Losing Deductions By Not Filing A Tax Return

I have become increasingly reluctant to accept a nonfiler as a client. That said, a partner somehow sneaks one or two a year into Command Center, and I – reluctant or not – become involved. It would not be so bad if it was just a matter of catching-up with the paperwork, but often one needs to stave off Collections, establish a payment plan, request penalty abatement (done after the taxes are paid, meaning I have to monitor it in my spare time) and on-and-on.

Try doing this during IRSCOVID202020212022. It is zero fun.

I am looking at a nonfiler that took a self-inflicted wound.

Let’s talk about Shawn Salter.

Salter was a loss prevention manager over 10 Home Depot stores in Arizona.  He worked from home but drove regularly to his stores. Home Depot offered to reimburse his mileage, but he turned it down. He thought that claiming the mileage on his return would give him a bigger refund.

COMMENT: Well, yes, as he was paying out-of-pocket for gasoline and wear-and-tear on his car. Clearly he is not a Warren Buffet successor.

Salter got laid off in 2013.

He took money out of his IRA to get through, but that is not the point of our discussion today.

He needed to file a 2013 return so he could get that tax refund, especially since he turned down the opportunity to be reimbursed.

What did he not do?

He did not file a 2013 return.

Eventually the IRS figured it out and asked for a tax return.

Salter blew it off.

The IRS prepared a “substitute for return.” You do not want the IRS to do this, by the way. The IRS will file you as single with no dependents (whether you are or not), include all your gross income and do its very best to not spot you any deductions. It is intentionally designed to maximize your tax liability.

The IRS wanted over $6 grand in tax, with all the assorted interest and penalty toppings.

Now Salter cared.

He told the IRS that he had used H&R Block software to file his return.

The IRS clarified that it had no 2013 tax return, either from H&R Block or from anyone else. Send us a copy, they said.

He did not have a copy to send. He did not have certified mail receipts or record of electronic filing. He had nothing.

Hard to persuade anyone with nothing.

Here is the Court:

We find that the petitioner did not file a return for 2013, ...”

This created a problem.

Salter wanted to claim that mileage, meaning that he needed to itemize his deductions.

OK.

Not OK. There is a tax issue.

Which is …?

Did you know that itemizing your deductions is considered a tax election?

And …?

You have to file a tax return to make the election.

Easy, you say, Salter should prepare and file a 2013 return claiming itemized deductions. Doing so is the election.

Too late. That window closed when the IRS prepared the substitute for return. The substitute is considered a return, and it did not itemize. Remember how a substitute works: income is reported at gross; deductions are grudgingly given, if given at all. 

No mileage. No deduction. No refund. Tax due.

As we said: self-inflicted wound.

Our case this time was Salter v Commissioner, T.C. Memo 2022-29.

Can $2 Million Be An Honest Mistake?

 

It is a good idea to look over your tax return before hitting the “Send” button.

Why? Because things happen. Some prep software approximates a black box. It asks questions, you provide numbers and together they go someplace hidden from the eyes of man. Granted, most times the result is just fine. But there are those times ….

Let’s talk about Candice and Randall Busch.

They were preparing their 2017 tax return using a popular tax software, which shall remain nameless. They reached the point where the software wanted mortgage interest. Easy enough. They entered “21,201.25.”

So?

The software did not accept pennies.

This means that 21,201.25 went in as 2,120,125.

That, folks, is a lot of mortgage interest.

BTW one cannot deduct that much mortgage interest on a principal residence. Why? The mortgage interest deduction had been capped for many years as interest paid on the first $1 million of indebtedness. Let’s say someone paid $62,000 on $2 million of principal residence debt. The tax preparer should have caught this and limited the deduction as follows:

         62,000 * 1,000,000/2,000,000 = 32,000

The $1,000,000 cap was further reduced to $750,000 in 2017.

The tax Code has no intention of allowing an unlimited deduction for this type of interest.

Is it ever possible to get past the $1,000,000 (or $750,000) limitation? Well, yes, and it happens all the time. Borrow money on commercial real estate (say a strip mall) and there is no limitation. Borrow money on residential real estate - as long as it is not a principal residence - and there is no limitation. An example would be an apartment complex.  The limitation we are discussing is personal and involves debt on your house.

