A Church Contribution Story: Durden

Our next two blogs discuss tax fails involving charitable contributions.

What each has in common is congressional resolve to address an area considered subject to tax abuse. How so? How many times has someone overvalued a Goodwill clothing donation, for example? Congress therefore placed restrictions – primarily documentation requirements – on one’s ability to deduct contributions. The general tax rule is simple: no documentation equals no deduction.  The key is to understand what Congress considers documentation, as your understanding may be different from theirs.

Let’s talk about Durden.

David and Veronda Durden contributed $25,171 in 2007 to the Nevertheless Community Church. With the exception of five checks (totaling $317), all checks were over $250.

FIRST RULE: Under Code Section 170(f)(8)(A), no deduction is allowed for any contribution of $250 or more unless taxpayer has contemporaneous written acknowledgment of the contribution by the charity organization that meets specified requirements.

The Durdens cleared the first rule, as they had a letter from the church dated January 10, 2008.

SECOND RULE: Under Code Section 170(f)(8)(B), the charity must state in the acknowledgment whether it provided any goods or services as consideration for the contributed property or cash. If so, it must include a description and good faith estimate of the value of any goods or services provided.

There is a problem: the church did not include language “no goods and services have been provided” in their letter.

The Durdens obtained a second letter dated June 21, 2009 containing the same information found in the first letter, plus a statement that no goods or services were provided in exchange for the contributions.

THIRD RULE: Code Section 170(f)(8)(C) considers the acknowledgment as contemporaneous if obtained on or before the earlier when the tax return is due or the actual filing date.

The IRS disallowed all but $317 of the charitable deduction for insufficient documentation. The Durdens go to Tax Court. Their argument is reasonable: we substantially complied with the spirit of the law. We had a letter. It might not be exactly the letter the IRS wanted, but we had a letter. When the IRS wanted more, we got them more. The IRS went too far in disallowing the deduction when everyone knows we gave to the church. We even showed them cancelled checks.  The wording in Code Section 170(f)(8)(C) is only one way – a safe harbor maybe – of meeting the “contemporaneous” standard.

The Tax Court disagreed. It noted that Congress intended to tighten the rules in this area and placed specific language in the Code requiring and defining “contemporaneous.” This was not the IRS’ doing; it was Congress’ doing.  The Court in the past had been lenient in cases involving substantial procedural compliance. This was not procedure. This was legislative compliance, and the matter was outside the Court’s hands.

The Durdens did not have the correct letter when they filed their return. That is the last possible date according to the law. There is no deduction. The Court did let them deduct $317, however. Since those individual contributions were under $250, those didn’t require a letter.

MY TAKE: I can understand Congress passing near-incomprehensible tax law to address complex and sophisticated tax issues. Those taxpayers are likely to have expert tax advisors and planners. This is not one of those issues. This is someone donating to a church. I strongly disapprove of routine activities triggering tax rules that make no sense to an average person.  

Congress should have included a “sanity” clause in this statute. They could have given the IRS discretion to accept “other but equal” documentation. True, the IRS could refuse to do so, but at least there would be a chance that the IRS – or a court reviewing the IRS – could blunt the capriciously sharp edge of this tax law.

Next time we will talk about Mohamed.

Do Tax Preparers Get Penalized On Their Own Returns?

Do tax preparers ever get penalized by the IRS on their own returns?

We are going to look at one today: Joyce Anne Linzy (JAL). She is party to a Tax Court Memorandum Decision issued on November 7, 2011.

JAL is a tax preparer with more than 15 years’ experience. During 2007 she operated an income tax return preparation business. She owned an apartment building in which she both lived and worked: the business was on the first floor and she lived on the second floor. She also rented out second-floor space that she did not use as a residence.

There were a number of proposed IRS adjustments for the Court to consider:

1.    JAL omitted $2,500 of gambling income.

This is actually the least of her problems.

2.    JAL claimed almost $35,000 of contract labor.

There is no problem with claiming this deduction, but the IRS expects one to maintain documentation to substantiate the deduction upon examination. Here is the Court’s language on this matter:

“Petitioner presented canceled checks, bank account statements, receipts and invoices purporting to substantiate various items claimed as business expenses deductions. These records are not well organized, and have not been submitted to the Court in a fashion that allows for easy association with the portions of the deductions that remain in dispute. Nonetheless, we make what sense we can with what we have to work with…”

The Court is trying to work with JAL. They are referring to the Cohan rule: if the Court knows that a taxpayer incurred an expense, it can (with some statutory exceptions) allow estimates of the actual expenses. JAL must be quite the tax adept, though, as the Court goes on…

“None of the numerous receipts petitioner offered in support of her claimed contract labor expense were for contract labor.”

“The checks are photocopied such that the dates are missing or incomplete, and the full amount cannot be determined…”

Oh, oh.

“These records are incomplete, and there is not enough information to permit a reasonable estimate. Accordingly, respondent’s complete disallowance of petitioner’s … deduction for contract labor is sustained.”

3.    Mortgage interest

JAL used one-third of the building for her tax return business. She deducted one-half of the mortgage interest as a business expenses.

Seems like simple math.

4.    Depreciation

During 2007 she purchased several depreciable items. She did not depreciate the cost of these items but instead claimed the costs as contract labor expenses.

Some of these items could not be immediately expensed under Section 179 because they related to building improvements. These items included siding and tuck pointing. Buildings of course have a long depreciation life, so the swing between immediately expensing and depreciating over many years is magnified.

There was no fallback position here for JAL.

