A Tax Preparer As A Witness

It is – once again – that time of year. Extensions. The business extensions came due last month. The individual extensions are due this month.

What a crazy thing to do for a living.

I have not had a lot of time to scan my normal sources, but I did see a case that caught my eye.

The taxpayers live in Illinois. They have an S corporation.

They rent a pole-barn garage to the S corporation. The corporation stores tractors, trailers and other equipment there.

Pretty normal.

They used a tax preparer for their 2012 and 2013 individual returns.

On their rental schedule, they deducted (among other expenses) the following:

·      Interest of $5,846 for 2012 and $4,336 for 2013

·      Taxes of $7,058 for 2012 and $10,395 for 2013

They also deducted the personal portion of their interest and taxes as itemized deductions.

I was anticipating that they double-counted the interest and taxes.

Nope.

They never could document the 2012 real estate taxes on their rental schedule.

Seriously?

Then we have 2013. The Court agreed that the taxes were paid, but they were paid by the S corporation.

Folks, to claim the taxes on a personal return one has to pay the taxes personally.

There went the rental real estate tax deduction for both years.

Onward to the 2012 mortgage interest.

Same answer as the 2013 real estate taxes.

Yeeessh.

The Court was a little more lenient in 2013, sort of. While they disallowed any interest on the rental schedule, the Court did allow substantiated mortgage interest in excess of claimed interest as an itemized deduction.

The IRS next went in to bayonet the wounded and dead: it wanted a 20% accuracy-related penalty.

Of course they did.

A common defense to this penalty is reliance on a tax professional.

Taxpayers used a tax preparer for 2013 and 2013.

Seems to me they have a potential defense.

The Court then drops this:

Although their returns were prepared by a paid income tax preparer, the return preparer used income and expense amounts petitioner provided. Apparently, no source documents underlying the deductions were provided to the return preparer; according to the return preparer, petitioners had ‘horrible books and records.’”

And this is a witness for the taxpayers?

Because petitioners did not furnish the return preparer with complete and accurate information, they failed to establish that their reliance upon the return preparer constitutes ‘reasonable cause’ and ‘good faith’ with respect to the underpayments of tax.”

Wow.

I get it. The preparer might have gotten them out of a penalty on a technical issue, but given the poor quality of the records the preparer could not get them out of a penalty for the numbers themselves.

The taxpayers probably would have done better by not bringing their preparer to testify.

And then I noticed: it was a “pro se” case.

Which means that the taxpayers represented themselves.

COMMENT: Pro se does not mean that your preparer is not there. I for example can appear before the Tax Court as part of a pro se. I would then be there as a witness, and I would not considered to be “practicing.”

In this case the taxpayers made a bad call by bringing in their preparer.

The case for the home gamers is Lawson v Commissioner.

Penalties And Reliance On A Tax Professional

I am working a penalty appeal case. The owner was fortunate: the business survived. There was a time when his fate was uncertain.

The IRS is being … difficult. The IRS considers “reasonable cause” when considering whether to mitigate or abate many penalties. The idea is simple enough: would a “reasonable” person have acted the same way, knowing his/her responsibility under the tax law?

That is a surprisingly high standard, considering that there are professionals who spend a career mastering the tax law. There is stuff in there that no reasonable person would suspect. I know. I make a living at it.

Back to my appeal case: take an overworked and overstressed business owner. He is facing the more-than-unlikely possibility of bankruptcy. It is the end of the year and his accountant mails him W-2s for distribution to employees. He does so and puts the envelope on a stack of paperwork. He forgets to send the employer copies to the IRS. Granted, this is not as likely to happen today with electronic filing, but it did happen and not so many years ago.

The IRS nails him. Mind you, he distributed the W-2s to the employees. He filed all the quarterly reports, he made all the tax deposits. He had a bad day, a messy office and forgot to put a piece of paper in the mail.

Do you think he has reasonable cause – at least to reduce the penalties - considering all the other factors in his favor?  I think so. The IRS thinks otherwise.

