The Old Three And Two

 

You will recognize the issue.

During 2017 Mary deNourie worked at a retail store. She had wages of $11,516 and social security of $7,559. She and her husband did not file an income tax return because the withholding was enough to cover any tax due.

In 2021 the IRS contacted them about not filing a 2017 tax return. The IRS was preparing a substitute for return showing the wages and social security as well as partnership income of $25,065. When you throw the partnership into the mix, they now owed tax of $4,192, plus interest and penalties.

What partnership income, they exclaimed? The partnership had not paid them anything.

COMMENT: That is not the way partnerships are taxed. For example, a 10% partner will generally be taxable on 10% of the partnership’s taxable income. This amount is reported to a partner on Schedule K-1, a copy of which goes to the IRS. Whether the partner has received cash to go with that K-1 does not matter to the IRS. That is a matter for the partner to take up with the partnership.

I then see a court order in April 2023 releasing the husband from the matter.

That is unusual. What happened?

The IRS had not sent out a Notice of Deficiency – the 90-day letter – to the husband. This is a no-no. The IRS also has rules and procedures, and each spouse (on a joint return) must receive his or her own Notice of Deficiency. Mary received hers. He did not.

Now Mary was on her own.

Coincidentally, the partnership income went away.

COMMENT: It appears the husband owned the partnership.

We are back to Mary’s W-2 and social security.

Mary and the IRS worked on an agreement. There was no tax due for 2017. In fact, there was an overpayment of $284.

Mary wanted the $284.

Can’t blame her.

The IRS said no.

Mary in response refused to sign the agreement.

In March 2024 Mary filed a tax return for 2017. She wanted her refund.

What do you think: will Mary receive that refund?

Here is the relevant law:

Sec. 6511 Limitations on credit or refund

Period of limitation on filing claim. Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid. Claim for credit or refund of an overpayment of any tax imposed by this title which is required to be paid by means of a stamp shall be filed by the taxpayer within 3 years from the time the tax was paid.

Right or wrong, there is a limit on how long you can wait to file for a refund. If you file a return, for example, you have three years to amend for a refund.

There is a riff on the above rule if you file now and pay later. The Code will then permit a refund until 2 years after the tax is paid if that date is after the three-year date.

Notice what this three-and-two have in common:

          You filed a return.

If you do not file a return, the rule gets grimmer:

          You have until 2 years after the tax was paid.

If you file, you start with three and might move to two – and only if two allows for more time.

Don’t file and you have two – period. You have no choice.

Let’s see what Mary did:

·       Mary’s 2017 tax return was due April 15, 2018.

·       She did not file, so the mandatory two-year rule applies.

·       There is still hope, though. If she files within three years – by April 15, 2021 – she can flip the mandatory two back to the normal three-and-two.

o   She filed 2017 in March 2024.

Nope. Too late all around.

Mary had no tax due for 2017, but she likewise had no refund for 2017.

My thought? If you have withholding, consider filing even if there is no tax due. Why? Because withholding represents tax paid, and not filing triggers the mandatory two-year rule. By filing you move to the three-and-two rule. It may save you; it may not, but it provides more breathing room than the alternative.

Today we discussed Mary deNourie v Commissioner, U.S. Tax Court, docket 18182-22.

An IRS Employee And Unreported Income

 

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

Many, I suspect, will be caught by surprise.

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

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

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

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

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

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

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

It started as a criminal tax investigation.

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

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

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

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

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

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

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

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

Orellana walked out of the meeting with the agent.

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

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

Off they went to Tax Court.

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

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

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

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

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

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

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

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

Alright then.

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

Orellana submitted records of purchases from PayPal.

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

She used a PayPal debit card.

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

How about receipts?

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

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

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

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

Frankly, so would I.

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

Good grief.

The IRS also asked for an accuracy penalty.

The Court agreed.

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

Firing A Client

We fired a client.

Nice enough fellow, but he would not listen. To us, to the IRS, to getting out of harm’s way.

He brought us an examination that started with the following:

We filed in Tax Court. I was optimistic that we could resolve the matter when the file returned to Appeals. There was Thanos-level dumb there, but there was no intentional underreporting or anything like that.

