Medical Deduction For Nonconventional Treatments

Is a tax deduction available for alternative medical care?

“Alternative” does not necessarily mean unusual. It includes, for example, chiropractic care. As a decades-long gym rat and chiropractic patient, I find that rather amusing.

What does the tax Code want to see before you are permitted a deductible medical expense?

You may ask: who cares? Starting in 2018 more and more people will claim the standard deduction rather than itemize under the new tax law. And – even if you itemize – what is the nondeductible percentage for medical expenses anyway – 2%, 7.5%, 10%, 100% of adjusted gross income? Congress abuses this deduction like an unwanted toy.

I’ll tell you why: because you have flexible spending accounts, health savings accounts and their siblings. To be reimbursable the expense must meet the definition of a deductible medical expense. This is a separate matter from whether you actually deduct any medical expenses on your tax return.

Let’s look at the Malev case.

Victoria Malev suffers from spinal disease. She had seen a chiropractor, but that offered only temporary and partial relief from pain.

You can probably guess the next type of doctor she would see, but Malev wanted nothing to do with surgery and its associated risks.

She instead decided to try four different alternative treatments.

The Court was diplomatic:

… Petitioner subscribed to various forms of treatment from four individuals, none of whom would be commonly recognized as a conventional medical caregiver. And to be sure, none of the methods utilized by these individuals would commonly be recognized as a conventional medical treatment. The methods Petitioner subscribed to might be termed “alternative medicine” by the polite, but we expect the less tolerant would characterize the treatments in other than legitimate or complimentary terms.”

When asked, Malev said that she had greatly improved.

She went to see an M.D a few years later – in 2016 – and the doctor suggested surgery. The doctor further suggested she investigate “integrative” medical care.

Seems to me she was already doing that.

Question: does she have a medical deduction?

The Court pointed out the obvious: had she seen the M.D. first, there would be no issue, as the M.D. recommended she investigate alternative medicine. By reversing the order, she was claiming medical deductions before the (traditional) medical diagnosis.

One can tell that the Court liked Malev. The Court acknowledged her “sincere belief” that the treatments received were beneficial, pointed out that she had not previously known the four providers and there was no reason to believe she would pay them except for the treatments given.

The Court looked at what the Code and Regulations do NOT require of deductible medical expenses:

(1) The services do not have to be furnished by one licensed to practice medicine in any particular discipline;

(2) The services do not have to be provided in-person;

(3) The services do not need to be universally accepted as effective; and

(4) The services do not have to be successful.

Malev could immediately use (1) and (3).

The Court was skeptical, but it wanted to allow for the wild card: the role a person’s state of mind plays in the treatment of disease.

Malev believed. The Court believed that she believed.

She got her medical deduction.

However, in an effort to indicate how fact-specific the case was, the Court continued:

… it is appropriate to note that we fully appreciate the position taken by the Respondent in this case, and [we] consider their position to be more than justified.”

I read Malev as a one-off. If you are thinking of alternative or integrative health care, see an M.D. – preferably an open-minded one – first. It will save both of us tax headaches.

The $64 Million Question

Let’s talk about hard rules in the tax Code.

Let’s say that you donate $500 to your church or synagogue. You come to see me to prepare your taxes. I ask you whether you have received a letter concerning that $500 donation.

You think that I am a loon. You after all have the cancelled check. What more does the government want?

That’s the problem.

Here’s the rule:

A single contribution of $250 or more – whether by cash, check or credit card – must be supported by a receipt that meets the following requirements:

a.    It must identify the amount.

b.    It must state that no goods or services were given in exchange (alternatively, it must subtract said goods and benefits from the donation if such were given); and

c.     The taxpayer must have such receipt before filing his/her tax return.

To restate this: you can give the IRS a cancelled check and it will not be enough to save your contribution deduction - if that deduction is over $250.

The tax Code is spring-loaded with traps like this. Congress and the IRS say this is necessary for effective tax administration. Nonsense. What they are interested in is taking your money.

There is a super-sized type of charitable deduction known as an “easement.” Think real property, like land or a building. The concept is that real estate is a combination of legal rights: the right to ownership, to development, to habitation, to just leave it alone and look at it.