Here is another one: you hire me to prepare an estate return. These things are rare enough. First of all, someone has to die. Second, someone has to have enough assets to be required to file. I tell you that the return is due next March. It turns out I am wrong, and the return is actually due in February.

The IRS sends a you a zillion-dollar penalty notice for filing the estate return late.

Do you have reasonable cause?

You might think this is relatively straightforward, but you would be wrong.

Let’s go through it:

(Q) Did you hire a professional?

(A) Yes

(Q) Was the professional qualified?

(A) I presume so. He/she had initials after their name.

(Q) Did you disclose all facts to the professional?

(A) I think so. Someone died. I presume the professional would prompt and question me on matters I would not know or have thought of.

(Q) Did you rely on the professional for matters of tax law?

(A) Uh, yes. Do you know what these accountants charge?

(Q) I mean, as opposed to something you can look up yourself.

(A) What do you mean?

That last one is alluding to a “ministerial” act. Think signing a return, putting a stamp on the envelope and dropping it in the mailbox. All the hard lifting is done, and it is time to break down and throw away the moving boxes.

Sounds easy enough.

Until someone pulls the rug out from underneath you by changing the meaning of “ministerial.”

That someone was the Supreme Court in Boyle, when it decided that a taxpayer’s reliance on a tax professional for an estate return’s due date was not enough. The taxpayer knew that a return was required. The taxpayer could not “delegate” the responsibility for timely filing by …. accepting the tax professional’s advice on when the return was due.

If that sentence makes no sense, it is because Boyle makes no sense outside the fantasy world of a tax zealot.

If you go to see a dentist, are you required to study-up on dental compounds, as the decision to use silver rather than composite could be deemed “ministerial?”

The IRS, sniffing an opportunity to ram even more penalties down your throat, has taken Boyle and characterized it to mean that reliance on a tax professional can never rise to reasonable cause.

As a tax professional, I take offense at that.

The IRS gets occasionally stopped in its tracks, fortunately, but not often enough.

I practice. I am only too aware that “it” happens. It is not a matter of being irresponsible or lacking diligence or other snarky phrases. It is a matter that one person – or a very small group of people – is multitasking as management, labor, owner, analyst, financier, ombudsman and so on. Perhaps you are a business owner thinking that you waited too long on replacing that employee who left…  did you call the insurance agent about the new business vehicle … you have to find time to talk to the banker about increasing your credit line… hey, did you see something from the accountant in the mail?

Yes, I get frustrated with the IRS and its unrealistic “reasonable” standard. Reasonable should be real-world based and not require pilgrimage to a Platonic ideal. Life is not a movie. “It” happens, even in an accounting firm. Yes, accountants make mistakes too.

Rounding back, though, there is one thing you must show if you are arguing that you relied on a tax professional.

I am reading the recent Keenan case. This thing has to do with Section 419 plans, which are employee welfare plans that were unfortunately abused by charlatans. The abuse is simple enough. Set up a welfare plan, preferably just for you. Stuff the thing to the gills with life insurance. Deduct everything for a few years. Then close the plan, buy the insurance for a pittance and meet with a financial planner about retirement.

The IRS got cranky – understandably - and starting looking at these things as tax shelters.

Which means outsized penalties.

So Keenan was in a penalty situation. He points at the accountant and says “Hey, I relied on you to keep me out of trouble.”

Problem: the taxpayer did whatever the taxpayer was going to so. There was sweet money at the end of that rainbow. Accountant? Please.

Not that the accountant was without fault. He should have researched these things harder. If he then had reservations, he should have either insisted on the correct tax reporting or have fired Keenan as a client.

The correct reporting is not hard. You can take the deduction, but you have to flag it for the IRS. The IRS can then pursue or not, but you met your responsibility. I have done so myself when a partner has brought in a hyper-aggressive client. By doing so I am protecting both my license and the client from those outsized penalties.