Back to the Busch’s.

They sound like average folk.

That mistake made their tax refund go through the roof.

They liked that answer.

They sent in the return.

The IRS flagged the return, which was not hard to do when the interest deduction was larger than the allowed debt for purposes of calculating the deduction itself.

The IRS wanted the excess refund back.

The Busch’s would do that.     

Then the IRS also wanted a heavy penalty (the accuracy-related penalty, for the home gamers).

The Busch’s said they wouldn’t do that. An exception to the accuracy-related penalty is reasonable cause, and they had reasonable cause all day long and three times on the weekend.

And what was that reasonable cause, asked the IRS.

It was an “honest mistake,” they replied.

Off to Tax Court they went.

The Busch’s represented themselves, the lingo for which is “pro se.”

The Court acknowledged that mistakes happen. One can get distracted and enter a wrong number, one can transpose, one can get surprised by what a software might do.

But that is not the mistake here.

The mistake here was failing to review the return before sending.

The biggest number on the return – literally – was that interest deduction. It hung over the form like a Big Texan 72-ounce steak on a normal-sized dinner plate.

Here is the Court:

A careful review of the return after it was prepared would most certainly have caught the error; actually, even as little as a quick glance at the return probably would have done so.”

The Busch’s got stuck with the penalty.

A Failure To Keep Records

You have to keep records.

Depending upon, this can be easy. Say that you have a job and a money market account – two sources of income. At year-end you receive a W-2 and a 1099-INT. File them with your individual tax return and you have kept records.

Dial this up to business level and the recordkeeping requirement can be more substantial.

Maybe you do not need a bookkeeper or accountant, but you can open a separate business bank account, running all deposit and disbursements through it. You can buy an expanding file – one with a pocket for each month – and keep invoices and receipts throughout the year. That might not be sufficient were you a regional contractor, with equipment and employees and whatnot, but it may be more than enough for what you do.

Why do this?

Because of taxes.

There is a repetitive phrase in tax cases - I have read it a thousand times:

Deductions are a matter of legislative grace, and the taxpayer must prove his or her entitlement to deductions.”

To phrase it another way:

Everything is taxable and nothing is deductible unless we say it is deductible.

One of the things the IRS says is that you must keep records. You can extrapolate what the IRS can do to you concerning deductions if you do not.

“But they can’t eat me, right, CTG?” you ask.

No, but here is what they can do.

Sam Fagenboym was a 50% owner of Alcor Electric, which provided electrical installation for midsize commercial projects. Alcor was a sub to a general contractor. Alcor in turn had suppliers and its own subs.

With the possible exception of the second round of subs, this is pretty routine stuff.

Alcor was an S corporation. It allocated Fagenboym a loss of approximately $110,000 on his 2015 Schedule K-1.

The IRS examined Alcor’s 2015 business return.

Alcor could not document over a quarter million dollars of purchases from a supplier.

Half of that audit adjustment went to Fagenboym, as he was a 50% owner.

The IRS next looked at Fagenboym’s personal return.

So much for the loss he had claimed from Alcor.

Fagenboym went to Tax Court. He went pro se, generally meaning that he was without tax representation.  As we have discussed before, that technically is not correct, as I could represent someone in Tax Court and they would be considered pro se.

Fagenboym argued for Cohan treatment of Alcor’s business expenses.

COMMENT: I would have expected Alcor to fight this issue during its business audit, but here is Fagenboym doing the fighting during his individual audit.    

Cohan is old tax case, going back to 1930 and involving someone who was known for entertaining but not for keeping receipts and records. The Court considered his situation, reasoning there was no doubt that Cohan had incurred expenses. It would be inequitable to disallow all expenses, so the question became: how much to allow?

Cohan has triggered tax changes ever since. It was responsible for the hyper-technical rules concerning meals and entertainment, for example, as well as business use of a vehicle.

Fagenboym wanted some of that Cohan.

I presume there truly were no records. There is no way that I would lead with Cohan if I had any other argument.

Why?

Think about it from the Court’s perspective.

(1) The Court will require a rational basis to estimate the expenses, and

(2)  The Court will consider the taxpayer’s culpability in creating this situation.