Let’s say that you own a historical building in name-a-town USA. Chances are that restrictions are in place disallowing your ability to upsize, downsize, renovate the place or whatever. You decide to donate a “façade” easement, meaning that you will not mess with the exterior of the building. Well, messing with the exterior of the building is one of those legal rights that together amalgamate to form real estate, and you just gave one such right away. Assuming that a value can be placed on it, you may have a charitable donation.   

There are a couple of questions that come to mind immediately:

(1) Depending upon the severity of town restrictions, you may not have had a lot of room to alter the exterior anyway. You may not have given away much, in truth.

(2) Even hurdling (1), how do you value the donation?

Sure enough, there are people who value such things.

That is one thing about the tax Code: Congress is always employing somebody to do something whenever it changes the rules, and it is forever changing the rules. Virtually all tax bills are jobs bills. We can question whether those jobs are useful to society, but that is a different issue.

You will not be surprised that a super deduction brings with it super rules:

(1) One must attached a specific tax form (8283)

(2) One must attach a qualified appraisal

(3) One must attach a photograph of the building exterior

(4) One must attach a description of all restrictions on the building

There is an LLC in New York that claimed a 2007 easement deduction of $64.5 million.

Folks, you know this is going to be looked at.  

Let’s set the trap:

The LLC received a letter from the charity acknowledging the easement. Assuming the return had been extended, this would have been a timely letter.

However, the letter did not contain all the “magic words” necessary to perform the required tax incantation. More specifically, it did not say whether the charity had provided any benefits to the LLC in return.

Guess who gets pulled for audit in 2011? Yeah, a $64 million-plus easement donation will do that.

While preparing for audit, the tax advisors realized that they did not have all the magic words. They contacted the charity, which in turn amended its 2007 Form 990 to upgrade the information provided about the donation.

Strikes you as odd?

Here is what the LLC was after:

IRC Section 170(f)(8):

(A) General rule

No deduction shall be allowed under subsection (a) for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgment of the contribution by the donee organization that meets the requirements of subparagraph (B).

(D) Substantiation not required for contributions reported by the donee organization

Subparagraph (A) shall not apply to a contribution if the donee organization files a return, on such form and in accordance with such regulations as the Secretary may prescribe, which includes the information described in subparagraph (B) with respect to the contribution.

The LLC was after that “(A) shall not apply if the donee organization files a return” language. The charity amended its return, after all, to beef-up its disclosure of the easement donation.

Nix, said the IRS. All that hullabaloo was predicated on “regulations as the Secretary may prescribe.” And guess what: the Secretary did not prescribe Regulations.

Do you remember about a year ago when we talked about charitable organizations issuing 1099-like statements to their donors? We here at CTG did not care for that idea very much, especially in an era of increasing identity theft. Many charities are small and simply do not have the systems and resources to secure this information.

Well, that was also the IRS trying to prescribe under Section 170(f)(8)(D). You may remember the IRS took a tremendous amount of criticism, after which it withdrew its 1099-like proposal.

The LLC argued that Congress told the IRS to issue rules under Section 170(f)(8)(D) but the IRS did not. It was unfair to penalize the LLC when the IRS did not do its job.

The IRS took a very different tack. It argued that Section 170(f)(8)(D) gave it discretionary and not mandatory authority. The IRS could issue regulations but did not have to. In the jargon, that section was not “self-executing.”

The Tax Court had to decide a $64 million question.

And the Tax Court said the IRS was right.

At which point the LLC had to meet the requirements discussed earlier, including:

The taxpayer must have such receipt before filing his/her tax return.

It had no such receipt before filing its return.

It now had no $64.5 million deduction. 

The taxpayer was 15 West 17th Street, and they ran into an unforgiving tax rule. I am not a fan of all-or-nothing-magic-tax-incantations, as the result appears ... unfair, inequitable, almost cruel ... and as if tax compliance is a cat-and-mouse game.

Deducting Everything - The Tanzi Doctrine

I admit: I got a chuckle from reading the case.