That was not going to happen with Keenan.

Keenan lost the case for the most obvious reason: to argue reliance on a professional you have to actually rely on a professional.

When The IRS Does Not Believe You Filed An Extension

I have a certain amount of concern whenever we approach a major due date. Let’s use your personal tax return as an example. It is due on April 15; an extension stretches that out to October 15. 

What is the big deal?

Penalties. Fail to extend the return, for example.

How does this happen?

A client moves to another city. A client was unhappy with your fees last year, and you are uncertain if the client is staying with you. A client’s kid starts working, prompting a tax return for the first time. A client gets involved with some business, and the first time you hear about it is when his/her information comes in. A client does business in a new state.

Or – let’s be frank here – you just miss it.

There are two common penalties; think of them as the salt and pepper of penalties:

·      Failure to file

·      Failure to pay

We associate the IRS with taking our money, so one would easily assume that the more onerous penalty is failure to pay. It is not. Owe money past April 15 and the IRS will charge a penalty of ½% per month.

Fail to file, however, and the penalty is 5% per month.

Yep, 10 times as much.

And when does the penalty start?

Miss that extension and it starts April 16.

Huh? Don’t you have until October 15 to file that thing?

Yes, IF you file an extension.

You do not want to miss that extension.

I was reading a case about the Laidlaw brothers. They sold Harley Davidson motorcycles, and they got pulled into Court for a welfare benefit plan that went awry.

There was one issue left: did their accountant file extensions for the two brothers by April 15? If not, those penalties included 5 zeroes. We are talking enough-to-buy-a-house money.

To add to the stress, the trial occurred about a decade after the tax year in question.

The accountant’s name was Morgan, and he presented extensions showing zero tax due for each brother. The IRS said it never received any extensions. Morgan did not send the extensions certified mail, but he recalled sending both extensions in the same envelope. He remembered taking the envelope to the post office and checking for proper postage. He took pride that the Post Office had never returned an extension request for insufficient postage.

He pointed out that there was no question about an extension for the year before, and the year before that, and so forth. The brothers were significant clients to his firm, and he went the extra mile.

The IRS was having none of it. They pointed out that Morgan had many clients, and the likelihood that he could remember something that specific from a decade ago was dubious. Additionally, any memory was suspect as self-serving.

Sounds like Morgan needed to present well in front of the Court.

And there is the rub. The Laidlaw case went Rule 122, meaning that depositions were submitted to the Court, but there was no opportunity for face-to-face questioning.

Here is the Court:

… we had no opportunity to observe Mr. Morgan’s credibility as a witness. The reliability of a witness’ testimony hinges on his credibility. We were not provided a full opportunity – so critical to our being able to find the witness reliable – to evaluate Mr. Morgan’s credibility on the issue of timely filing because petitioners never offered his live testimony in a trial setting. While we can learn much from reading the testimony, it is not the same as a firsthand observation of the witness’ demeanor and sincerity, both essential aspects of credibility and reliability.

The brothers lost, and the IRS collected a sizeable penalty amount.

Back in the day, we used to log all extensions going to the IRS. We would certify each envelope and then attach the receipt to a log detailing each envelope’s contents. Granted, that log could not prove that a given envelope contained a given extension, but it did show our attention to policies and procedures. I recall getting out of at least one sizeable penalty by arguing that point to the IRS.

Those were different times, and many (including me) would say that today’s IRS is less forgiving of basic human error

And, to some extent, we are talking ancient history with extension procedure. Today’s practices, our included, has moved to electronic filing. Our software tracks and records our extensions and returns and their receipt by the IRS. I do not need to keep a mail log as my software does it for me.

Morgan needed something like a log. It would have given the Court confidence in and support for his recollection of acts occurring a decade earlier, even without him being present to testify in person.

What Does It Take To Get Reasonable Cause Around Here?

My partner has a difficult IRS penalty issue.

He expects a client to be penalized for more than one year. This complicates how we handle the first year.