Perhaps if there were extenuating circumstances: illness of a key employee, a data loss, a pandemic, something that compromised the taxpayer.  The more one is responsible for causing the mess, the less likely the Court will be to clean-up the mess.

Fagenboym tried. He presented the Court with estimates of job profitability. He then subtracted labor and other known expenses to arrive at what the missing purchases should have been. He submitted four pages of handwritten analysis, but he did not or could not support it with business bank statements or other records, such as an accounts payable history for the supplier in question. Despite how earnest he seemed and how well he understood the business, there were no records backing him up.

Fagenboym could not overcome the two factors above. Even if the Court allowed some leniency on his culpability, it decided it could not independently arrive at a reasonable estimate of the costs involved.

No Cohan. No tax deduction. Bad day in Court for Fagenboym.

Starting A Business In The Desert

 

Tax has something called “startup costs.”

The idea is to slow down how quickly you can deduct these costs, and it can hurt.

Let’s take a common enough example: starting a restaurant.

You are interested in owning a restaurant. You look at several existing restaurants that may be available for purchase, but you eventually decide to renovate existing space and open your own- and new – restaurant. You lease or buy, then hire an architect for the design and a contractor for the build-out of the space.

You are burning through money.

You still do not have a tax deduction. Expenses incurred when you were evaluating existing restaurants are considered investigatory expenses. The idea here is that you were thinking of doing something, but you were not certain which something to do – or whether to do anything at all.

Investigatory expenses are a type of startup expense.

The contractor comes in. You are installing walls and windows and floors and fixtures. The equipment and furniture are delivered next.

You will depreciate these expenses, but not yet. Depreciation begins when an asset is placed in service, and it is hard to argue that assets are placed in service before the business itself begins.

You still do not have a tax deduction.

You will be the head chef, but still need your sous and line chefs, as well as a hostess, waitpersons, bartender and busboys. You have payroll and you have not served your first customer.

It is relatively common for a restaurant to have a soft launch, meaning the restaurant is open to invited guests only. This is a chance to present the menu and to shakedown the kitchen and floor staff before opening doors to the general public. It serves a couple of purposes: first, to make sure everyone and everything is ready; second, to stop the startup period. 

Think about the expenses you have incurred just to get to your soft launch: the investigatory expenses, the architect and contractor, the construction costs, the fixtures and furniture, employee training, advertising and so on.

Carve out the stuff that is depreciable, as that has its own rules. The costs that are left represent startup costs.

The tax Code – in its wisdom or jest – allows you to immediately deduct up to $5,000 of startup costs, and even that skeletal amount is reduced if you have “too many” startup costs.

Whatever remains is deductible pro-rata over 15 years.

Yes, 15 years. Almost enough time to get a kid through grade and high school.

You clearly want to minimize startup costs, if at all possible. There are two general ways to do this:

·      Start doing business as soon as possible.  Perhaps you start takeout or delivery as soon as the kitchen is ready and before the overall restaurant is open for service.

·      You expand an existing business, with expansion in this example meaning your second (or later) restaurant. While you are starting another restaurant, you are already in the business of operating restaurants. You are past startup, at least as far as restaurants go.

Let’s look at the Safaryan case.

In 2012 or 2013 Vardan Antonyan purchased 10 acres in the middle of the Mojave desert. It was a mile away from a road and about 120 miles away from where Antonyan and his wife lived. It was his plan to provide road access to the property, obtain approval for organic farming, install an irrigation system and subdivide and rent individual parcels to farmers.  

The place was going to be called “Paradise Acres.” I am not making this up.

Antonyan created a business plan. Step one was to construct a nonlivable structure (think a barn), to be followed by certification with the Department of Agriculture, an irrigation system and construction of an access road.

Forward to 2015 and Antoyan was buying building materials, hiring day laborers and renting equipment to build that barn.

Antoyan and his wife (Safaryan) filed their 2015 tax return and claim approximately $25 thousand in losses from this activity.

The IRS bounced the return.

Their argument?

The business never started.

How did the IRS get there?

Antonyan never accomplished one thing in his business plan by the end of 2015. Mind you, he started constructing the barn, but he had not finished it by year-end. This did not mean that he was not racking-up expenses. It just meant that the expenses were startup costs, to be deducted at that generous $5,00/15-year burn rate starting in the year the business actually started.

