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.

Botching An IRS Bank Deposit Analysis

 

What caught my eye was the taxpayer’s name. I am not sure how to pronounce it, and I am not going to try.

I skimmed the case. As cases go, it is virtually skeletal at only 6 pages long.

There is something happening here.

Let’s look at Haghnazarzadeh v Commissioner.

The IRS wanted taxes, penalties and interest of $2,424,100 and $1,152,786 for years 2011 and 2012, respectively.

Sounds like somebody is a heavy hitter.

Here is the Court:

“… the only remaining issue is whether certain deposits into petitioners’ nine bank accounts are ordinary income or nontaxable deposits.”

For the years at issue, Mr H was in the real estate business in California. Together, Mr and Mrs H had more bank accounts than there are days of the week. The IRS did a bank deposit analysis and determined there was unreported income of $4,854,84 and $1,868,212.

Got it.

Here is the set-up:

(1) The tax Code requires one to have records to substantiate their taxable income. For most of us, that is easy to do. We have a W-2, maybe an interest statement from the bank or a brokers’ statement from Fidelity. This does not have to be rocket science.

This may change, however, if one is in business. It depends. Say that you have a side gig reviewing articles before publication in a professional journal. What expenses do you have? I suspect that just depositing the money to your bank account might constitute adequate recordkeeping.

Say you have a transportation company, with a vehicle fleet and workforce. You are now in need of something substantial to track everything, perhaps QuickBooks or Sage, for example. 

(2) Let’s take a moment about being in business, especially as a side gig.

Many if not most tax practitioners will advise a separate bank account for the gig. All gig deposits should go into and all business expenses should be paid from the gig account. What about taking a draw? Transfer the money from the gig account to a personal account. You can see what we are doing: keep the gig account clean, traceable.

  (3) Bad things can happen if you need records and do not keep any.

We know the usual examples: you claim a deduction and the IRS says: prove it. Don’t prove it and the IRS disallows the deduction.

The tax Code allows the IRS to use reasonable means to determine someone’s income when the records are not there.  

(4) One of those methods is the bank deposit analysis.

It is just what it sounds like. The IRS will look at all your deposits, eliminating those that are just transfers from other accounts. If you agree that what is left over is taxable, the exercise is done. If you disagree, then you have to provide substantiation to the IRS that a deposit is not taxable income.

The substantiation can vary. Let’s say that you took a cash advance on a credit card. You would show the credit card statement – with the advance showing – as proof that the deposit is not taxable.

Let’s say that your parents gifted you money. A statement or letter from your parents to that effect might suffice, especially if followed-up with a copy of their cancelled check.

You might be wondering why you would deposit everything if you are going to be flogged you with this type of analysis. There are several reasons. The first is that it is just good financial and business practice, and you should do it as a responsible steward of money. Second, you are not going to wind up here as default by the IRS. Keep records; avoid this outcome. A third reason is that the absence of bank accounts – or minimal use of the same – might be construed as an indicator of fraud. Go there, and you may have leaped from being perceived as a lousy recordkeeper to something more sinister.

Back to the H’s.

They have to show something to the IRS to prove that the $4.8 million and $1.8 million does not represent taxable income.

Mr H swings:

For 2011 he mentioned deposits of $1,556,000 $130,000, and $60,000 for account number 8023 and $1,390,000, $875,000, and $327,000 for account number 4683”

All right! Show your cards, H.

Why would I need to do that? asks Mr H.

Because ……. that is the way it works, H-man. Trust but verify.

Not for me, harumphs Mr H.

Here is the Court:

Petitioner husband did not present evidence substantiating his claim that any of these deposits should be treated as nontaxable.”

Maybe somebody does not understand the American tax system.

Or maybe there is something sinister after all.

What it is isn't exactly clear.

COMMENT: This was a pro se case. As we have discussed before, pro se generally means that the taxpayer was not represented by a tax professional. Technically, that is not correct, as someone could retain a CPA and the decision still remain pro se. With all that hedge talk, I believe that the H’s were truly pro se. No competent tax advisor would make a mistake this egregious.  

Our case (again) was Haghnazarzadeh v Commissioner, T.C. Memo 2021-47.

