cryptocurrency account is not reportable.

Some require a google search to understand what is being said.

·      A Canadian registered retirement savings plan is reportable.

·      A Mexican fondo para retiro is reportable.

Next, the foreign financial account has to exceed a certain dollar balance ($10,000) at some point during the year.

That $10,000 balance has been there for as long as I can remember. You will have a hard time persuading me that $10,000 in 1986 is the same as $10,000 now, but that number is apparently eternal and unchanging.

The $10,000 is tested across all foreign financial accounts. If it takes your fourth foreign account to put you over $10 grand, then you are over. Testing is done. All your accounts are reportable on a FBAR.

Like so many things, the FBAR started with reasonable intentions but has morphed into something near unrecognizable.

Fail to file an FBAR and the standard penalty is $10 grand. Fail to file for two years and the penalty is $20 grand. Have two foreign accounts and fail to file for two years and the penalty is $40 grand.

And that is assuming the error is unintentional. Do it on purpose and I presume they will execute you.

I exaggerate, of course. They will just bankrupt you.

It puts a lot of pressure on defining “on purpose.”

Let’s look at Osamu Kurotaki (OK).

OK was born in Japan and lives in Japan. He obtained a U.S. green card, making him a U.S. permanent resident. One of the pleasures of being a permanent resident is filing an annual tax return with the United States, irrespective of whether you live in the U.S. or not. One can talk about a foreign income exclusion or foreign tax credit – which is fine – but that annual filing makes sense only if someone intends to eventually return to the U.S. It does not make as much sense if someone does not intend to return, someone like OK.

OK paid someone to prepare his annual U.S. tax return. He found a CPA who was bilingual.

In 2021 the U.S. Treasury assessed civil penalties against OK for more than $10 million. His footfall? He failed to file FBARs. Treasury also upped the ante by saying that his failure was “willful.”

Huh?

Treasury is requesting summary judgement that OK willfully failed to file FBARs, prefers waffle over sugar cones and rooted for the Diamondbacks in the World Series. 

The Court wanted to know how Treasury climbed the ladder to get to that “willful” step.

So do I.

Here is what the Court saw:

·      OK is a Japanese speaker and does not speak English “at all.”

·      OK relied on his bilingual CPA to make sense of U.S. tax filing obligations.

·      His CPA provided annual tax questionnaires in both English and Japanese. The English was for theater, I suppose, as OK could not read English.

·      The CPA’s translation now becomes critical. Here are instructions to the FBAR in English:

U.S. taxpayers are required to report their worldwide income; that is, income from both U.S. and foreign sources.”

·      Here is the Japanese translation:

U.S. resident taxpayers are required to report their worldwide income, that is, income from both US. and foreign sources."

OK told the Court that he did not think he had a filing obligation because he was not a “U.S. resident.”

I get it. He lives in Japan. He works in Japan. His kids go to school in Japan. He is as much a “U.S. resident” as I am a Nepalese Sherpa.

Except …

OK was green card – that is, a “permanent” resident of the U.S.

Technically …

The Court cut OK some slack. Technically - and in a law school vacuum - he was a “resident.” Meanwhile - in the real world – no one would think that. Furthermore, OK hired a CPA who made a mistake. Even a trained professional erred interpreting the Treasury’s word salad. 

The Court said “no” to summary judgement.

Treasury will have to argue its $10 million-plus proposed penalty.

And I believe the Court just outlined reasonable cause.

Perhaps OK should consider turning in that green card. 

Our case this time was Osamu Kurotaki v United States, U.S. District Court, District of Hawaii.

 

Failing To Take A Paycheck

I am looking at a case involving numerous issues. The one that caught my attention was imputed wage income from a controlled company in the following amounts:

2004                    $198,740

2005                    $209,200

2006                    $220,210

2007                    $231,800

2008                    $244,000

Imputed wage income means that someone should have received a paycheck but did not.

Perhaps they used the company to pay personal expenses, I think to myself, and the IRS is treating those expenses as additional W-2 income. Then I see that the IRS is also assessing constructive dividends in the following amounts:

2004                    $594,170

2005                    $446,782

2006                    $375,246

2007                    $327,503

2008                    $319,854 

The constructive dividends would be those personal expenses.