The Court wanted to see revenue. Revenue is the gold standard when arguing business startup. There was none, however, placing tremendous pressure on Antonyan to explain how the business had started without tenants or rent – when tenants and rent were the entirety of the business.  Perhaps he could present statements from potential tenants about negotiations with Antonyan – something to persuade the Court.   

He couldn’t.

Meaning he did not start in 2015.

Our case this time was Safaryan v Commissioner, T.C. Memo 2021-138.

Qualifying For Stock Loss Under Section 1244

 

I am looking at a case having to do with Section 1244 stock.

And I am thinking: it has been a while since I have seen a Section 1244.

Mind you; that is not a bad thing, as Section 1244 requires losses. The most recent corporate exit I have seen was a very sweet rollup of a professional practice for approximately $10 million. No loss = no Section 1244.

Let’s set up the issue.

We are talking about corporations. They can be either C or S corporations, but this is a corporate tax thing. BTW there is a technical issue with Section 1244 and S corporations, but let’s skip it for this discussion.

The corporation has gone out of business.

A corporation has stock. When the corporation goes out of business, that stock is worthless. This means that the shareholder has incurred a loss on that stock. If he/she acquired the stock for $5,000, then there is a loss of $5,000 when the corporation closes.

Next: that loss is – unless something else kicks-in – a capital loss.

Capital losses offset capital gains dollar-for-dollar.

Let’s say taxpayer has no capital gains.

Capital losses are then allowed to offset (up to) $3,000 of other income.

It will take this person a couple of years to use up that $5,000 loss.

Section 1244 is a pressure valve, of sorts, in this situation.

A shareholder can claim up to $50,000 of ordinary loss ($100,000 if married filing joint) upon the sale, liquidation or worthlessness of stock if:

 

(1)  The stock is be either common or preferred, voting or nonvoting, but stock acquired via convertible securities will not qualify;

(2)  The stock was initially issued to an individual or partnership;

(3)  The initial capitalization of the corporation did not exceed $1 million;

(4)  The initial capitalization was done with stock and property (other than stock and securities);

(5)  Only persons acquiring stock directly from the corporation will qualify; and

(6)  For the five tax years preceding the loss, the corporation received more than 50% of its aggregate gross receipts from sources other than interest, dividends, rents, royalties, and the sale or exchange of stocks or securities.

The advantage is that the ordinary loss can offset other income and will probably be used right away, as opposed to that $3,000 year-by-year capital loss thing.

Mind you, there can also be part Section 1244/part capital loss.

Say a married couple lost $130,000 on the bankruptcy of their corporation.

Seems to me you have:

                      Section 1244                     100,000

                      Capital loss                         30,000

Let’s look at the Ushio case.

Mr Ushio acquired the stock of PCHG, a South Carolina corporation, for $50,000.

PCHG intended to was looking to get involved with alternative energy. It made agreements with a Nevada company and other efforts, but nothing ever came of it. PCHG folded in 2012.

Ushio claimed a $50,000 Section 1244 loss.

The IRS denied it.

There were a couple of reasons:

(1)  Mr. Ushio still had to prove that $1 million limit.

 

The issue here was the number at the corporate level: was the corporation initially capitalized (for cash and property other than stock and securities) for $1 million or less? If yes, then all the issued stock qualified. If no, the corporation must identify which shares qualified and which shares did not.

        

It is possible that PCHG was not even close to $1 million in capitalization, in which a copy of its initial tax return might be sufficient. Alternatively, PCHG’s attorney or accountant might/should have records to document this requirement.        

 

(2)  PCHG never had gross receipts.

 

This means that PHGC could not meet the 50% of gross receipts requirement, as it had no gross receipts at all.

 

Note that opening a savings or money market account would not have helped. PCHG might then have had gross receipts, but 100% of its gross receipts would have been interest income – the wrong kind of income.

Mr Ushio did not have a Section 1244 loss, as PCHG did not qualify due to the gross-receipts requirement. You cannot do percentages off a denominator of zero.