Incompetent Employees And IRS Penalties

 

“Taxes are what we pay for civilized society.” Compania General De Tabacos de Filipinas v. Collector, 275 U.S. 87, 100 (1927) (Taft, C.J.). For good reason, there are few lawful justifications for failing to pay one's taxes. Plaintiff All Stacked Up Masonry, Inc. (“All Stacked Up”), a corporation, believes it has such an excuse. It brings this suit to challenge penalties and interest assessed by the Internal Revenue Service (“IRS”) following its failure to file the appropriate payroll tax documents and its failure to timely pay payroll tax liabilities for multiple tax periods.

The above is how the Court decision starts.

Here are the facts from 30,000 feet.

·      The company provides masonry services.

·      The company got into payroll tax issues from 2013 through 2015.

·      The company paid over $95 thousand in penalties and interest.

·      It now wanted that money back. To do so it had to present reasonable cause for how it got into this mess in the first place.

Proving reasonable cause is not easy, as the IRS keeps shrinking the universe of reasonable cause.  An example is an accountant missing a timely extension. There is a case out there called Boyle, and the case divides an accountant’s services into two broad camps:

·      Advice on technical issues, and

·      Stuff a monkey could do.

Let’s say that CTG Galactic Command is planning a corporate reorganization and we blow a step, causing significant tax due. Reliance on us as your advisors will probably constitute reasonable cause, as the transaction under consideration was complex and required specialized expertise. Let’s say however that we fail to extend the corporate return – or we file it two days after its extended due date. Boyle stands for the position that anyone can google when the return was due, meaning that relying on us as your tax advisors to comply with your filing deadline is not reasonable.

As a practitioner, I have very little patience with Boyle. We prepare well over a thousand individual tax returns, not to mention business, nonprofit, payroll, sales tax, paper airplanes and everything in between. Visit this office during the last few days before April 15th, for example, and you can feel the tension like the hum from an electrical transformer. What returns are finished? What returns are only missing an item or two and can hopefully be finished? What returns cannot possibly be finished? Do we have enough information to make an educated guess at tax due? Who is calling the client?  Who is tracking and recording all this to be sure that nothing is overlooked? Why do we do this to ourselves?

Yeah, mistakes happen in practice. Boyle just doesn’t care. Boyle holds practitioners to a standard that the IRS itself cannot rise to. I have several files in my office just waiting, because the IRS DOES NOT KNOW WHAT TO DO. I brought in the Taxpayer Advocate recently because IRS Kansas City botched a client. We filed an amended return in response to a Notice of Deficiency the client did not inform us about. The amended must have appeared as “too much work” to some IRS employee, and we were informed that Kansas City inexplicably closed the file. This act occurred well before but was fortuitously masked by subsequent COVID issues. The after-effects were breathtaking, with lien notices, our requests for releases, telephone calls with IRS attorneys, Collection’s laughable insistence on a payment plan, and – ultimately – a delay on the client’s refinancing. IRS incompetence cumulatively cost me the better part of a day’s work. Considering what I do for a living, that is time and money I cannot get back

I should be able to bill the IRS for wasting my time over stuff a monkey could do.

The Advocate did a good job, by the way.

Let’s get back to All Stacked Up, the company whose payroll issues we were discussing.

The owner fell on ice and suffered significant injuries. This led to the owner relying on an employee for tax compliance. That reliance was misplaced.

·      The first two quarterly payroll returns for 2013 were filed late.

·      The fourth quarter, 2013 return would have been due January 31, 2014. It was not filed until July 13, 2015.

·      None of the 2014 quarterly returns were filed until the summer of 2015.

·      To complete this sound track, the payroll tax deposits were no timelier than the filing of the returns themselves.

Frankly, the company should just have let its CPA firm take care of the matter. Had the firm botched the work this badly, at least the company would have a possible malpractice lawsuit.

The company pleaded reasonable cause. The owner was injured and tried to delegate the tax duties to someone during his absence. Granted, it did not go well, but that does mean that the owner did not try to behave as a prudent business person.

I get the argument. All Stacked Up is not Apple or Microsoft, with acres and acres of lawyers and accountants. They did the best they could with the (clearly limited) resources they had.

The company appealed the penalties. IRS Appeals was willing to compromise – but only a bit. Appeals would abate 16.66% of the penalties and related interest. This presented a tough call: accept the abatement or go for it all.