The IRS has reorganized its penalty review function to a system called the Reasonable Cause Assistant (RCA). There however is a problem: the system does not work well. The Treasury Inspector General for Tax Administration (TIGTA) reported that RCA was inaccurate 89% of the time in 2012.

Step away from RCA and you still have the following:

 * It used to be that penalties were assessed as a means to encourage voluntary compliance. Many tax pros feel that is no longer the case, and penalties are being used as a means to raise revenue.  An example is the penalty assessed for late filing of a partnership return: $195 per month per partner. Take a 10-person partnership, file a week late and face a $1,950 penalty. There is little consideration for the size of the partnership, its total assets or revenues - or the fact that partnerships do not pay federal taxes.            

* Penalties are assessed even when taxpayers are trying to do the right thing. For example, enter into a reportable transaction, disclose it on your tax return but forget to file a copy with a second office and you will be assessed a penalty. Fail to disclose the transaction at all and you will be subject to the same penalty.

 * The IRS is automatically asserting penalties. For example, for fiscal year 2015, the IRS assessed over 40 million penalties on individuals and businesses. To put that in context, there were approximately 243 million returns filed for the period.

* Many penalties can be waived if the taxpayer can show "reasonable cause," but many tax professionals believe the IRS has so narrowed the definition as to be almost unreachable, unless you are willing to die. To aggravate the matter, the IRS has also instructed its personnel to substitute "first time abatement" (FTA) for reasonable cause as a matter of policy. While the IRS argues that FTA is easier to review and administer than reasonable cause, there exists a high degree of skepticism. Why would a taxpayer automatically burn a "get out of penalty-jail free" card if the taxpayer otherwise has reasonable cause? Wouldn't a taxpayer want to keep that card available just in case?

My partner - by the way - has that last situation: burning his FTA chip without a reasonable-cause backup for the second year. Ironically, he may have reasonable cause for the first year, but that sequence does not follow IRS policy. I anticipate going to Appeals to obtain reasonable cause and preserve the FTA for the second year.

Let's talk about the Carolyn Rogers (Rogers v Commissioner) case.

Carolyn lived in New York. In 2006 she had a small business (Talk of the Town Singles) which she operated from her cooperative. In 2006 there was a fire which rendered the place uninhabitable.

She moved. In 2007 there was another fire, one she appears to have caused herself. The local newspaper called her out, and she was thereafter harassed by people in her neighborhood.

She moved to the YWCA until 2010. She did not have a pleasant time there, and in 2009 she fell off a subway platform and fractured her skull on the rails. She was in the hospital for days, and she continued to suffer from dizzy spells thereafter.

Prior to this period, she had a record of filing timely returns. She also made significant efforts to correctly prepare her tax returns, consulting books and references and more than once contacting the IRS. She did not use a paid preparer.

The IRS penalized her for not filing a 2009 return.

She explained that the insurance company settled the second fire in 2009, and she lost a bundle. According to her research, the casualty loss would wipe out her income, and she was therefore below the filing threshold. She did not need to file.

The IRS then trotted technical guidance on a casualty loss. While the layperson might think that the loss would be deferred until the insurance is settled, the tax Code uses a different test:

* If an insurance claim is not paid in the year of casualty AND there is a reasonable prospect of recovery, then the loss is deferred until one can determine the amount of recovery.

* If there is no hope for insurance - or the prospect of recovery is unreasonable - then the loss is deductible in the year of the casualty.

 The IRS said that she came under the second rule. She knew that insurance would not cover the full loss from the 2007 fire. The loss was therefore deductible in 2007.

COMMENT: There is enough "what if" to this rule that even a tax professional could blow it.

The IRS wanted penalties for not filing that 2009 return.  

The Tax Court reviewed her filing history and her chaotic life. It noted:

Petitioner's error (regarding the proper year of deduction of the portion of a casualty loss for which there is no reasonable prospect of recovery from insurance) is considerably different from the errors made by a taxpayer whose failure to file, late filing, or late payment is chronic. Erroneously deducting a loss in a year later than the correct year is not usually considered to be a blatant tax avoidance technique ..."

