A Current Individual Tax Audit

 

We have an IRS audit at Galactic Command. It is of a self-employed individual. The self-employeds have maintained a reasonable audit rate, even as other individual audit rates have plummeted in recent years.

I was speaking with the examiner on Friday, lining up submission dates for records and documents. We set tentative dates, but she reminded me that Congress was going into budget talks this weekend.  Depending on the resolution, she might be furloughed next week. No prob, we will play it by ear.

This is a relatively new client for us. We did not prepare the records or the tax returns for the two years under audit. We requested underlying records, but there was little there for the first year and only slightly more for the second. We then did a cash analysis, knowing that the IRS would be doing the same.

COMMENT: The IRS will commonly request all twelve bank statements for a business-related bank account. The examiner adds up the deposits for the twelve months and compares the total to revenues reported on the tax return. If the tax return is higher, the IRS will probably leave the matter alone. If the tax return is lower, however, the IRS will want to know why.

We had a problem with the analysis for the first year: our numbers had no resemblance to the return filed. Our numbers were higher across the board: higher deposits, higher disbursements, higher excess of deposits over disbursements.

Higher by a lot.

The accountant asked me: do you think …?

Nope, not for a moment.

Implicit here is fraud.

There are two types of tax fraud: civil and criminal. Yes, I get it: if you have criminal, you are virtually certain to have civil, but that is not our point. Our point is that there is no statute of limitations on civil fraud. The IRS could go back a decade or more - if they wanted to.

I do not see fraud here. I do see incompetence. I think someone started using a popular business accounting software, downloading bank statements and whatnot to release their inner accountant. There are easy errors to one not familiar: you do not download all months for an account; you do not download all the accounts; you fail to account for credit cards; you fail to account for cash transactions.

OK, that last one could be a problem, if significant.

The matter reminded me of a famous tax case.

It is easy to understand someone committing fraud on his/her tax return. Put too much in, leave too much out. Do it deliberately and with malintent and you might have fraud.

Question: can you be responsible for your tax preparer’s fraud?

Vincent Allen was a UPS driver in Memphis. He used a professional preparer (Goosby) for 1999 and 2000.  Allen did the usual: he gave Goosby his W-2, his mortgage interest statement, property taxes and whatnot. Standard stuff.

Goosby went to town on miscellaneous itemized deductions; He goosed numbers for a pager, computer, meals, mileage and so forth. He was creative.

The IRS came down hard, understandably.

They also wanted fraud penalties.

Allen had an immediate defense: the three-year statute had run.

The IRS was curt: the three years does not apply if there is fraud.

Allen argued the obvious:

How was I supposed to know?

Off to Tax Court they went.

The Court looked at the following Code section:

 § 6501 Limitations on assessment and collection

(c)  Exceptions.

(1)  False return.

In the case of a false or fraudulent return with the intent to evade tax, the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time.

The Court noted there was no requirement that the “intent to evade” be the taxpayer’s.

The statute was open.

Allen owed tax.

The IRS - in a rare moment of mercy - did not press for penalties. It just wanted the tax, and the Court agreed.

The Allen decision reminds us that there is some responsibility when selecting a tax preparer. One is expected to review his/her return, and – if it seems too good …. Well, you know the rest of that cliche.

Do I think our client committed fraud?

Not for a moment.

Might the IRS examiner think so, however?

It crossed my mind. We’ll see.

Our case this time was Allen v Commissioner, 128. T.C. 37.

There Is No Tax Relief If You Are Robbed

 

Some tax items have been around for so long that perhaps it would be best to leave them alone.

I’ll give you an example: employees deducting business mileage on their car.

Seems sensible. You tax someone on their work income. That someone incurs expenses to perform that work. Fairness and equity tell you that one should be able to offset the expenses of generating the income against such income.

The Tax Cut and Jobs Act of 2017 (TCJA) did away with that deduction, however. Mind you, the TCJA itself expires in 2025, so we may see this deduction return for 2026.

There are reasons why Congress eliminated the deduction, we are told. They increased the standard deduction, for example, and one could not claim the mileage anyway if one’s itemized deductions were less than the standard deduction. True statement.

Still, it seems to me that Congress could have left the deduction intact. Many if not most would not use it (because of the larger standard deduction), but the high-mileage warriors would still have the deduction if they needed it.