The company went for it all.

Here is the Court:

Applying Boyle to this case, it is clear as a matter of law that retention of an employee or software to prepare and remit tax filings, make required deposits, and tender payments cannot, in itself, constitute “reasonable cause” for All Stacked Up’s failure to satisfy those tax obligations. The employee’s failures are All Stacked Up’s failures, no matter how prudent the delegation of those duties may have been.”

And there is full Boyle: we don’t care about your problems and you doing your best with the resources available. Your standard is perfection, and do not ask whether we hold ourselves to the same standard.

I wonder if that employee is still there.

I mean the one at IRS Kansas City.

Our case this time was All Stacked Up v U.S., 2020 PTC 340 (Fed Cl 2020).

Changes to 2020 Federal Payroll Taxes

There were two bills passed in March that significantly impacted payroll taxes for 2020. The first – Families First Coronavirus Response Act – expanded employee paid leave, with the intent that the cost of the leave be shifted to the government via refundable payroll tax credits. The second – The Coronavirus Aid, Relief and Economic Security Act - allows employers to defer the deposit of (some) payroll taxes, while also providing a payroll tax credit to encourage employers directly affected by the virus (either through government order or decline in business) to retain employees.

Following is a recap to aid as you work through this new minefield. As always, remember that no recap is exhaustive. Please be advised to review the underlying guidance for specific issues and questions.

The President signed the CARES Act on March 27, 2020.

The CARES act brought us the Employee Retention Credit (ERC).

(1)  Eligible employers include tax-exempt organizations but not government agencies.

(2)  Eligible employers have a refundable credit equal to 50% of qualified wages (including allocable health care expenses) paid employees if the employer …

(a)  Fully or partially suspends operations during 2020 due to orders from an appropriate governmental authority due to COVID-19; or

(b)  Experiences a significant decline in gross receipts during a calendar quarter.

a.    The period begins with the first quarter in which gross 2020 receipts are less than 50% of gross receipts for the same quarter in 2019.

b.    The period ends the quarter after the quarter whose gross receipts exceed 80% for the same quarter in 2019.

(3)  Qualified wages mean wages paid after March 12, 2020 and before January 1, 2021.

NOTE: This means that an eligible employer may claim the credit for qualified wages paid as early as March 13, 2020.

(4) Qualified wages include allocable health care expenses and are limited to $10,000 per employee for 2020.

(5) Qualified wages vary significantly depending on the size of the employer.

(a)   If the employer had 100 or fewer full-time equivalents (FTEs) in 2019, then qualified wages include wages paid all employees.

(b)  If the employer had more than 100 FTEs in 2019, then qualified wages mean wages paid an employee not working because of (a) government orders or (b) a significant decline in gross receipts.

(6) The credit is 50% of qualified wages, meaning the maximum credit is $5,000 ($10,000 times 50%).

(7) Technically, the credit is allowed only against the employer share of social security tax (that is 6.2%), but this is misleading. The credit is fully refundable, so it will continue offsetting employee payroll withholdings and employer payroll taxes until the credit exhausted. If there is still a credit remaining, then the remaining credit is refundable to the employer.

EXAMPLE: CTG Command Center pays $10,000 in qualifying wages in quarter 2, 2020. Employee federal income tax, social security and Medicare withholdings are $4,000. The employer social security is $620 ($10,000 times 6.2%), for a required total payroll tax deposit of $4,620. The retention credit is $5,000. The retention credit will offset all the required payroll tax deposits – employee and employer – and result in a $380 refund to CTG Command Center.

(8) The IRS realized that having an employer make payroll tax deposits, only to have those deposits later refunded, is not prudent cash flow management. The IRS will therefore allow an employer to offset otherwise required payroll tax deposits by anticipated payroll tax credits. The amounts otherwise due or credited are to be accounted for with the filing of the quarterly Form 941. If payroll tax credits are expected to exceed payroll tax deposits otherwise required, there is also a procedure to obtain an advance refund (that is, before filing Form 941) from the IRS.

(9) There is an unusual interaction with the CARES deferral of employer payroll taxes:

·      An employer can defer and still receive the employee retention credit, resulting in, in effect, an interest-free loan from the government.