The taxpayers (Tanzi's) are married, and for the year in question they were employed by Seminole State College, which is Sanford, Florida. I remember a conversation with a Sanford CPA a year or two ago lamenting that there no longer was separation between Orlando and Sanford. I was in Orlando this year, and he is right - there isn't.

Our taxpayer was an adjunct instructor teaching communications, and his wife worked at the campus library. Although an adjunct, he held a PhD in communications, so we can presume he was hoping for a permanent full-time position.

On their 2011 return they deducted the following as employee expenses:

            (1) 100% of their telephone, internet and television

            (2) depreciation

            (3) books, CDs and DVDs

            (4) computer expenses

The IRS bounced the employee expenses and sent them a notice for approximately $3,000.

Employee expenses are a subset of "miscellaneous deductions." One has to itemize to get to miscellaneous deductions, and even then these miscellaneous deductions are not what they used to be. The common itemized deductions are mortgage interest, real estate taxes and contributions. Living in Florida, our taxpayers did not have to concern themselves with another common itemized deduction - state income taxes. Chances are the first three got them into itemized deduction range, and their miscellaneous deductions then became usable. It is rare that miscellaneous deductions by themselves will be enough to get you to itemize.

Miscellaneous deductions are not tax-efficient, though. The Code requires that you reduce your miscellaneous deductions by 2% of your adjusted gross income, so that portion is immediately forfeited.

EXAMPLE: You and your spouse make a combined $150,000. You would have to immediately reduce your miscellaneous deductions by $3,000 (i.e., $150,000 times 2%). If your miscellaneous deductions totaled $3,500, only $500 would be deductible. And yes, it is intentional. It is a way for Congress to pry a few more tax dollars from everyone who incurs employee expenses.

COMMENT: My daughter is working before returning to graduate school. She is required to use her car for work. Although reimbursed something for mileage, it is not the full rate permitted by the IRS. Her employer explained to her that she could deduct the difference come tax time. As her dad and tax advisor, I explained that this was not true. She would not have enough to itemize, and her unreimbursed mileage would be deductible only if she itemized.

By the way, you forfeit all miscellaneous deductions if you are subject to the AMT (alternative minimum tax). As I said, they are not efficient.

The Tanzi's were deducting employee business expenses. The IRS was questioning how 100% of their telephone and internet - just to start - became business. There is a long-standing doctrine that an employee is "in the business" of being an employee, but one still has to show some nexus between the expenses and being an employee. I receive a W-2, for example, but I cannot deduct my Starbucks tab solely for the reason that I am an employee. I would have a business nexus if I met a client there, but not because I was picking up coffee for my commute to the office.

The IRS wanted to know what that nexus was.

The Tanzi's argued that they must constantly expand their "general knowledge" to be effective at their jobs. Mr Tanzi explained that individuals holding terminal degrees - such as himself, coincidently - especially bear a lifelong burden of "developing knowledge, exploring [and] essentially self-educating."   Mr. Tanzi insisted that all expenses paid in pursuing his general knowledge should be deductible as unreimbursed business expenses.

COMMENT: If Mr Tanzi won this argument, I would immediately try to expand the Tanzi doctrine to include tax CPAs with Masters degrees who also maintain a tax blog. Our burdened ranks must constantly expand our general knowledge to be effective at our jobs. I for example sometimes work with and write about international tax matters. Seems to me that a trip overseas to visit my wife's family should be deductible, as it expands my knowledge of being overseas, or some reasoning along those lines.

The tax Code recognizes that some expenses are simply personal in nature. There is even a Code section that says this out loud:

  Section 262 - Personal, living, and family expenses

      (a) General rule

Except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses.

Here is the Court:

While we find credible the Tanzi's testimony that they spent significant time and resources educating themselves, we do not believe the expenses are ordinary and necessary for the trades of being a professor or a campus librarian but rather are personal, living or family expenses nondeductible under section 262(a)."

No surprise for the Tanzi's, but I am a bit disappointed. Looks like I won't be able to deduct my life expenses as ordinary and necessary to the business of being a tax CPA and blogger. Those tax refunds would have been sweet.