Here’s another:  a tree falls on your house. Or you get robbed.

This has been a tax break since Carter had liver pills.

Used to be.

Back to the TCJA. Personal casualty and theft losses are deductible only if the loss results from a federally declared disaster.

Reread what I just said.

What does theft have to do with a federally declared disaster?

Nothing, of course.

I would make more sense to simply say that the TCJA did away with theft loss deductions.

Let’s talk about the Gomas case.

Dennis and Suzanne Gomas were retired and living their best life in Florida. Mr. G’s brother died, and in 2010 he inherited a business called Feline’s Pride. The business sold pet food online.

OK.

The business was in New York.

We are now talking about remote management. There are any numbers of ways this can go south.

His business manager in New York must have binged The Sopranos, as she was stealing inventory, selling customer lists, not supervising employees, and on and on.

Mr. G moved the business to Florida. His stepdaughter (Anderson) started helping him.

Good, it seems.

By 2015 Mr. G was thinking about closing the business but Anderson persuaded him to keep it open. He turned operations over to Anderson, although the next year (2016) he formally dissolved the company. Anderson kept whatever remained of the business.

In 2017 Anderson prevailed on the G’s to give her $20,000 to (supposedly) better run the business.

I get it. I too am a parent.

Anderson next told the Gs that their crooked New York business manager and others had opened merchant sub-accounts using Mr. G’s personal information. These reprobates were defrauding customers, and the bank wanted to hold the merchant account holder (read: Mr. G) responsible.

          COMMENT: Nope. Sounds wrong. Time to lawyer up.

Anderson convinced the G’s that she had found an attorney (Rickman), and he needed $125,000 at once to prevent Mr. G’s arrest.

COMMENT: For $125 grand, I am meeting with Rickman.

The G’s gave Anderson the $125,000.

But the story kept on.

There were more business subaccounts. Troubles and tribulations were afoot and abounding. It was all Rickman could do to keep Mr. G out of prison. Fortunately, the G’s had Anderson to help sail these treacherous and deadly shoals.

The G’s never met Rickman. They were tapping all their assets, however, including retirement accounts. They were going broke.

Anderson was going after that Academy award. She managed to drag in friends of the family for another $200 grand or so. That proved to be her downfall, as the friends were not as inclined as her parents to believe. In fact, they came to disbelieve. She had pushed too far.

The friends reached out to Rickman. Sure enough, there was an attorney named Rickman, but he did not know and was not representing the G’s. He had no idea about the made-up e-mail address or merchant bank or legal documents or other hot air.

Anderson was convicted to 25 years in prison.

Good.

The G’s tried to salvage some tax relief out of this. For example, in 2017 they had withdrawn almost $1.2 million from their retirement accounts, paying about $410 grand in tax.

Idea: let’s file an amended return and get that $410 grand back.

Next: we need a tax Code-related reason. How about this: we send Anderson a 1099 for $1.1 million, saying that the monies were sent to her for expenses supposedly belonging to a prior business.

I get it. Try to show a business hook. There is a gigantic problem as the business had been closed, but you have to swing the bat you are given.

The IRS of course bounced the amended return.

Off to Court they went.

You might be asking: why didn’t the G’s just say what really happened – that they were robbed?

Because the TCJA had done away with the personal theft deduction. Unless it was presidentially-declared, I suppose.

So, the G’s were left bobbing in the water with much weaker and ultimately non-persuasive arguments to power their amended return and its refund claim.

Even the judge was aghast:

Plaintiffs were the undisputed victims of a complicated theft spanning around two years, resulting in the loss of nearly $2 million dollars. The thief — Mrs. Gomas’s own daughter and Mr. Gomas’s stepdaughter — was rightly convicted and is serving a lengthy prison sentence. The fact that these elderly Plaintiffs are now required to pay tax on monies that were stolen from them seems unjust.

Here is Court shade at the IRS:

In view of the egregious and undisputed facts presented here, it is unfortunate that the IRS is unwilling — or believes it lacks the authority — to exercise its discretion and excuse payment of taxes on the stolen funds.

There is even some shade for Congress:

It is highly unlikely that Congress, when it eliminated the theft loss deduction beginning in 2018, envisioned injustices like the case before this Court. Be that as it may, the law is clear here and it favors the IRS. Seeking to avoid an unjust outcome, Plaintiffs have attempted to recharacterize the facts from what they really are — a theft loss — to something else. Established law does not support this effort. The Court is bound to follow the law, even where, as here, the outcome seems unjust.