(10) There is no equivalent of the retention credit for self-employeds.

(11) This credit does not play well with the emergency sick or expanded family leave provisions. In short, one cannot use the same wages for more than one credit.

(12) This credit is not available if the employer receives a Paycheck Protection loan.

 The CARES Act also brought us the deferral of employer social security taxes.

(1) An employer’s payroll tax liability has two parts: social security tax at 6.2% and Medicare tax at 1.45%. The deferral is solely for the employer share of social security taxes (that is, 6.2%).

(2) Unlike the ERC, the deferral applies to deposits (rather than wages paid) otherwise required beginning March 27, 2020 and through December 31, 2020.

COMMENT:  Therefore, payroll taxes accrued before March 27, 2020 would qualify as long as the payroll tax deposit was due on or after March 27, 2020.

(3) All employers are eligible. Unlike the ERC, there is no employer size limitations.

(4) Unlike the ERC, there is no requirement that the employer be affected by COVID-19.

(5) The deferral is as follows:

(a)  50% of taxes deferred are due December 31, 2021

(b)  The remaining 50% is due December 31, 2022

(6) The deferral also applies to self-employeds. The amount deferred is 6.2% of the total 15.3% self-employment tax rate. The is no deferral once the self-employed exceeds the maximum social security wage base.

(7) There is an unusual interaction with the Families First emergency sick and expanded family leave credits.

·      An employer can defer and still receive the emergency sick and expanded family leave credits, resulting in, in effect, an interest-free loan from the government.

(8) There is an unusual interaction with the employee retention credit (ERC).

·      An employer can defer and still receive the employee retention credit, resulting in, in effect, an interest-free loan from the government.

(9) There is an unusual interaction with a Paycheck Protection loan.

·      No further deferrals are allowed after an employer receives notice of Paycheck Protection Loan forgiveness.

·      However, deferrals up to that date remain eligible for deferral and are due December 31, 2021 and 2022.

(10) Note that the deferral affects payroll taxes due on or after March 27, 2020, meaning that one would expect the deferral to be accounted for on the first quarter employer Form 941.

The IRS has clarified that the credit for this stub period will NOT be accounted for on the first quarter Form 941. Rather they will be added to any credits arising during the quarter two and reported on the second quarter Form 941.

The President signed the Families First Coronavirus Response Act on March 18, 2020, introducing two new (and temporary) paid-leave benefits.

Emergency Sick Leave

(1)  Applies to businesses and tax-exempt organizations with fewer than 500 employees 

(2)  Applies immediately to employees of the above employers

(3)  The tax credit is based on qualifying leave provided employees between April 1, 2020 and December 31, 2020.

·      Note that emergency sick leave wages paid in 2021 will qualify if paid for leave taken between April 1 and December 31,2020. 

(4)  Full-time employees can receive up to 80 hours of sick leave. Part-time employees can receive leave based on the average number of hours worked over a two-week period of time.  

(5)  If …

a.     The employee is subject to a federal, state or local quarantine or isolation order related to COVID-19;

b.    The employee has been directed by a healthcare provider to self-quarantine due to concerns related to COVID-19;

c.     The employee is seeking to obtain medical diagnosis when experiencing symptoms of COVID-19

… then the maximum (creditable) paid leave is the employee’s regular rate of pay, up to $511 per day and limited to $5,110 per employee.

(6)  If the employee takes time-off …

a.     To care for a family member who is subject to a federal, state or local quarantine or isolation order related to COVID-19;

b.    To care for a child (under 18 years of age) whose school has been closed or paid childcare provider is unavailable due to COVID-19; or

c.     Because the employee is experiencing any other substantially similar conditions as specified by the Secretary of Health and Human Services

… then the maximum (creditable) paid leave is 2/3 of the employee’s regular rate of pay, up to $200 per day and limited to $2,000 per employee.

(7)  For both (5) and (6), the employer is allowed to increase the credit amount by the allocable cost of the employee’s health insurance coverage.

(8)  Employers are still required to withhold employee federal income taxes and the employee’s share of Social Security and Medicare taxes. 

·      The intent is that this will be covered by the $511/$200 per day allowance.