5.    Charitable contributions

You may be aware that you are required to get a timely statement from the charity describing the contribution and that you received nothing of monetary value in return, or to estimate the amount if there was monetary value. You are supposed to have this in hand before you file your return.

JAL seems to have forgotten this.

She deducted a $2,500 donation to Schneider School.

Here is the Court:

               

“Although petitioner received a receipt from the Chicago Public Schools, it does not qualify as a contemporaneous written acknowledgement because it does not state whether she received any goods or services in return for her contribution.”

She deducted a $7,500 donation to Faith Deliverance.

Again, here is the Court:

               

“The letter does not state whether petitioner received goods or services in exchange for contribution and was not received by the earlier of her return’s filing date or its due date…. Thus there is no contemporaneous written acknowledgement from the donee that would permit petitioner to deduct the contributions.”

6.    The substantial understatement penalty

This is a “super penalty” if you misstate your taxable income by too much. The IRS defines “too much” as more than 10% of the final tax but at least $5,000.

JAL had no problem leaping over this hurdle.

The IRS can waive this penalty if one has “reasonable cause.” There are a number of factors that constitute reasonable cause, but a common one is reliance on a tax professional. In fact, I drafted a letter this week requesting abatement of this very penalty, and the reason I gave was their reliance on a tax professional. What happens, however, when you are a tax professional and it is your OWN tax return?

Here is the Court:

“Petitioner’s records were insufficient to substantiate several of her claimed deductions, and she failed to keep adequate books and records. Furthermore, petitioner, a tax return preparer with more than 15 years experience, improperly deducted….Petitioner offered no evidence that she acted with reasonable cause and in good faith. Accordingly, we hold that petitioner is liable … due to negligence or disregard of rules or regulations.”

The penalty alone was over $3,100.

What can I say about JAL?

A lesson here is that the Tax Court is going to hold a professional preparer to a higher standard. Now, JAL was not an attorney, CPA or enrolled agent, but when she stepped into “professional preparer” shoes the Court was going to be less lenient. It is not unreasonable, as others pay you for knowing more about the tax system than the average person. It seems to me that JAL did not rise to the occasion.

Another Warning on Deducting Auto Expenses

There is a very recent case concerning tax deductions for business use of a vehicle that I am considering as mandatory reading for many of our clients.

The pattern is repetitive. Either the business provides the car or the employee uses his/her car for business and is not reimbursed. Tax time we ask the following questions: what is your mileage? What do you have as documentation to support that mileage? We review the danger associated with this tax deduction (the IRS will disallow it if you cannot back it up), to which it seems most of the clients roll their eyes and go “yea, yea.”

Well, Jessica Solomon just got schooled. It’s a shame, too, as it sounds like Jessica was trying to do the right thing, but she just didn’t know what that meant. Let’s look at Jessica Solomon v Commissioner.

Jessica Solomon moved from Illinois to Missouri in 2006. First, let me say that I went to the University of Missouri, so I approve of her move. Second, she started work as a commission-only salesperson for seven months – June through December. She was peddling office supplies. Every day she started the morning at the company office in St Louis, and at the end of the day she finished with an evening meeting there. She only made $3,307 in commissions. Considering that she was reimbursed for NOTHING, it sounds to me like this was a waste of her time.

She kept a log in her car. At the start of the day she wrote down her mileage, and at the end she noted her mileage. Unfortunately, there was no other information, such as the towns, prospects or customers she was visiting. It was bare-boned, but it was something.

At the end of the year she went to H&R Block. They deducted her business expenses, including 18,741 business miles.

In January, 2009 the IRS issued a statutory notice disallowing all her mileage and employee expenses for 2006. Jessica, bless her heart, went to Tax Court representing herself (this is called “pro se”). It did not go well for Jessica.

Unfortunately, the court was right. Let’ go through this…

* It is an axiom in tax practice that deductions are a matter of legislative grace. This is fancy way of saying that there is no deduction just because you really, really want there to be one.
* If a taxpayer presents credible evidence on a factual issue concerning tax liability, Code Section 7491(a) shifts the burden of proof to the IRS.
* If Section 7491(a) kicks in, the IRS (or Court) may even estimate the amount of expenses, if the supporting documentation is poor or even nonexistent.
* There are some expenses where the burden of proof does not shift under Section 7491(a).
* A car is one of those expenses. Car expenses are addressed under Section 274(n).
* Section 274(n) says that no deductions are allowed with respect to listed property (think a car) unless very specific documentation requirements are met:

** The amount
** The time and place
** The business purpose
** The taxpayer’s relationship with the persons involved

The Court looked at her log. The court had several problems;

(1) The log noted only the beginning and ending mileage for each day

(2) The log included a 27 mile commute

(3) The log may have included personal trips

So far, I could have worked with this. I would ask Jessica for a Day Runner or some other record of who she visited, where and etc. In fact, had she submitted contact reports to the company, I would ask the company to provide copies for her tax audit. I need corroborating evidence. The evidence does not have to be on the same sheet of paper. In truth, it need not even had been created at the time, although that would of course carry more weight.

Unfortunately Jessica could not do this. Here is the Court:

Petitioner did not present any evidence at trial, such as appointment books, calendars, or maps of her sales territories, to corroborate the bare information contained in the mileage log…”

But the court KNEW that she had to use her car – right? Surely the Court would spot her something.

Although we do not doubt that petitioner used her Chevrolet Cavalier for business between June and December, 2006, we have no choice but to deny in full petitioner’s deduction for mileage expenses. For reasons discussed …, petitioner’s mileage log does not satisfy the adequate records requirement of Section 274(d).”

No mileage deduction for Jessica.

As I said, perhaps this case should be mandatory reading for many of our clients.