Ouch. The Court did not appreciate the IRS wasting its time.

Taking into account all of the facts and circumstances, we conclude that petitioner exercised ordinary business care and prudence under the difficult circumstances in which she was living at the time leading up to the due date of her 2009 return...."

The Court found reasonable cause. She owed the tax, but she did not owe the penalties.

The IRS should have found reasonable cause too. It is troubling that it didn't.

A Baseball Player Gets Hit By A Penalty

I have a question for you: let’s say you are a professional athlete. You have hired a financial advisor and an accountant. You give the financial advisor a durable power of attorney, allowing him/her to pay your bills, manage your money and grow your investments. You ask your accountant to prepare tax returns as necessary keep you out of trouble.

These services are not cheap. They cost you an upfront fee of $150,000 and an ongoing $360,000 annually.

            COMMENT: I am available and open to relocation.

You get robbed for millions of dollars. Tax returns do not get filed.

The IRS now wants big penalties from you.

QUESTION: Do you have “reasonable cause” to have the IRS remove those penalties?

We are talking about Mo Vaughn, who played baseball with the Red Sox, the Anaheim Angels and the New York Mets in the nineties and aughts.  He was the American League MVP in 1995.

In 2004 he hired Ra Shonda Kay Marshall to handle his money matters. She wound up leaving her employer, Omni Elite, and set up her own company, RKM Business Services, Inc. He also hired David Krebs with CPA Advisory Group, Inc. for the preparation of his tax returns.

Something happened, and in 2008 he fired both of them. Vaughn was going through his bank statements when he realized that Marshall had been embezzling. He hired forensic accountants, who determined that from 2004 to 2008 she had embezzled more than $2.7 million.

He then learned that his 2006 taxes were not paid.

Even that was better news than 2007, when his taxes were not even filed, much less paid.

He sued Marshall and RKM Business Services.

He hired new CPAs to get him caught up. The IRS – in that show of neighborliness that we have come to expect – hit him with penalties of $1,037,158 for 2006 and $102,106 for 2007. He had filed and/or paid late, and there were penalties for both.

He owed the tax, of course, but he had to contest the penalties. He went the administrative route – meaning appealing and working within the IRS itself. Striking out, he then took his case to court. He went to district court and then to appeals.

His main argument was simple: he was paying people to keep him out of tax problems. There was a lot of money leaving his account, so he had every reason to believe that a good chunk of it was going to the IRS. He was robbed. The IRS was robbed. Surely robbery is reasonable cause.

The IRS and the court pretty much knew his story at this point, and they knew that he was suing to get his millions back. The court however decided the government was due its money. There was no reasonable cause.

How is this possible?

There is a tax case (Boyle) where the Supreme Court addressed the issue of penalties assessed a taxpayer for his/her agent’s failure to file and pay taxes. The Court stated:

“It requires no special training or effort to ascertain a deadline and make sure that it is met. The failure to make a timely filing of a tax return is not excused by the taxpayer’s reliance on an agent, and such reliance is not ‘reasonable cause’ for a late filing under [Section] 6651(a)(1).”

The Court was addressing deadlines, and it set a fairly high standard. The Court distinguished relying on an attorney or accountant for advice from relying on an attorney or accountant to actually file the return itself. Reliance on an agent did not relieve the principal of compliance with statutory deadlines, except in extremely limited circumstances.

Vaughn could not clear this standard. He had delegated too much when he turned over responsibility for both preparing and filing his taxes to Marshall and Krebs.

Vaughn had a backup argument: the malfeasance of his agents rendered him unable to pay. He did not have enough money left to pay taxes by the time Marshall was done with him.

He was referring to a tax case (American Biomaterials Corp) where two corporate officers defrauded their corporation, including failing to file and pay taxes. Those two were the only officers with the responsibility to file returns and make payment. The Court held that the corporation was not vicariously liable for the acts of its officers and therefore was not liable for penalties.