It may have been one of the most demanding audits of my career. The demanding part was the client.

Folks, staring down a $700 grand-plus assessment from the IRS is not the time to rage against the machine.  An audit requires documentation: of receipts, of expenses. Yes, it is bothersome (if not embarrassing) to contact a supplier for their paperwork on your purchases in a prior year. Consider it an incentive to improve your recordkeeping.

At one point we drew a very harsh rebuke from the Appeals Officer over difficulties in providing documentation and adhering to schedules. This behavior, especially if repetitive, could be seen as the bob and weave of a tax protester, and the practitioner involved could also be seen as enabling said protestor.

As said practitioner I was not amused.

We offered to provide a cash roll to the AO. There was oddball cash movement between the client and a related family company, and one did not need a psychology degree to read  that the AO was uncomfortable. The roll would show that all numbers had been included on the return. I wanted the client to do the heavy lifting here, especially since he knew the transactions and I did not. There were a lot of transactions, and I had a remaining book of clients requiring attention. We needed to soothe the AO somehow.

He did not take my request well at all.

I in turn did not take his response well.

Voices may have been raised.

Wouldn’t you know that the roll showed that the client had missed several expenses?

Eventually we settled with the IRS for about 4 percent of the above total. I knew he would have to pay something, even if only interest and penalties on taxes he had paid late. 

And that deal was threatened near the very end.

IRS counsel did not care for the condition of taxpayer’s signature on a signoff. I get it: at one point there was live ink, but that did not survive the copy/scan/PDF cycle all too well. Counsel wanted a fresh signature, meaning the AO wanted it and then I wanted it too.

Taxpayer was on a cruise.

I left a message: “Call me immediately upon return. There is a wobble with the IRS audit. It is easily resolved, but we have time pressure.”

He returned. He did not call immediately. Meanwhile the attorneys are calling the AO. The AO is calling me. She could tell that I was beyond annoyed with him, which noticeably changed her tone and interaction. We were both suffering by this point.

The client finally surfaced, complaining about having to stop everything when the IRS popped up.

Not so. The IRS reduced its preliminary assessment by 96%. We probably could have cut that remaining 4% in half had we done a better job responding and providing information. Some of that 4% was stupid tax.”

And second, you did not stop everything. You had been in town a week before calling me.”

We had a frank conversation about upping his accounting game. I understand that he does not make money doing accounting. I am not interested in repeating that audit. Perhaps  we could use a public bookkeeper. Perhaps we could use our accountants. Perhaps he (or someone working for him) could keep a bare-boned QuickBooks and our accountants would review and scrub it two or three times a year.

Would not listen.

We fired a client.

Filing A Zero-Income Tax Return

Here’s a question:

Would you file a tax return if you have no income – or minimal income - to report?

I would if there was a refund.

I also lean to filing if one has a history of tax filings.

The former is obvious, unless the incremental cost of filing the return is more than the refund.

The latter is because of my skepticism. I do not want a letter from the IRS stating they have not received a tax return for name-a-year. Granted, the issue should be easily resolved, but I have lost track of how many should-be’s have turned out to not-be.

Another reason is a rerun of Congress’ decision to automatically send advance payments back in 2021 – specifically, the child tax credit.       

You were ahead of the game by having filed a prior year return.

Ruben Varela filed a 1040EZ for 2017. It showed a refund of $1,373.

OK.

Ruben attached four Forms 4852 Substitute for Form W-2.

This form is used when an employer fails to send a W-2, among other situations. It happens and I see one every few years. But four …? That is odd.

The 4852’s that Ruben prepared showed zero wages.

And the $1,373 included Social Security and Medicare taxes., taxes which are not refundable.

Ruben, stop that yesterday. This is common tax protestor nonsense.

Let’s read on. There was third party reporting (think computer matching) for wages of $11,311 and cancellation of indebtedness income of $1,436.

Not surprisingly, the IRS considered it a protest filing and assessed a Section 6702(a) penalty.

§ 6702 Frivolous tax submissions.

(a)  Civil penalty for frivolous tax returns.