My first thought when reviewing the case was the long odds of the IRS even looking at the return, much less disallowing a Section 1244 loss on said return. That is not what happened. The IRS was initially looking at other areas of the Ushio return. In fact, Ushio had not even claimed a capital loss – much less a Section 1244 loss – on the original return. The issue came up during the examination, making it easy for the IRS to say “prove it.”

How would a tax advisor deal with this gross-receipts hurdle in practice?

Well, the initial and planned activity of PCHG failed to produce any revenues. It seems to me that an advisor would look to parachute-in another activity that would produce some – any – revenues, in order to meet the Section 1244 requirement. The tax Code wants to see an operating business, and it uses gross receipts as its screen for operations.

Could the IRS challenge such effort as failing to rise to the level of a trade or business or otherwise lacking economic substance? Well, yes, but consider the alternative: a slam-dunk failure to qualify under Section 1244.

Our case this time was Ushio v Commissioner, TC Summary Opinion 2021-27.

Uber Driver Failed To Report Income

I am reading a case concerning an Uber driver who ran afoul of Form 1099 requirements.

The amounts at issue were impressive.

           Tax                          $193,784

           Penalties                  $ 85,354

Robert Nurumbi drove for Uber in 2015. He ran the business through a single-member LLC and used two bank accounts. Business was doing well. He bought multiple cars which he rented out to family and friends who drove for Uber through him. The twist to the tale is that all Uber payments were paid to the LLC’s bank account - meaning Nurumbi’s bank account, as he was the LLC - and he in turn would pay his family and friends.

Sounds like he established a small business, with employees and all.

Except that he treated his drivers as independent contractors, not employees. I get it: Uber is gig economy.

Every week Uber would pay Nurumbi. He would transfer the family-and-friends portion to a second bank account. He would sometimes pay them by electronic transfer; at other times he paid in cash. He did not keep documentation on these payments, and he further muddied the waters by also paying nondriver expenses from the second bank account.

He filed his 2015 personal tax return showing wages of approximately $19 grand.

Uber meanwhile issued him two 1099s totaling approximately $543 thousand.

The IRS saw a case of unreported income.

It is not clear to me how Nurumbi prepared his tax return, as a self-employed does not receive a W-2 from himself. He should have filed a Schedule C with his return, as Schedule C reports self-employed business activity. I would have expected his C to report gross receipts of approximately $543 grand, with a bunch of expenses reducing the net to approximately $19 thousand. The IRS would have matched Uber’s 1099 to the gross receipts on the Schedule C and spared us the drama.

However, Nurumbi did not prepare his taxes this way.

Dumb, I am thinking, but not necessarily fatal. Nurumbi would submit a Schedule C (or a facsimile thereof) and argue his point.

But the damage had been done. Nurumbi had spotted the IRS gross income of $543 grand. He next had to show expenses bringing his net income down to $19 thousand. This gave the IRS the chance to say: prove it.

Which is why we keep records: invoices, bank statements, cancelled checks, QuickBooks files and so forth.  

Nurumbi had a problem. He kept next to no records. He had not issued 1099s. His records in many cases were inadequate to even calculate a 1099.

Nurumbi played a wild card.

There is a court-created exception to the customary documentation requirements. It is called the Cohan rule, and it refers to the person and case that prompted the exception decades ago. The rule has two key requirements:

(1)  One must prove that the expenditure occurred, and

(2)  One must prove that the expenditure relates to and was incurred in one’s trade or business.

Even then, the exception will probably not yield the same result as keeping records. The Court may spot you something, but that something is likely to be much less than what you actually incurred.

Nurumbi’s records were so feckless that it would have been unsurprising if the Court allowed nothing.

Except …

Remember that he sometimes paid his drivers electronically from the second bank account.

The Court spotted him a deduction of approximately $157 grand for those payments.

What about the cash payments to his drivers?

No dice.

Let’s summarize the damage.

The IRS increased his 2015 income from $18 to $543 thousand.

The Court allowed a deduction of approximately $157 thousand.

There was another significant deduction that we did not discuss: the fee paid to Uber itself. That was approximately $163 thousand.

That still leaves a bump to income of almost $205 grand.

I believe that Nurumbi paid the money to his family and friends.

But there was no tax deduction.

To be fair, he is the one who decided to keep the payments under-the-table. While not stated, I suspect this … flexibility … was a key factor in the Court’s decision.