(9)  Wages paid under the emergency sick leave provision ….

a.     Are NOT be subject to employer social security (6.2%), and

b.    ARE subject to employer Medicare (1.45%)

                                                      i.     However, this employer Medicare requirement is misleading because the credit will be increased by the amount of

1.    The employer Medicare tax, and

2.    The allocable cost of health insurance coverage

EXAMPLE: CTG Command Center pays one employee $200 per day for 10 days. It also pays $100 in health care costs. Employee withholdings are $300 for federal income tax, $124 for social security and $29 for Medicare – a total of $453.Net pay is therefore $1,547 ($2,000 – $453) and total compensation (including health care and employer Medicare) is $2,129. CTG Command Center will receive credit on its payroll tax return for $2,000 + $100 (allocable health care) + $29 (employer Medicare) = $2,129. This means that the cost of the employee (excluding unemployment insurance and workers compensation) has been shifted from CTG Command to the federal government for the covered period.  

(10)        The credit can be offset against all employee withholdings and employer payroll taxes.

·      Any excess is refundable to the employer.

(11)       Any credits utilized will constitute taxable income to the employer.

·      Offsetting the employer payroll tax expense on wages paid emergency leave employees.

(12)       There is a comparable provision for self-employeds

a.     However, the “average daily self-employment income” will not be calculable until year-end, as it refers to 2020 net earnings from self-employment divided by 260 days.

EXAMPLE. Rocket Man is self-employed. He earned $185,000 for 2020, and he spent 10 days taking care of his mom during the crisis. His daily self-employment income is $712 ($185,000 divided by 260). That however exceeds $200, so his allowable paid sick leave is $2,000. His 2020 net earnings from self-employment are reduced by $2,000. He is also allowed to reduce his otherwise-required quarterly estimated tax payments accordingly. 

(13)       There is an unusual interaction with the emergency sick leave credit and the employer payroll tax deferral.

·      An employer can defer and still receive the emergency sick leave credit, resulting, in effect, an interest-free loan from the government.

(14) This credit does not play well with the employee retention credit. In short, one cannot use the same wages for more than one credit.

Expanded Family Leave

(1)  Applies to businesses and tax-exempt organizations with fewer than 500 employees 

(2)  This is a narrow expansion of FMLA to include

… employees unable to perform services (including telework) because of need to care for a child whose school or place of care is closed or whose childcare provider is unavailable due to COVID-19. 

(3)  The employee must have worked for the employer for at least 30 day to qualify.

(4)  The credit is based on qualifying leave provided employees between April 1, 2020 and December 31, 2020

·      Note that emergency sick leave wages paid in 2021 will qualify if paid for leave taken between April 1 and December 31,2020. 

(5)  The provision allows up to 12 weeks of employer-provided protected leave, 10 of which is creditable to the employer.

(6) The maximum (creditable) emergency family leave is the employee’s regular rate of pay, up to $200 per day and limited to $10,000 per employee.

(7) The employer is allowed to increase the credit amount by the allocable cost of the employee’s health insurance coverage.

(8)  Employers are still required to withhold employee federal income taxes and the employee’s share of Social Security and Medicare taxes.

·      The intention is that this will be covered by the $200 per day allowance.

(9)  Wages paid under the expanded family leave provision ….

a.     Are NOT be subject to employer social security (6.2%), and

b.    ARE subject to employer Medicare (1.45%)

                                                      i.     However, this employer Medicare requirement is misleading because the credit will be increased by the amount of

1.    The employer Medicare tax, and

2.    The allocable cost of health insurance coverage

(10)       The credit can be offset against all employee withholdings and employer payroll taxes.

·      Any excess is refundable to the employer.

(11)       Any credits utilized will constitute taxable income to the employer.

·      Offsetting the employer payroll tax expense on wages paid emergency leave employees.

(12)       The example given above for emergency sick leave also covers expanded family leave.

(13)       The discussion about self-employeds given above also covers expanded family leave.

(14)       There is an unusual interaction with the expanded family leave credit and the employer payroll tax deferral.

·      An employer can defer and still receive the expanded family leave credit, resulting in, in effect, an interest-free loan from the government.

(15)       This credit does not play well with the employee retention credit. In short, one cannot use the same wages for more than one credit.

(16)       The FMLA “restoration to position” provision under FMLA does not apply to employers with fewer than 25 employees and meeting certain other requirements.