A person shall pay a penalty of $5,000 if-

(1)  such person files what purports to be a return of a tax imposed by this title but which-

(A)  does not contain information on which the substantial correctness of the self-assessment may be judged, or

(B)  contains information that on its face indicates that the self-assessment is substantially incorrect, and

(2)  the conduct referred to in paragraph (1) -

(A)  is based on a position which the Secretary has identified as frivolous under subsection (c) , or

(B)  reflects a desire to delay or impede the administration of Federal tax laws. 

That caught Ruben’s attention, and he disputed the penalty. On to Tax Court they went.

How can I owe a penalty if there was NO TAX, argued Ruben.

On first impression, it seems a reasonable argument.

But this is tax. Let’s look at that Code section again. 

              Such person files ….                                                      OK

              What purports to be a tax return …                                OK

      Does not contain information on

   which the substantial correctness …                             ?

 

Let’s talk about this last one. The Tax Court has a history of characterizing “zero” W-2s as both substantially incorrect and not containing sufficient information allowing one to judge the self-assessment of tax.

We have a third “OK.”

Back to Section 6702.

Is there any reference in Section 6702 to whether the return did or did not show tax due?

I am not seeing it.

The Court did not see it either.

They upheld the Section 6702 penalty.

The IRS wanted more, of course. They also wanted the Section 6673 penalty.

§ 6673 Sanctions and costs awarded by court

This penalty can be imposed when somebody clogs the Court in order to impede tax administration. The penalty can be harsh.

How harsh?

Up to $25 grand of fresh-brewed harsh.

The Court noted they had not seen Ruben Varela before nor was it aware of him previously pursuing similar arguments. They declined to impose the Section 6673 penalty, but …

We caution petitioner that a penalty may be imposed in future cases before this Court should he continue to pursue these misguided positions.”

The Court was warning him in the strongest legalese it could muster.

Our case this time was Ruben Varela v Commissioner, T.C. Memo 2024-92.

 

A Real Estate Course – And Dave

 

The case made me think of Dave, a friend from long ago – one of those relationships that sometimes surrenders to time, moving and distance.

Dave was going to become a real investor.

That was not his day job, of course. By day he was a sales rep for a medical technology company. And he was good at sales. He almost persuaded me to join his incipient real estate empire.

He had come across one of those real estate gurus – I cannot remember which one – who lectured about making money with other people’s money.

There was even a  3-ring binder or two which Dave gave me to read.

I was looking over a recent case decided by the Tax Court.

The case involved an engineer (Eason) and a nurse (Leisner).

At the start of 2016 they owned two residential properties. One was held for rent; the other was sold during 2016.

COMMENT: Seems to me they were already in the real estate business. It was not a primary gig, but it was a gig.

Eason lost his job during 2016.

A real estate course came to his attention, and he signed up – for the tidy amount of $41,934.

COMMENT: Say what?

In July 2016 the two formed Ashley & Makai Homes (Homes), an S corporation. Homes was formed to provide advice and guidance to real estate owners and investors.  They had business cards and stationary made and started attending some of those $40 grand-plus courses. Not too many, though, as the outfit that sponsored the courses went out of business.

COMMENT: This is my shocked face.

By 2018 Eason and Leisner abandoned whatever hopes they had for Homes. They never made a dime of income.

You know that $40 grand-plus showed up on the S corporation tax return.

The IRS disallowed the deduction.

And tacked on penalties for the affront.

This is the way, said the IRS.

And so we have a pro se case in the Tax Court.

Respondent advances various reasons why petitioners are not entitled to any deductions …”

The respondent will almost always be the IRS in these cases, as the it is the taxpayer who petitions the Court.

And we have discussed “pro se” many times. It generally means that a taxpayer is representing himself/herself, but that is not fully accurate. A taxpayer can be advised by a professional, but if that professional has not taken and passed the exam to practice before the Tax Court the matter is still considered pro se.

Back to the Court:

          … we need to focus on only one [reason].”

That reason is whether a business had started.

Neither Homes nor petitioners reported any income from a business activity related to the disputed deductions, presumably because none was earned.”

This is not necessarily fatal, though.