To be fair, Congress changed the law. The change was unfair to the G’s, but the Court could not substitute penumbral law over actual law.

The G’s were hosed.

Seriously, Congress should have left theft losses alone. The reason is the same as for employee mileage. The Code as revised for TCJA would make most of the provision superfluous, but at least the provision would exist for the most extreme or egregious situations.

COMMENT: I for one am hopeful that the IRS and G's will resolve this matter administratively. This is not a complementary tale for the IRS, and – frankly – they have other potentially disastrous issues at the moment. It is not too late, for example, for the IRS and G’s to work out an offer in compromise, a partial pay or a do-not-collect status. This would allow the IRS to resolve the matter quietly. Truthfully, they should have already done this and avoided the possible shockwaves from this case.

Our case this time was Gomas v United States, District Court for the Middle District of Florida, Case 8:22-CV-01271.

Penalty Abatement For Preparer Errors

 

I was looking over a law review article weighing the pros and cons of different types of Tax Court decisions.

Nerd train, I admit.

But there is something here to talk about.

There are several types of Tax Court opinions. Some have precedential value, and some do not. Precedence means that a Court applies the law in the same manner to cases with the same facts.

One type is a Memorandum opinion. These tend to be heavily factual, and they involve relatively well-settled law.

Another is the Summary (or S) opinion. These involve a relatively modest amount of tax (currently $50 grand) and use a streamlined set of procedures.

The reason for different types of opinion is grounded in practicality. Memo opinions allow the Court to process more clear-cut cases without worrying about establishing unanticipated precedent. The S opinions allow taxpayers a forum without having to hire an attorney to navigate cumbersome Tax Court procedural rules.

I am looking at a case decided as a bench opinion. 

Think about the judge issuing an oral opinion right there and then and you have a bench opinion.

And these types can be combined. A judge may, for example, issue a bench opinion in a memo or S case.

I am looking at something I know all too well.

Mr. Trammer was an IT consultant.

Mrs. Trammer was a social worker.

Mr. Trammer worked primarily from home. Depending upon, he was paid as a W-2 employee or as a 1099 gig worker. He had an office-in-home and all that.

Mrs. Trammer was a W-2 employee. She drove around Michigan visiting childcare and foster care locations. She at times would purchase gifts for the kids.

She sounds like a good person.

They reported all kinds of deductions on their 2019 and 2020 returns: business deductions for the gig, employee business deductions for the social work, charitable deductions for the church.

If you recall, many itemized deductions were reduced or eliminated altogether beginning in 2018.

No surprise, the IRS disallowed a swath of deductions. Some – like employee business deductions – simply did not exist for the tax year at issue. Others – like office-in-home for the gig – had calculation errors.

Got it. They need to dig up documentation. They should immediately concede on the calculation error and employee expenses. The matter should be resolved as routine in correspondence exam.

Off to Tax Court they went.

Huh?

Upon reflection, this makes sense. The IRS and Covid did not play well together. They were not answering the phones over there. Faxing supporting documentation to the AUR Unit was often a joke. I suspect this matter went to Court by default.

Here we go:

The Trammers relied on a paid return preparer to prepare their returns for the years at issue. Although the individual return preparers identified on the 2019 and 2020 returns differed, the Trammers used the same preparation firm for both years.”

That does not sound like a CPA firm. Granted, I prepare only a fraction of returns I sign - staff accountants generally prepare - but I do review all returns before signing. 

Each year, they brought their records … who decided what items to report on the Trammers’ return and where.”

Yep.

The returns contained obvious errors such as reporting the same expense in multiple places.”

The old list-the-same-thing-over-and-over routine. Often these returns are not complex, but the preparer must be diligent when moving numbers. It consequently is common to give these returns to more experienced staff. Ideal would be to give the return to the same experienced staff every year.

The Court made short work of the returns.

Schedule C/Gig work

They failed to demonstrate the amount of expenses that they incurred or the business purposes for those expense, and they did not provide sufficient evidence from which the Court could formulate an estimate.”

Form 2106/employee business expenses

… the Trammers failed to substantiate the expenses Mrs. Trammer incurred in the conduct of her social work.”