What happened here?

Let’s look at the Hacker case.

Barry and Celeste Hacker owned and were the sole shareholders of Blossom Day Care Centers, Inc., an Oklahoma corporation that operated daycare centers throughout Tulsa. Mr. Hacker also worked as an electrician, and the two were also the sole shareholders of another company - Hacker Corp (HC).

The Hackers were Blossom’s only corporate officers. Mrs. Hacker oversaw the workforce and directed the curriculum, for example, and Mr. Hacker was responsible for accounting and finance functions.

Got it. She sounds like the president of the company, and he sounds like the treasurer.

For the years at issue, the Hackers did not take a paycheck from Blossom.

COMMENT: In isolation, this does not have to be fatal.

Rather than pay the Hackers directly, Blossom made payments to HC, which in turn paid wages to the Hackers.

This strikes me as odd. Whereas it is not unusual to select one company out of several (related companies) to be a common paymaster, generally ALL payroll is paid through the paymaster. That is not what happened here. Blossom paid its employees directly, except for Mr. and Mrs. Hacker.

I am trying to put my finger on why I would do this. I see that Blossom is a C corporation (meaning it pays its own tax), whereas HC is an S corporation (meaning its income is included on its shareholders’ tax return). Maybe they were doing FICA arbitrage. Maybe they did not want anyone at Blossom to see how much they made.  Maybe they were misadvised.

Meanwhile, the audit was going south. Here are few issues the IRS identified:

(1)  The Hackers used Blossom credit cards to pay for personal expenses, including jewelry, vacations, and other luxury items. The kids got on board too, although they were not Blossom employees.

(2)  HC paid for vehicles it did not own used by employees it did not have. We saw a Lexus, Hummer, BMW, and Cadillac Escalade.

(3) Blossom hired a CPA in 2007 to prepare tax returns. The Hackers gave him access to the bank statements but failed to provide information about undeposited cash payments received from Blossom parents.

NOTE: Folks, you NEVER want to have “undeposited” business income. This is an indicium of fraud, and you do not want to be in that neighborhood.

(4)  The Hackers also gave the CPA the credit card statements, but they made no effort to identify what was business and what was family and personal. The CPA did what he could, separating the obvious into a “Note Receivable Officer” account. The Hackers – zero surprise at this point in the story - made no effort to repay the “Receivable” to Blossom.  

(5) Blossom paid for a family member’s wedding. Mr. Hacker called it a Blossom-oriented “celebration.”  

(6) In that vein, the various trips to the Bahamas, Europe, Hawaii, Las Vegas, and New Orleans were also business- related, as they allowed the family to “not be distracted” as they pursued the sacred work of Blossom.

There commonly is a certain amount of give and take during an audit. Not every expense may be perfectly documented. A disbursement might be coded to the wrong account. The company may not have charged someone for personal use of a company-owned vehicle. It happens. What you do not want to do, however, is keep piling on. If you do – and I have seen it happen – the IRS will stop believing you.

The IRS stopped believing the Hackers.

Frankly, so did I.

The difference is, the IRS can retaliate.

How?

Easy.

The Hackers were officers of Blossom.

Did you know that all corporate officers are deemed to be employees for payroll tax purposes? The IRS opened a worker classification audit, found them to be statutory employees, and then went looking for compensation.

COMMENT: Well, that big “Note Receivable Officer” is now low hanging fruit, isn’t it?

Whoa, said the Hackers. There is a management agreement. Blossom pays HC and HC pays us.

OK, said the IRS: show us the management agreement.

There was not one, of course.

These are related companies, the Hackers replied. This is not the same as P&G or Alphabet or Tesla. Our arrangements are more informal.

Remember what I said above?

The IRS will stop believing you.

Petitioner has submitted no evidence of a management agreement, either written or oral, with Hacker Corp. Likewise, petitioner has submitted no evidence, written or otherwise, as to a service agreement directing the Hackers to perform substantial services on behalf of Hacker Corp to benefit petitioner, or even a service or employment agreement between the Hackers and Hacker Corp.”

Bam! The IRS imputed wage income to the Hackers.

How bad could it be, you ask. The worst is the difference between what Blossom should have paid and what Hacker Corp actually paid, right?