Our case this time was Nurumbi v Commissioner, TC Memo 2021-79.

"I Never Heard Of The Alternative Minimum Tax"

 

I am looking at a case that involves the alternative minimum tax.

While it still exists, much of the steam has thankfully been taken out of the AMT. It started off as Congressional reaction to a handful of ultrawealthy families paying little to no income taxes decades ago. Congress’s response was to require a second tax calculation, disallowing certain things – such as exemptions for your dependents.

Yes, you read that correctly, you large-family tax scofflaw.

Now, it wouldn’t be so bad if this thing had been scaled to only reach the wealthy and ultrawealthy, but that is not what Congress did. Congress instead gave you a spot, and then you were on your own. For 2017 that spot was approximately $84 grand in income for marrieds filing jointly.

I used to see the AMT as often as a Gibson’s employee sees donuts.

Thankfully the Tax Cut and Jobs Act of 2017 did a couple of things to defang the AMT:

(1) It increased the exemption (that is, the spot) for everyone. Marrieds now have an exemption of approximately $115,000, for example.

(2)  More importantly, it adjusted a previous rule that phased-out the exemption as one’s income increased. For example, marrieds in 2017 would start phasing-out when their income reached approximately $160,000. Now it is over $1 million, which makes a lot more sense it if was truly targeted at the wealthy.

Why the absurdly low previous income thresholds for the AMT, especially since it was supposed to target the “rich?” Think of it as Congressional addiction to paper crack – the paper being your dollar bills.

The tax law is a little saner until 2026, when the TCJA goes “poof.” Much prior tax law will then resurrect – including the previous version AMT.

Robert Colton and Alina Mazwin (R&A) filed a joint return for 2016.

The IRS did its computer matching and sent them a notice. There was $125,000 reported by JP Morgan Chase Bank. The IRS wanted taxes on it.

R&A explained to the IRS that the $125,000 was a legal settlement, and that half of it went to Mr Colton’s ex-spouse.

The IRS said OK, but we want taxes on the $62,500.

Let’s take an aside here. You may have heard that lawsuit settlements are not taxable. That is only partially true. The lawsuit has to involve physical injury (think a car crash, for example) to be tax-free.

It appears that Mr Colton’s settlement was of the non-car crash variety, meaning that it was taxable.

R&A then amended their 2016 return, picking up the $62,500 but also claiming a miscellaneous itemized deduction of $80,075 for attorney fees.

Hah! They might even get a tax refund out of this, right? Take that, IRS.

Except …

Guess what is not deductible for the AMT.

Yep, that miscellaneous itemized deduction.

So – for AMT purposes – their income went up by the $62,500 but there was no deduction for the related legal fee.

How much income did R&A have before the IRS contacted them?

About $40 grand.

Yep, the AMT had been bent so far beyond recognition that it trapped someone amending a return to show perhaps $100 grand in income.

Folks, that income level does not go you invited to the cool parties on Martha’s Vineyard.

Let me share a line from the case:

Petitioners stated in their petition that ‘[they] never heard of [the] alternative minimum tax.”

I get it. I consider it unconscionable that an average person has to hire someone like me to prepare their taxes.  

Our case this time for the home gamers was Colton and Mazwin v Commissioner, T.C. Memo 2021-44.

Downside Of Not Issuing 1099s

Let’s be honest: no one likes 1099s.

I get it. The government has conscripted us – business owners and their advisors – into unpaid volunteers for the IRS. Perhaps it started innocently enough, but with the passage of years and the accretion of reporting demands, information reporting has become a significant indirect tax on businesses.

It’s not going to get better. There is a proposal in the White House’s Green Book, for example, mandating banks to report gross deposit and disbursement account information to the Treasury.

Back to 1099s.

You see it all the time: one person pays another in cash with no intention – or ability – to issue a 1099 at year-end.

What can go wrong?

Plenty.

Let’s look at Adler v Commissioner as an example.

Peter Adler owned a consulting company. He had a significant client. He would travel for that client and be reimbursed for his expenses.

The accounting is simple: offset the travel expenses with the reimbursements. Common sense, as the travel expenses were passed-on to the client.

However, in one of the years Peter incurred expenses of approximately $44 thousand for construction work.