Schedule A/Itemized Deductions

The Trammers failed to substantiate itemized deductions in excess of the standard deduction amounts that the Commissioner allowed…”

The IRS wanted penalties. They always do.

Not his time. Here is the Court:

The Trammers relied on a return preparer to whom they had been referred. They supplied the return preparer with necessary and accurate information each year, and the return preparer decided what to do with that information. The Trammers reasonably relied in good faith on their return preparer’s judgement. Accordingly, the section 6662 accuracy-related penalty does not apply for the years in issue.”

I am impressed, as I was expecting a rubber stamp.

What was different this time?

For one thing, Mr. Trammer showed up for the trial, and Mrs. Trammer participated via conference call. This gave them a chance to humanize their situation. While not conceding the errors, the Court did believe them when they said they tried. The Court, however, was not as kind to the preparer.

And remember: the next person cannot use this case (technically) as precedent in a future penalty. The Court had room to be lenient.

Our case this time was Trammer v Commissioner, TC Bench Order March 14, 2023.

When A Tax Audit Is Not An Audit

 

I am cleaning-up files here at Galactic Command. I saw an e-mail from earlier this year chastising someone for running business deposits through a personal account.

I remember.

He wanted to know why his extension payment came in higher than expected.

Umm, dude, you ran umpteen thousands of dollars through your personal account. I am a CPA, not a psychic.

Let’s spend some time in this yard.

If you are self-employed – think gig worker – and are audited, the IRS is almost certain to ask for copies of your bank accounts. Not just the business account(s), mind you, but all your accounts, business and personal.

I have standard advice for gig workers: open a separate business account. Make all business deposits to that account. Pay all business expenses from that account. When you need personal money, draw the needed amount from the business account and deposit to your personal account.

This gives the accountant a starting point: all deposits are income until shown otherwise. Expenses are trickier because of depreciation, mileage, and other factors.

Is it necessary?

No, but it is best practice.

I stopped counting how many audits I have represented over the years. I may not win the examiner’s trust with my record-keeping, but I assure you that I will win their distrust without it.

Does the examiner want to pry money from you? You bet. Examiners do not like to return to their managers with a no-change.

Will the examiner back-off if all the “i’s” are dotted? That varies per person, of course, but the odds are with you.

And sometimes unexpected things happen.

Let’s look at the Showalter case.

Richard Showalter (RS) owned a single-member LLC. The LLC in turn had one bank account with Wells Fargo.

This should be easy, I am thinking.

RS did not file a tax return for 2013.

Yep, horror stories often start with that line.

The IRS prepared a substitute for return (SFR) for 2013.

COMMENT: The IRS prepares the SFR with information available to it. It will add the 1099s for your interest and dividends, the sales price for any securities trades, any 1099s for your gig, and so forth. It considers the sum to be taxable income.

         Where is the issue?

Here’s one: the IRS does not spot you any cost for securities you sold. Your stock may have gone through the roof, but the odds that it has no cost is astronomical.

Here is another. You have a gig. You have gig expenses. Guess what the IRS does not include in its SFR? Yep, you get no gig expenses.

You may be thinking this has to be the worst tax return ever. It is leaving out obvious numbers.

Except that the IRS is not trying to prepare your tax return. It is trying to get your attention. The IRS throws an inflated number out there and hopes that you have enough savvy to finally file a tax return.

So, RS caught an SFR. The IRS sent him a 90-day notice (also known as a statutory notice of deficiency or SNOD), which is the procedure by which the IRS can move your file to Collections. You already know the tender mercies of IRS Collections.

RS responded to the SNOD by filing with the Tax Court. He wanted his business expenses.

Well, yeah.

RS provided bank statements. The IRS went through and – sure enough – found about $250 grand of deductions, either business or itemized.

That turned out rather well for RS. He should have done this up-front and spared himself the headache.

Then the IRS looked at his deposits. Lo and behold, they found another hundred grand or so that RS did not report as income.

It is not taxable, said RS.

Prove it, said the IRS.

RS did not.

COMMENT: It is unclear to me whether this disputed deposit was fully or partially taxable or wholly nontaxable. The deposit came from a closing statement. Maybe I am being pedantic, but I expect a cost for every sale. The closing statement for the sale is not going to show cost. Still, RS did not argue the point, so ….  

Now think about what RS did by getting into IRS dispute.