There is a limit on American Biomaterials, though: a corporation is not entitled to relief if – by act or omission – its internal controls are so lax that that there was no reasonable expectation that malfeasance would be detected in the ordinary course of business. In other words, the corporation cannot willfully neglect normal checks and balances and expect to be relieved of penalties.

Vaughn got smacked on his second argument. The Court noted the obvious: in American Biomaterials there was no one left in the company to file and pay the taxes. This was not Vaughn’s situation. While he had delegated responsibility, there was someone left who could and should have stepped in: Mo Vaughn himself. He did not. That was his decision and provided both reason and cause to impose penalties.

And so Vaughn lost both in the district and the appeals courts. He owed the IRS enough penalties to allow either you or me to retire. He lost because he delegated the one thing the tax Code does not allow one to delegate, except in the most extreme cases: the duty to file the return itself.

Helping Out A Family Member’s Business

Let’s say that you have a profitable business. You have a family member who has an unprofitable business. You want to help out the family member. You meet with your tax advisor to determine if there is tax angle to consider.

Here is your quiz question and it will account for 100% of your grade:

What should you to maximize the chances of a tax deduction?

Let’s discuss Espaillat and Lizardo v Commissioner.

Mr. Jose Espaillat was married to Ms. Mirian Lizardo. Jose owned a successful landscaping business in Phoenix for a number of years. In 2006 his brother (Leoncio Espaillat) opened a scrap metal business (Rocky Scrap Metal) in Texas. Rocky Scrap organized as a corporation with the Texas secretary of state and filed federal corporate tax returns for 2008 and 2009.

Being a good brother, Jose traveled regularly to help out Leoncio with the business. Regular travel reached the point where Jose purchased a home in Texas, as he was spending so much time there.

Rocky Scrap needed a big loan. The bank wanted to charge big interest, so Jose stepped in. He lent money; he also made direct purchases on behalf of Rocky Scrap. In 2007 and 2008 he contributed at least $285,000 to Rocky Scrap. Jose did not charge interest; he just wanted to be paid back.

Jose and Mirian met with their accountant to prepare their 2008 individual income tax return. Jose’s landscaping business was a Schedule C proprietorship/sole member LLC, and their accountant recommended they claim the Rocky Scrap monies on a second Schedule C. They would report Rocky Scrap the same way as they reported the landscaping business, which answer made sense to Jose and Mirian. Inexplicably, the $285,000 somehow became $359,000 when it got on their tax return.

In 2009 Rocky Scrap filed for bankruptcy. I doubt you would be surprised if I told you that Jose paid for the attorney. At least the bankruptcy listed Jose as a creditor.

In 2010 Jose entered into a stock purchase agreement with Leoncio. He was to receive 50% of the Rocky Scrap stock in exchange for the aforementioned $285,000 – plus another $50,000 Jose was to put in.

In 2011 Jose received $6,000 under the bankruptcy plan. It appears that the business did not improve all that much.

In 2011 Miriam and their son (Eduan) moved to Texas to work and help at Rocky Scrap. Jose stayed behind in Phoenix taking care of the landscaping business.

Then the family relationship deteriorated. In 2013 a judge entered a temporary restraining order prohibiting Jose, Miriam and Eduan from managing or otherwise directing the business operations of Rocky Scrap.  

Jose, Miriam and Eduan walked away. I presume they sold the Texas house, as they did not need it anymore.

The IRS looked at Jose and Mirian’s 2008 and 2009 individual tax returns.  There were several issues with the landscaping business and with their itemized deductions, but the big issue was the $359,000 Schedule C loss.

The IRS disallowed the whole thing.

On to Tax Court they went. Jose and Mirian’s petition asserted that they were involved in a business called “Second Hand Metal” and that the loss was $285,000. What happened to the earlier number of $359,000? Who knows.

What was the IRS’ argument?