The absence of income, in and of itself, does not compel a finding that a business has not yet started if other activities show that it has.”

This seems a reasonably low bar to me: take steps to market the business, whatever those words mean in context. If the context is to acquire clients, then perhaps a website or targeted advertising in the local real estate association newsletter.

Here, however, the absence of income coupled with the absence of any activity that shows that services were offered or provided to clients or customers […] supports respondent’s position that the business had not yet started by the close of the year.”

Yeah, no. The Court noted that a business deduction requires a business. Since a business had not started, no business deduction was available.

The Court disagreed with any penalties, though. There was enough there that a reasonable person could have decided either way.

I agree with the Court, but I also think that just a slight change could have changed the outcome in the taxpayers’ favor.

How?

Here’s one:  remember that Eason and Leisner owned a rental property together?

What if they had broadened Homes’ principal activity to include real estate rental and transferred the property to the S corporation? Homes would have been in business at that point. The tax issue then would have been expansion of the business, not the start of one.

Our case this time was Eason and Leisner v Commissioner, T.C. Summary Opinion 2024-17.

An Erroneous Tax Refund Check In The Mail

 

Let’s start with the Code section:

§ 6532 Periods of limitation on suits.

(b)  Suits by United States for recovery of erroneous refunds.

 

Recovery of an erroneous refund by suit under section 7405 shall be allowed only if such suit is begun within 2 years after the making of such refund, except that such suit may be brought at any time within 5 years from the making of the refund if it appears that any part of the refund was induced by fraud or misrepresentation of a material fact.

 

I have not lost sleep trying to understand that sentence.

But someone has.

Let’s introduce Jeffrey Page. He filed a 2016 tax return showing a $3,463 refund. In early May 2017, he received a refund check of $491,104. We are told that the IRS made a clerical error.

COMMENT: Stay tuned for more observations from Captain Obvious.

Page held the check for almost a year, finally cashing it on April 5, 2018.

The IRS – having seen the check cash – wanted the excess refund repaid.

Page wanted to enjoy the spoils.

Enter back and forth. Eventually Page returned $210,000 and kept the rest.

On March 31, 2020, Treasury sued Page in district court.

Page blew it off.

Treasury saw an easy victory and asked the district court for default judgement.

The court said no.

Why?

The court started with March 31, 2020. It subtracted two years to arrive at March 31, 2018. The court said that it did not know when Page received the check, but it most likely was before that date. If so, more than two years had passed, and Treasury could not pass Section 6532(b). They would not grant default. Treasury would have to prove its case.

Treasury argued that it was not the check issuance date being tested but rather the check clearance date. If one used the clearance date, the suit was timely.

The district court was having none of that. It pointed to precedence – from the Ninth Circuit Court of Appeals - and dismissed the case.

The government appealed.

To the Ninth Circuit Court of Appeals, ironically.

The Ninth wanted to know when a refund was “made.”

“within 2 years after the making of such refund …”

Is this when the refund is allowed or permitted or is it when the check clears or funds otherwise change hands?

The Ninth reasoned that merely holding the check does not rise to the threshold of “making” a refund.

Why, we ask?

Because Treasury could cancel the check.

OK. Score one for the government.

The Ninth further reasoned that the statute of limitations cannot start until the government is able to sue.

Why, we again ask?

Had Page shredded the check, could the government sue for nearly half a million dollars? Of course not. Well then, that indicates that a refund was not “made” when Page merely received a check.

Score two for the government.

The Ninth continued its reasoning, but we will fast forward to the conclusion:

… we hold that a refund is made when the check clears the Federal Reserve.”

Under that analysis, Treasury was timely in bring suit. The Ninth reversed the district court decision and remanded the case for further proceedings.

What do I think?

I see common sense, although I admit the Ninth has many times previously eluded common sense. Decide otherwise, however, and Treasury could be negatively impacted by factors as uncontrollable as poor mail delivery.

Or by Page’s curious delay in depositing the check.

Then again, maybe a non-professional was researching the matter, and it took a while to navigate to Section 6532 and its two years.

Our case this time was U.S. v Page, No 21-17083 (9th Cir. June 26, 2024).