RS filed with the Tax Court because he wanted his deductions. Mind you, he could have gotten them by filing a return when required. But no, he did this the hard way.

He now submitted invoices and bank statements to support his deductions.

However, using bank statements is an audit procedure. Why is the IRS using an audit procedure?

Well, he is in Tax Court and all. He picked the battleground.

Had RS filed a return, the IRS might have processed the return without examination or further hassle. Since bank statements are an examination step, the IRS would never have seen them.

Just saying.

Was this this fair play by the IRS?

The Court thought so. The IRS cannot run wild. There must be a “minimal evidentiary showing” tying the taxpayer to potential income. The IRS added up his deposits; that exceeded what he reported as income. Seems to me the IRS cleared the required “minimal” hurdle.

By my reckoning, RS should still come out ahead. The IRS bumped his income by a smidgeon less than a hundred grand, but they also spotted him around a quarter million in business and itemized deductions. Unless there is crazy in that return, this should have improved his tax compared to the SFR.

Our case this time was Richard Showalter v Commissioner, T.C. Memo 2022-114.

No Deduction For African Sculpture

 

You can anticipate the final decision when you read the following sentence:

One does not need to be a tax expert to open his eyes and read plain English.”

This time we are talking about art. Expensive art. And donations of said expensive art.

I am not a fan of the minutiae in this area. It strikes me as a deliberate gambit to blow-up an otherwise laudable donation for what one could consider ministerial oversight, but such is the state of tax law.

Then again, the taxpayer side of these transactions tends to have access to high-powered professional advice, so perhaps the IRS is not being intractable.

Still, one likes to see reasonable application of the rules, with acknowledgement that not everyone has advanced degrees and decades of experience in tax practice. Even if one does, there can be disagreement in reading a sentence, the interpretation of a comma, the precedence of a prior case, or the interplay - or weighting - of related tax provisions. Or maybe someone is overworked, exhausted, running the kids to activities, attending to aging parents and simply made - excuse a human foible - a mistake. 

It used to be known as reasonable cause and can be grounds for penalty abatement. I remember it existing when I was a younger tax practitioner. Today? Not so much.

One way to (almost certainly) blow reasonable cause?

Be an expert. I doubt the IRS would ever allow reasonable cause on my personal return, for example.

Let’s look at the Schweizer case.

Heinrich Schweizer was a high-powered art advisor.

He better not get into it with the IRS about art donations, then.

Schweizer received a law degree in Germany. He then worked an internship with Sotheby’s in New York City. When the internship ended, he returned to Germany to pursue a PhD, a goal interrupted when Sotheby’s recruited him for a position in their African art department. He there served as Director of African and Oceanic Art from 2006 to 2015. He increased the value of the annual auctions and provided price estimates at which customers might sell their art at auction. He also worked closely with Sotheby’s appraisal department in providing customers with formal appraisals.

Schweizer filed his first US tax return in 2007. He hired a CPA firm to help with the tax return. He continued this relationship to our year in question.

In 2011 Schweizer made a substantial donation to the Minneapolis Institute of Art (MIA). He donated a Dogon sculpture that he had acquired in Paris in 2003. The deduction was $600 grand.

The accountants filed for an extension and contacted the IRS Art Appraisal Services (AAS) unit.

COMMENT: One can spend a career in tax and never do this. AAS provides advice and assistance to the IRS and taxpayers on valuation questions. A reason to contact AAS is to obtain a statement of value (SOV) after donating but before filing a tax return. The donor can rely on the SOV as support for the value deducted on the tax return. It is – by the way – not easy to get into AAS. The minimum ticket is a $50 grand donation as well as a filing fee for time and attention.

Schweizer obtained his SOV. All he had to do now was file his return and include the magic forms (Form 8283 with all the required signatures and secret handshakes, a copy of the appraisal, yada yada).

Guess what he did not do?

No properly completed Form 8283, no copy of the appraisal, nothing.

Remember: form is everything in this area of the tax law.

Off to Tax Court they went.

His argument?

His failure to meet the documentation requirements was due to reasonable cause and not willful neglect.

 Move me with a story.

He received and reasonably relied on advice from the accounting firm that it was unnecessary to include either a qualified appraisal or a fully completed Form 8283 with his 2011 return.

Why would I believe this?

Because the IRS already had these documents through the SOV process.