Can You Have A Mortgage Interest Deduction Without A Mortgage?

A new client comes in to meet with you. Let's call him Burley. Burley lives with his girlfriend, Julie, who purchased a house. The deed and mortgage is in her name, as Burley has lousy credit. He would have been no help with a mortgage approval.

Burley and Julie consider themselves domestic partners with equal ownership of the house.

Burley pays Julie $1,000 a month as "interest only" mortgage payments. Burley is not a big fan of bank accounts, preferring to conduct much of his activity in cash. This means he does not have cancelled checks to back-up his claim.

QUESTION: Does Burley have a tax deduction for mortgage interest?

The first problem is that Burley does not own the house.

This may seem fatal, but there is a loophole. Many states recognize the doctrine of equitable ownership, and their courts will enforce express or implied contracts between nonmarital partners. It is possible to have a tax deduction, even if you are not on the deed or mortgage, as long as your nonmarital partner is and you can prove such a contract.

But while a necessary first step, the tax Code goes further. It wants to see that the equitable owner has taken on the burdens of ownership as well as the benefits. Such burdens, for example, would include:

            (1) the right to use the property and enjoy its use

            (2) a duty to maintain the property

            (3) a responsibility to insure the property

            (4) the assumption of risk of loss

            (5) a responsibility to pay taxes and assessments

            (6) the right to improve the property

Burley pays $1,000 a month, which amount would cover his share of the mortgage payment, as well as (supposedly) his share of the insurance, taxes and other expenses of ownership. The amount does not vary for repairs, or for snow removal in the winter or lawn-mowing in the summer.

That sounds a lot like rent.

It would help if the arrangement between Burley and Julie were reduced to writing. After all, real estate is a significant purchase for most people, and it is not be unreasonable to want the agreement documented.

Burley and Julie of course have no such document.

Well, at least Julie could show up in person at the hearing and answer the judge's questions. Considering that Burley has little proof to provide on his own power, her testimony would be important.

Julie doesn't want to do that, however, but she is willing to send a letter instead.

The case is Jackson, and it is a pro se Tax Court case decided in July.

Jackson lost, which is about as surprising as daily summer showers in south Florida.

Here is the Court:

           

Because she held legal title to the residence and was the sole mortgagee, [Julie's] testimony would have been highly relevant to the question whether she and petitioner had agreed (expressly or impliedly) that he would hold an interest in the property.... Despite ample advance notice of the trial date and the Court's considerable flexibility in scheduling the trial in these cases, [Julie] did not appear as a witness."

What happens when you anger the Court?

Under the circumstances, we give no weight to [Julie's] ... letter to respondent's counsel related to petitioner's history of transferring funds to her."                              

This was the Court's polite way of saying "we do not believe you."

Pouring Concrete In Phoenix

I read the tax literature differently than I did early in my career. There is certainly more of “been there, read that,” but there is also more consideration of why the IRS decided to pursue an issue.

I am convinced that sometimes the IRS just walks in face-first, as there is no upside for them. Our recent blog about the college student and her education credit was an example. Other times I can see them backfilling an area of tax law, perhaps signaling future scrutiny. I believe that is what the IRS is doing with IRAs-owning-businesses (ROBS).

A third category is when the IRS goes after an issue even though the field has been tilled for many years. They are signaling that they are still paying attention.

I am looking at a reasonable compensation case.  I believe it is type (3), although it sure looks a lot like type (1).

To set up the issue, a company deducts someone’s compensation – a sizeable bonus, for example. In almost all cases, that someone is going to be an owner of the company or a relation thereto. 

There are two primary reasons the IRS goes after reasonable compensation:

(1)  If the taxpayer is a C corporation (meaning it pays its own tax), the deduction means that the compensation is being taxed only once (deducted by the corporation; taxed once to the recipient). The IRS wants to tax it twice. In a C environment, the IRS will argue that you are paying too much compensation. It wants to move that bonus to dividends paid, as there is no tax deduction for paying dividends.