The Court wondered how a consultant could incur construction expenses.

Frankly, so do I.

For one reason or another Peter could not provide 1099s to the IRS.

One possible reason is that Peter made his checks out to a corporation. One is not required to issue 1099s to an incorporated business. Peter could present copies of the cancelled checks. He could then verify the corporate status of the payee on the secretary of state’s website.

Nah, I doubt that was the reason.

Another possibility is that Peter got caught deducting personal expenses. Let’s assume this was not the reason and continue our discussion.

A third possibility is that Peter went to the bank, got cash and paid whoever in cash. Paying someone in cash does not necessarily mean that you will not or cannot issue a 1099 at year-end, but the odds of this happening drop radically.

Peter had nothing he could give the Court. I suppose he could track down the person he paid cash and get a written statement to present the Court.

Rigghhhtttt ….

The Court did the short and sweet: they disallowed the deduction.

Could it get worse?

Fortunately for Peter, it ended there, but – yes – it can get worse.

What if the IRS said that you had an employee instead of a contractor? You are now responsible for withholdings, employer matching, W-2s and so on.

COMMENT: You can substitute “gig worker” for contractor, if you wish. The tax issues are the same.

Folks, depending upon the number of people and dollars involved, this could be a bankrupting experience.

Hold on CTG, say you. Isn’t there a relief provision when the IRS flips a contractor on you?

There are two.

I suspect you are referring to Section 530 relief.

It provides protection from an IRS flip (that is, contractor to employee) if three requirements are met:

1.    You filed the appropriate paperwork for the relationship you are claiming exists with the service provider.

2.    You must be consistent. If Joe and Harry do the same work, then you have to report Joe and Harry the same way.

3.    You have to have a reasonable basis for taking not treating the service provider as an employee. The construction industry is populated with contractors, for example.

You might be thinking that (3) above could have saved Peter.

Maybe.

But (1) above doomed him.

Why?

Because Peter should have issued a 1099. He had a business. A business is supposed to issue a 1099 to a service provider once payments exceed $600.

There was no Section 530 relief for Peter.

I will give you a second relief provision if the IRS flips a contractor on you. 

Think about the consequences of this for a second.

(1)  You were supposed to withhold federal income tax.

(2)  You were supposed to withhold social security.

(3)  You were supposed to match the social security.

(4)  You were supposed to remit those withholdings and your match to the IRS on a timely basis.

(5)  You were supposed to file quarterly employment reports accounting for the above.

(6)  You were supposed to issue W-2s to the employee at year-end.

(7)  You were supposed to send a copy of the W-2 to the Social Security Administration at year-end.

(8)  Payroll has some of the nastiest penalties in the tax Code.

This could be a business-shuttering event. I had a client several years ago who was faced with this scenario. The situation was complicated by fact that the IRS considered one of the owners to be a tax protestor. I personally did not think the owner merited protestor status, as he was not filing nonsense appeals with the IRS or filing delaying motions with the Tax Court. He was more …  not filing tax returns.  Nonetheless, I can vouch that the IRS was not humored.

Back to relief 2. Take a look at this bad boy:

§ 3509 Determination of employer's liability for certain employment taxes.

(a)  In general.

If any employer fails to deduct and withhold any tax under chapter 24 or subchapter A of chapter 21 with respect to any employee by reason of treating such employee as not being an employee for purposes of such chapter or subchapter, the amount of the employer's liability for-

(1)  Withholding taxes.

Tax under chapter 24 for such year with respect to such employee shall be determined as if the amount required to be deducted and withheld were equal to 1.5 percent of the wages (as defined in section 3401 ) paid to such employee.

(2)  Employee social security tax.

Taxes under subchapter A of chapter 21 with respect to such employee shall be determined as if the taxes imposed under such subchapter were 20 percent of the amount imposed under such subchapter without regard to this subparagraph .

Yes, you still owe federal income and social security, but it is a fraction of what it might have been. For example, you should have withheld 7.65% from the employee for social security. Section 3509(a)(2) gives you a break: the IRS will accept 20% of 7.65%, or 1.53%.

Is it great?

Well, no.

Might it be the difference between staying in business and closing your doors?

Well, yes.