I know the conclusion is wrong, but it gives me pause.

OK, reliance on tax advice can be grounds for reasonable cause. He will of course need the firm to back up his story ….

The spokesman for the firm testified but did not corroborate, in any respect, Schweizer’s testimony about the alleged advice.”

Well, that seems to be prompting a malpractice suit.

Schweizer’s attorney will have to cross-examine aggressively.

And petitioner’s counsel asked no questions of […] squarely directed to this point.”

Huh? Why not?

The fact that petitioner did not seek corroborative testimony from the person who might have supplied it weighs against him.”

Well, yeah. If someone can bail you out and they fail to do so, the Court will double-down on its skepticism.

Now it became a matter of whom the Court believed.

To tighten the screws even further, the Court noted that – even if the firm had told Schweizer that he need not include a phonebook with his tax return - the Court did not believe that Schweizer would have relied on such advice in good faith.

Why not, pray tell?

Schweizer was a high-powered art advisor. He was also trained in law. He had done this - or something very similar - for clients at Sotheby’s over the years. The Court said: he knew. He may not have been an expert in tax, but he had been up and down this stretch of road enough to know the rules.

There was no deduction for Schweizer.

Our case this time was Schweizer v Commissioner, T.C. Memo 2022-102.

A Foreclosure And A Mortgage Interest Deduction

I am looking at a case involving mortgage interest. While I get the issue, I think the taxpayers got hosed.

I am going to streamline the details so we can follow the key points.

The Howlands had two mortgages on their house.

The first mortgage started with Countrywide and eventually wound up with Bank of New York Mellon.

The second mortgage started with Haven Trust Bank and wound up with CenterState Bank.

The house was foreclosed in 2016. It sold for $594,000.

The Howlands owed the following when the house was sold:

            Mellon        CenterState

        Principal      $     $377,060

        Interest     $100,607

        Interest & other    $247,046

The Howlands deducted mortgage interest of $103,498 on their 2016 joint tax return.

Neither bank, however, issued a Form 1098 for mortgage interest.

Allow for a little computer matching (or nonmatching in this case), and the IRS disallowed any interest deduction and assessed penalties to boot.

This story partially happened during the Great Recession of the late aughts. That is when we learned of “too big to fail,” of “ninja” loans and of banks playing musical chairs to survive. Good luck guessing where a given loan would wind up when the music stopped. Perhaps a taxpayer borrowed from someone (let’s call them “A”). A was acquired by B, which was later merged into C and yada, yada, yada. The data platforms between A and B were incompatible, meaning there was a one-way data transfer. The odds that someone years later – especially after the yada, yada, yada - could get back to A were astronomical.

While not clarified in the opinion, I suspect that is what happened here. CenterState Bank was not going to issue a 1098 because it could/would not time travel to determine if their interest calculations were correct. In the absence of such assurance, they were not going to issue a 1098. Or perhaps they were lazy and problem-solving outside a comfortable, numbing rote was a request beyond the pale. I prefer to believe the former reason.

But there was a problem: under the terms of the second mortgage, payments were to be applied first to interest.

COMMENT: Seems to me the Howlands paid interest of some amount.

Let’s focus in on that second mortgage. The money available to repay the second mortgage (after satisfaction of the first mortgage) would have been:

$594,000 – 247,046 = $346,954

There should also have been some interest embedded in the first mortgage, but let’s ignore that for now.

There is $347 grand to pay $377 grand of debt and $100 grand of back interest.

The IRS argued there was not enough money left to cover the principal, much less the interest. That is why the bank did not issue a 1098.

But we know that interest was to be paid first, per the loan agreement.

The Tax Court had to decide.

You know who was not in Court to testify? 

CenterState Bank – the second mortgage holder - that’s who.

Here is the Court:

The record before us is silent as to how CenterState applied the funds received and whether petitioners owe any remaining principal balance. These facts (if favorable) could support a finding that petitioners in fact paid home mortgage interest ….”

True.

However, statements in briefs do not constitute evidence.”

Again, true, but why say it?

Petitioners bear the burden of proof and must show, by a preponderance of evidence, that they are entitled to a home mortgage interest deduction ….”

Oh, oh.

... we conclude that petitioners have failed to meet their burden.”

Sheeshh.

I am not certain what more the Howlands could have done. They were at the mercy of the bank, and the new bank that took the payoff was not the same as the old bank that originated the loan. 