Here is the Court:

Petitioner’s arguments are misguided in that wages paid by Hacker Corp do not offset reasonable compensation requirements for the services provided by petitioner’s corporate officers to petitioner.”

Can it go farther south?

Respondent also determined that petitioner is liable for employment taxes, penalties under section 6656 for failure to deposit tax, and accuracy-elated penalties under section 6662(a) for negligence.”

How much in penalties are we talking about?

2005                    $17,817

2006                    $18,707

2007                    $19,576

2008                    $20,553

I do not believe this is a case about tax law as much as it is a case about someone pushing the boundary too far. Could the IRS have accepted an informal management agreement and passed on the “statutory employee” thing? Of course, and I suspect that most times out of ten they would. But that is not what we have here. Somebody was walking much too close to the boundary - if not walking on the fence itself - and that somebody got punished.

Our case this time was Blossom Day Care Centers, Inc v Commissioner, T.C. Memo 2021-86.

Tax Preparer Gives Gambler A Losing Hand

 

I am looking at a bench opinion.

The tax issue is relatively straightforward, so the case is about substantiation. To say that it went off the rails is an understatement.

Let us introduce Jacob Bright. Jacob is in his mid-thirties, works in storm restoration and spends way too much time and money gambling. The court notes that he “recognizes and regrets the negative effect that gambling has had on his life.”

He has three casinos he likes to visit: two are in Minnesota and one in Iowa. He does most of his sports betting in Iowa and plays slots and table games in Minnesota.

He reliably uses a player’s card, so the casinos do much of the accounting for him.

Got it. When he provides his paperwork to his tax preparer, I expect two things:

(1)  Forms W-2G for his winnings

(2)  His player’s card annual accountings

The tax preparer adds up the W-2Gs and shows the sum as gross gambling receipts. Then he/she will cross-check that gambling losses exceed winnings, enter losses as a miscellaneous itemized deduction and move on. It is so rare to see net winnings (at least meaningful winnings) that we won’t even talk about it.

COMMENT: Whereas the tax law changed in 2018 to do away with most miscellaneous itemized deductions, gambling losses survived. One will have to itemize, of course, to claim gambling losses.   

Here starts the downward cascade:

Mr. Bright hired a return preparer who was recommended to him, but he did not get what or whom he expected. Rather than the recommended preparer, the return preparer’s daughter actually prepared his return.”

OK. How did this go south, though?

The return preparer reported that Mr. Bright was a professional gambler ….”

Nope. Mind you, there are a few who will qualify as professionals, but we are talking the unicorns. Being a professional means that you can deduct losses in excess of winnings, thereby possibly creating a net operating loss (NOL). An NOL can offset other income (up to a point), income such as one’s W-2. The IRS is very, very reluctant to allow someone to claim professional gambler status, and the case history is decades long. Jacob’s preparer should have known this. It is not a professional secret.

Jacob did not review the return before signing. For some reason the preparer showed over $240 grand of gross gambling receipts. I added up the information available in the opinion and arrived at little more than $110 grand. I have no idea what she did, and Jacob did not even realize what she did. Perhaps she did not worry about it as she intended the math to zero-out.

She should not have done this.

The IRS adjusted the initial tax filing to disallow professional gambler status.

No surprise.

Jacob then filed an amended return to show his gambling losses as miscellaneous itemized deductions. He did not, however, correct his gross gambling winnings to the $110 grand.

The IRS did not allow the gambling losses on the amended return.

Off to Tax Court they went.

There are several things happening:

(1)  The IRS was arguing that Jacob did not have adequate documentation for his losses. Mind you, there is some truth to this. Casino reports showed gambling activity for months with no W-2Gs (I would presume that he had no winnings, but that is a presumption and not a fact). Slot winnings below $1,200 do not have to be reported, and he gambled on games other than slots. Still, the casino reports do provide some documentation. I would argue that they provide substantiation of his minimum losses.

(2)  Let’s say that the IRS behaved civilly and allowed all the losses on the casino reports. That is swell, but the tax return showed gambling receipts of $240 grand. Unless the casino reports showed losses of (at least) $240 grand, Jacob still had issues.