Easy: there was no trade or business to put on a Schedule C. There was a corporation organized in Texas, and its name was Rocky Scrap Metals. It filed its own tax return.  The loss belonged to it. Jose and Mirian may have loaned it money, they may have worked there, they may have provided consulting expertise, but at no time were Jose and Mirian the same thing as Rocky Scrap Metal.

Jose and Mirian countered that they intended all along to be owners of Rocky Scrap. In fact, they thought that they were. They would not have bought a house in Texas otherwise. At a minimum, they were in partnership or joint venture with Rocky Scrap if they were not in fact owners of Rocky Scrap.

Unfortunately thinking and wanting are not the same as having and doing. It did not help that Leoncio represented himself as the sole owner when filing the federal corporate tax returns or the bankruptcy paperwork. The Court pointed out the obvious: they were not shareholders in 2008 and 2009. In fact, they were never shareholders.

OBSERVATION: Also keep in mind that Rocky Scrap filed its own corporate tax returns. That meant that it was a “C” corporation, and Jose and Mirian would not have been entitled to a share of its loss in any event. What Jose and Mirian may have hoped for was an “S” corporation, where the company passes-through its income or loss to its shareholders, who in turn report said income or loss on their individual tax return. 

 

The Court had two more options to consider.

First, perhaps Jose made a capital investment. If that investment had become worthless, then perhaps … 

Problem is that Rocky Scrap continued on. In fact, in 2013 it obtained a restraining order against Jose, Miriam and Eduan, so it must have still been in existence.  Granted, it filed for bankruptcy in 2009. While bankruptcy is a factor in evaluating worthlessness, it is not the only factor and it was offset by Rocky Metal continuing in business.  If Rocky Scrap became worthless, it did not happen in 2009.

Second, what if Jose made a loan that went uncollectible?

The Court went through the same reasoning as above, with the same conclusion.

OBSERVATION: In both cases, Jose would have netted only a $3,000 per year capital loss. This would have been small solace against the $285,000 the IRS disallowed.

The Court decided there was no $285,000 loss.

Then the IRS – as is its recent unattractive wont – wanted a $12,000 penalty on top of the $60-plus-thousand-dollar tax adjustment it just won. Obviously if the IRS can find a different answer in 74,000+ pages of tax Code, one must be a tax scofflaw and deserving of whatever fine the IRS deems appropriate.

The Court decided the IRS had gone too far on the penalty.

Here is the Court:

He [Jose] is familiar with running a business and keeping records but has a limited knowledge of the tax code. In sum, Mr. Espaillat is an experienced small business owner but not a sophisticated taxpayer.”

Jose and Mirian relied on their tax advisor, which is an allowable defense to the accuracy-related penalty. Granted, the tax advisor got it wrong, but that is not the same as Jose and Mirian getting it wrong. The point of seeing a dentist is not doing the dentistry yourself.

What should the tax advisor done way back when, when meeting with Jose and Mirian to prepare their 2008 tax return?

First, he should have known the long-standing doctrine that a taxpayer devoting time and energy to the affairs of a corporation is not engaged in his own trade or business. The taxpayer is an employee and is furthering the business of the corporation.

Granted Jose and Mirian put-in $285,000, but any tax advantage from a loan was extremely limited – unless they had massive unrealized capital gains somewhere. Otherwise that capital loss was releasing a tax deduction at the rate of $3,000 per year. One should live so long.

The advisor should have alerted them that they needed to be owners. Retroactively. They also needed Rocky Scrap to be an S corporation.  Retroactively. It would also have been money well-spent to have an attorney draw up corporate minutes and update any necessary paperwork.

That is also the answer to our quiz question: to maximize your chance of a tax deduction you and the business should become one-and-the-same. This means a passthrough entity: a proprietorship, a partnership, an LLC or an S corporation. You do not want that business filing its own tax return.  The best you could do then is have a worthless investment or uncollectible loan, with very limited tax benefits.