The Tax Court did strike down the penalties. Small consolation, but it was something.

Our case this time was Howland v Commissioner, TC Memo 2022-60.

New York And State Donation Programs

You may have read that the new tax law will limit your itemized tax deduction beginning this year (2018).

This is of no concern to you if you do not itemize deductions on your personal return.

If you do itemize, then this might be a concern.

Here is the calculation:

        *  state income taxes plus

        *  local income taxes plus

        *  real estate taxes plus

        *  personal property taxes

There is a spiff in there if you live in a state without an income tax, but let’s skip that for now.

You have a sum. You next compare that sum to $10,000, and

… you take the smaller number. That is the maximum you can deduct.

Folks, if you live in New Jersey odds are that real estate taxes on anything is going to be at least $10 grand. That leaves you with no room to deduct New Jersey income taxes. You have maxed.

Same for New York, Connecticut, California and other high tax states.

Governor Cuomo said the new tax law would “destroy” New York.

Stepping around the abuse of the language, New York did put out an idea – two, in fact:

·       Establish a charitable fund to which one could make payments in lieu of state income taxes. When preparing one’s individual tax return, one could treat contributions to that fund as state taxes paid. To make this plausible, New York would not make the ratio one-to-one. For example, if you paid $100 to the charitable fund, your state tax credit might be $90. Surely no one would then argue that you had magically converted your taxes into a charitable deduction. The only one on the short end is the IRS, but hey … New York.

·      Have employers pay a new payroll tax on employee compensation, replacing employee withholding on that compensation.  Of course, to get this to work the employee would probably have to reduce his/her pay, as the employer is not going to keep his/her salary the same and pay this new tax.

Other states put out ideas, by the way. New York was not alone.

I somewhat like the second idea. I do however see the issue with subsequent raises (a smaller base means a smaller raise), possibly reduced social security benefits, possible employer reluctance to hire, and the psychological punch of taking a cut in pay. Ouch.

The first idea however has a sad ending.

You see, many states for many years thought that there were good causes that they were willing to subsidize.

·       Indiana has the School Scholarship Credit. You donate to a scholarship-granting charity and Indiana gives you a tax credit equal to 50% of the donation on your personal return.

·       South Carolina has something similar (the Exceptional SC), but the state tax credit is 100%.

New York and its cohorts saw these and said “What is the difference between what Indiana or South Carolina is doing and what we are proposing?”

Well, for one thing money is actually going to a charitable cause, but let’s continue.

This past summer the IRS pointed out the obvious: there was no charity under New York’s plan., The person making the “donation” was simultaneously receiving a tax benefit. That is hardly the hallmark of a charitable contribution.

Wait, wait, New York said. We are not giving him/her a dollar-for-dollar credit, so …..

Fine, said the IRS. Here is what you do. Subtract the credit from the “donation.” We will allow the difference as a deductible contribution.

In fact, continued the IRS, if the spread is 15% or less, we will spot you the full donation. You do not have to reduce the deduction for the amount you get back. We can be lenient.

So what have New York and cohorts done to Indiana, to South Carolina and other states with similar programs?

You got it: they have blown up their donation programs.

Way to go.

Why did the IRS not pursue this issue before?

Well, before it did not matter whether one considered the donation to be a tax or a deductible contribution. Both were deductible as itemized deductions. There was no vig for the IRS to chase.

This changed when deductible taxes were limited to $10,000. Now there was vig.

There are about 30 states with programs like Indiana and South Carolina, so do not be surprised if this reaches back to you.

The New Qualified Business Deduction

I spent a fair amount last week looking over the new IRS Regulations on the qualified business deduction. It was a breezy and compact 184 pages, although it reads longer than that.

I debated blogging on this topic. While one of the most significant tax changes in decades, the deduction is difficult to discuss without tear-invoking side riffs. 

But – if you are in business and you are not a “C” corporation (that is, the type that pays its own taxes) - you need to know about this new deduction.

Let’s swing the bat:

1.    This is a business deduction. It is 20% of something. We will get back to what that something is.

2.    There historically has been a spread between C-corporation tax rates and non-C-corporation tax rates. It is baked into the system, and tax advisors have gotten comfortable understanding its implications. The new tax law rattled the cage by reducing the C-corporation tax rate to 21%. Without some relief for non-C-corporation entities, lawyers and accountants would have had their clients folding their S corporation, partnership and LLC tents and moving them to C-corporation campgrounds.