(3)  The Court disagreed with the IRS disallowing all gambling deductions. It looked at the casino reports, noting that each was prepared differently. Still, it did not require advanced degrees in mathematics to calculate the losses embedded in each report. The Court calculated total losses of slightly over $191 grand. That relieved a lot – but not all – of the pressure on Jacob.

(4)  Jacob did the obvious: he told the Court that the $240 grand of receipts was a bogus number. He did not even know where it came from.

(5)  The IRS immediately responded that it was being whipsawed. Jacob reported the $240 grand number, not the IRS. Now he wanted to change it. Fine, said the IRS: prove the new number. And don’t come back with just numbers reported on W-2Gs. What about smaller winnings? What about winnings from sports betting? If he wanted to change the number, he was also responsible for proving it.

The IRS had a point. It was being unfair and unreasonable but also technically correct.

Bottom line: the IRS was not going to permit Jacob to reduce his gross receipts number without some documentation. Since all he had was the casino reports, the result was that Jacob could not change the number.

Where does this leave us? I see $240 – $191 = $49 grand of bogus income.

My takeaway is that we have just discussed a case of tax malpractice. That is what lawyers are for, Jacob.

Our case this time was Jacob Bright v Commissioner, Docket No. 0794-22.

Income and Credit Card Rebates

I am reading a case so unique that I doubt there is much takeaway taxwise, other than someone beat the IRS.

What gets the story started is automobile rebates back in the mid -70s. The economy was limping along, and car manufacturers wanted to sell cars. Buy a car, get money back from the manufacturer.

To a tax geek, receiving a check in the mail raises the question of whether there is income somewhere.

The overall concept behind taxable income is that one has experienced an accession to wealth. That is how discharge of debt can create income, for example. As one’s debt goes down, one’s wealth increases.

What to do with a car rebate?

The IRS did the obvious thing: it saw a car; it saw payment for a car; and it saw a rebate going back to whoever bought the car. There was no increase in wealth here, it decided. The result was that one paid less for the car.

There are countless variations on the theme. What to do with airline miles, for example?

Our case features Konstantin Anikeev (K). K got himself a Blue Cash American Express credit card. The card had a reward program. American Express would send you money for buying (approved) things with the card.

American Express disallowed certain purchases from the program, however, including:

(1)  Interest charges and fees

(2)  Balance transfers

(3)  Cash advances

(4)  Purchase of traveler’s checks

(5)  Purchase or reloading of prepaid cards

(6)   Purchase of any cash equivalent

I get it. American Express did not want someone to walk the transaction through back to cash.

K noticed something: the program did not address gift cards.

A gift card is just a prepaid card, right? Not quite. A gift card is not redeemable in cash or eligible for deposit into your bank account.

I had not really thought about it.

K did think about.

You know what you can do with a gift card?

You can buy a money order, that’s what. You then deposit the money order in the bank.

Sounds like a lot of work for a couple of bucks.

K went to town. Over the course of a year or so, he and his wife generated rebates of over $300 grand.

K knows how to commit.

Interestingly enough, American Express did not seem to care. 

The IRS however did care. They were going to tax K on his $300 grand. K pointed out that the IRS had provided guidance way back by saying that rebates were not income, and all he received were rebates. Granted, there were more bells and whistles here than a 1978 Chrysler Cordoba, but that did not change anything.

The IRS said nay-nay. The guidance they put out back in the 70s involved a product or service. That product or service had a cost, and that cost could then be reduced to absorb the effect of the rebate. There were no goods and services with K’s scheme. There was nothing to “absorb” the rebate.

Off they went to Tax Court.

There is a tax subtlety that we need to point out.

The IRS could have argued that the exchange of the gift card for a money order was a taxable event. Since the cost of the gift card had been adjusted down by the rebate K received (meaning the cost was less than a dollar-on-a-dollar), there would be a gain upon the exchange.

It is a formidable argument.

That is not what the IRS did. They instead argued that K had an income recognition event when he bought the gift card.

Huh? How?

Because he intended to ….

The Court was having none of this argument.