(2) If the taxpayer is an S corporation (and its one level of tax), the IRS will argue that you are paying too little compensation. There is no income tax here for the IRS to chase. What it is chasing instead is social security tax. And penalties. Some of the worst penalties in the tax Code revolve around payroll.

There is a world of literature on how to determine “reasonable.” The common judicial tests have you run a gauntlet of five factors:

(1) The employee’s role in the company

(2) Comparison to compensation paid others for similar services

(3) Character and condition of the company

(4) Potential conflict of interest

(5) Internal consistency of compensation

Let’s look at the Johnson case as an example.

Mom and dad started a concrete company way back when. They had two sons, each of which came into the business. They specialized in Arizona residential development. As time went on, the brothers wound up owning 49% of the stock; mom owned the remainder. The family was there at the right time to ride the Phoenix housing boom, and the company prospered.

A downside to the boom was periodic concrete shortages. The company did not produce its own concrete, and the brothers came to believe it to be a business necessity. They presented an investment opportunity in a concrete supplier to mom. Mom wanted nothing to do with it; she argued that the company was a contractor, not a supplier. This was how companies overextend and eventually fail, she reasoned.

The brothers went ahead and did it on their own. They invested personally, and mom stayed out. They even guaranteed some of the supplier’s bank debt.

Who would have thought that concrete had so many problems? For example, did you know that concrete becomes unusable after 

(1) 90 minutes or

(2) If it reaches 90 degrees.

I am not sure what to do with that second issue when you are in Phoenix. 

The brothers figured out how to do it. They developed a reputation for specialized work. They worked 10 or 12 hours a day, managed divisions of 100 employees each, were hands-on in the field and often ran job equipment themselves. Sometimes they even designed equipment for a given job, having their fabrication foreman put it together.

Not surprisingly, the developers and contractors loved them.

That concrete supplier decision paid off. They always had concrete when others would not. They could even charge themselves a “friendly” price now and then.

We get to tax years June 30, 2003 and 2004 and they paid themselves a nice bonus. The brothers pulled over $4 million in 2003 and over $7 million in 2004.

COMMENT: I really missed the boat back in college.

The brothers were well-advised. They maintained a cumulative bonus pool utilizing a long-time profit-sharing formula, and they had the company pay annual dividends.

The IRS disallowed a lot of the bonus. You know why: they were a C corporation and the government was smelling money.

The Court went through the five tests:

(1) The brothers ran the show and were instrumental in the business success. Give this one to the taxpayer.

(2) The IRS argued that compensation was above the average for the industry. Taxpayer responded that they were more profitable than the industry average. Each side had a point. Having nothing more to go on, however, the Court considered this one a push.

(3) Company sales and profitability were on a multi-year uptrend. This one went to the taxpayer.

(4) The IRS appears to have wagered all on this test. It brought in an expert who testified that an “independent investor” would not have paid so much compensation and bonus, because the result was to drop the company’s profitability below average.

Oh, oh. This was a good argument.

The idea is that someone – say Warren Buffett – wants to buy the company but not work there. That investor’s return would be limited to dividends and any increase in the stock price. Enough profitability has to be left in the company to make Warren happy.

This usually becomes a statistical fight between opposing experts.

It did here.

And the Court thought that the brothers’ expert did a better job than the government’s expert.

COMMENT: One can tell that the Court liked the brothers. It was not overly concerned that one or two years’ profitability was mildly compromised, especially when the company had been successful for a long time. The Court decided there was enough profitability over enough years that an independent investor would seriously consider the company. 

Give this one to the taxpayer.

(5) The company had a cumulative bonus program going back years and years. The formula did not change.

This one went to the taxpayers.

By my count the IRS won zero of the tests.

Why then did the IRS even pursue this?

They pursued it because for years they have been emphasizing test (4) – conflict of interest and its “independent investor.” They have had significant wins with it, too, although some wins came from taxpayers reaching too far. I have seen taxpayers draining all profit from the company, for example, or changing the bonus formula whimsically. There was one case where the taxpayer took so much money out of the company that he could not even cash the bonus check. That is silly stuff and low-hanging fruit for the IRS.

This time the IRS ran into someone who was on top of their game.