3.    It is sometimes called a “passthrough” deduction, but that is a misnomer. It is more like a non-C-corporation deduction. A sole proprietorship can qualify, as well as rentals, farms and traditional passthroughs like S corporations, LLCs and partnerships. Heck even estates and trusts are in on the act.

4.    But not all businesses will qualify. There are two types of businesses that will not qualify:

a.     Believe it or not, in the tax world your W-2 job is considered a trade or business. It is the reason that you are allowed to deduct your business mileage (at least, before 2018 you were). Your W-2 however will not qualify for purposes of this deduction.

b.    Certain types of businesses are not invited to the party: think doctors, dentists, lawyers, accountants and similar. Think of them as the “not too cool” crowd.

                                                   i.There is however a HUGE exception.

5.   Congress wanted you to have skin in the game in order to get this 20% deduction. Skin initially meant employees, so to claim this deduction you needed Payroll. At the last moment Congress also allowed somebody with substantial Depreciable Property to qualify, as some businesses are simply not set-up with a substantial workforce in mind. If you do not have Payroll or Depreciable Property, however, you do not get to play.

a.     But just like (4)(b) above, there is a HUGE exception.

6.   Let’s set up the HUGE exception:

a.     If you do not have Payroll or Depreciable Property, you do not get to play.

b.    If you are one of “those businesses” - doctors, dentists, lawyers, accountants and similar - you do not get to play.

c.     Except …

                                                   i. … if your income is below certain limits, you still get to play.

                                                 ii. The limit is $157,500 for non-marrieds and $315,000 for marrieds.

                                              iii. Hit the limit and you provoke math:

1.    If you are non-married, there is a phase-out range of $50 grand. Get to $207,500 and you are asked to leave.

2.    If you are married, double the range to $100 grand; at $415,000 you too have to leave.

                                               iv. Let’s consider an easy example: A married dentist with household taxable income of less than $315,000 can claim the passthrough deduction, as long as the income is not from a W-2.

1.    At $415,000 that dentist cannot claim anything and has to leave.

                                                 v. Depending on the fact pattern, the mathematics are like time-travelling to a Led Zeppelin concert. The environment is familiar, but everything has a disorienting fog about it.

1.    Why?

a.     The not-too-cool crowd has to leave the party once they get to $207,500/$415,000.

b.    Simultaneously, the too-cool crowd has to ante-up either Payroll and/or Depreciable Property as they get to $207,500/$415,000. There is no more automatic invitation just because their income is below a certain level.

c.     And both (a) and (b) are going on at the same time.

                                                                                                               i.     While not Stairway to Heaven, the mathematics are … interesting.

7.    The $207,500/$415,000 entertainment finally shows up: Payroll and Depreciable Property. Queue the music.

a.     The deduction starts at 20% of the specific trade or business’s net profit.

b.    It can go down. Here is how:

                                                   i. You calculate half of your Payroll.

                                                 ii. You calculate one-quarter of your Payroll and add 2.5% of your Depreciable Assets.

                                              iii. You take the bigger number.

                                               iv. You are not done. You next take that number and compare it to the 20% number from (a).

                                                 v. Take the smaller number.

c.     You are not done yet.

                                                   i. Take your taxable income without the passthrough deduction, whatever that deduction may someday be. May we live long enough.

                                                 ii. If you have capital gains included in your taxable income, there is math. In short, take out the capital gain. Bad capital gain.

                                              iii. Take what’s left and multiply by 20%.

                                               iv. Compare that number to (7)(b)(v).

1.    Take the smaller number.

8.    Initially one was to do this calculation business by business.

a.     Tax advisors were not looking forward to this.

b.    The IRS last week issued Regulations allowing one to combine trades or businesses (within limits, of course).

                                                   i. And tax advisors breathed a collective sigh of relief.

c.     But not unsurprisingly, the IRS simultaneously took away some early planning ideas that tax advisors had come up with.

                                                   i. Like “cracking” a business between the too-cool and not-too-cool crowds.  

And there is a high-altitude look at the new qualified business deduction.

If you have a non-C-corporation business, hopefully you have heard from your tax advisor. If you have not, please call him/her. This new deduction really is a big deal.