The Court reminded the IRS that gift cards are a product. The card has a uniform product code that the cashier uses to ring up the cost. It is a product, just like a car. The IRS was upset because it got gamed. It did not like the result, but that did not give the IRS leash to arbitrarily look down the road and back-up the tax truck when it did not like the destination. The IRS should tighten its rules.

Here is the Court:

These holdings are based on the unique circumstances of this case. We hope that respondent polices the IRS policy in the future in regulations or in public pronouncements rather than relying on piecemeal litigation.”

K won. He and his wife had tax-free cash.

BTW, K did all this with a card whose credit limit was $35 grand. I am REALLY curious how much time they put into this.

Our case this time was Anikeev v Commissioner, TC Memo 2012-23.

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.

Difference Between An Advance And A Loan

Do you remember when the Washington Redskins and the Miami Dolphins went to the Super Bowl? It was 1983, and I was living in Florida at the time. I am pretty sure I was rooting for the Florida team. The Redskins had a hard-charging fullback named John Riggins. His nickname was “Diesel” and he scored a touchdown on a forty-something yard run. Blocking for him was (among others) George Starke, an offensive tackle. The Washington offensive linemen, the ones who block for the quarterback and running back, were known as The Hogs.

George Starke is second from the left.

George was very much on the backside of his career at that point. He shortly thereafter left football and opened a car dealership in Maryland. He couldn’t help but notice that the dealership had difficulty recruiting service technicians. He helped establish a technical school to educate and train technicians. He also hoped that - by providing a realistic hope for a better life – the school would also help with the poverty and violence in the area.

He eventually sold the dealership and cofounded the Excel Institute, a nonprofit program that provided a two-year reading, writing, arithmetic and technical skills curriculum. The program was free of charge, but one had to commit.

Starke received a salary and housing allowance, as well as a credit card. He would charge business and personal expenses on the card. The personal charges were segregated on the books and records. George discontinued any personal charges in 2006, and from 2007 onward the only activity relating to the credit card was a payroll deduction to repay the balance.

There was a change in the Board, and Starke did not like the new direction of things. He stopped fundraising. He left the Excel Institute altogether in 2010.

Excel put the remaining balance due from George of $83,698 on a Form 1099, sent a copy to George, a second to the IRS and figured that was that.

George did not include the $83 grand on his individual tax return, however.

The IRS noticed and insisted that George do so. George said no.

And off to Tax Court they went.

Before proceeding, tell me: do you think George has a prayer?

As you know, forgiveness of a loan triggers income. The tax issue is whether these monies were ever a loan.

Your first thought is: of course they were! Heck, he was paying it back, wasn’t he?

Let’s walk through this.

Just because someone gives you money does not mean that there exists a loan. A loan implies that both sides anticipate the monies will be repaid. It would also be swell if there were some attention to the basic formalities, like perhaps a loan agreement and repayment terms.

And – just to dream – maybe interest could be charged on the whole affair.

There was no loan agreement. Excel itself gave mixed messages to the Court on whether it thought the monies were a loan. George told the Court that he never had any intention of paying back the money, and that he thought the payroll deductions were for health insurance or something like that.

If not a loan, then what were the monies to George?

They were advances, akin to nonrecoverable draws.

Advances are more easily understood in a draw-against-commission environment. Draws are intended to provide some predictable cash flow to the salesperson. Say that a salesperson receives commissions, and against the commissions is a $5,000 monthly draw. There are two types of draws - recoverable and nonrecoverable. A nonrecoverable draw does not have to be paid back should a saleperson fail to meet quota. A recoverable draw does have to be paid back. Granted, a salesperson who fails on a continuous basis to meet quota would soon be unemployed, but that is a different conversation.  For our purposes, the key is that a nonrecoverable draw represents income upon receipt.

Back to our courtroom drama.

The IRS pulled his 2010 tax year.

George received no advances in the 2010 tax year.

George last received advances in 2006.

There was nothing to tax in 2010 because George received no monies in 2010.

The IRS should have pursued his 2006 tax year. They did not, nor could they under the statute of limitations.

The Court dismissed the case. George won. The IRS got embarrassed.

I am curious why the IRS even bothered. The only thing I can figure is that they were hoping for a miracle play. Maybe like John Riggins running that football for a touchdown in Super Bowl XVII with George Starke blocking for him.