Driving To South Africa

Our protagonist this time is Donald Durden. He is a pastor with the Seventh Day Adventist Church, and he was based out of Columbus, Ohio for the tax year at issue. His territory included part of Maryland, Ohio, western Pennsylvania, West Virginia, and a part of Virginia.

Got it. I am guessing the case has something to do with travel expenses.

The Church reimbursed his business-related travel expenses using both an accountable and nonaccountable plan.

I guessed right.

COMMENT: The big difference between an accountable and nonaccountable plan is whether you have to provide your employer with receipts and other paperwork. If you do, the plan is accountable and the employer can leave the reimbursement off your W-2. Fail to turn in paperwork and the plan becomes nonaccountable. The reimbursement then goes on your W-2. That used to mean that one would have to itemize and claim employee business expenses. The new tax law disallows employee business expenses, meaning that – beginning with 2018 - one has income with no offsetting deduction.

Pastor Burden claimed $41,950 of unreimbursed employee expenses when he filed his 2013 tax return.

Good grief!

The IRS wanted to know what made up this number. Actually, so do I. There were all kinds of travel in there as well as vehicle expenses and other stuff, including “special shoes.”

Let’s talk about his South Africa visit.

He claimed travel expenses of $10,897. When pressed, he did not present receipts or records, opting to explain that he was away from home on ministerial duties for 100 days. At $180 per day – which he described as the “conservative high-low method” - that comes to $18,000 and was way more than he actually deducted. Why was there an issue?

Folks, it does work like that. I presume that he was referring to a per diem, but a per diem refers to hotels, meals and incidental expenses; it does not mean the air fare to get there in the first place. Additionally, one still has to substantiate the business reason for the trip and document the number of days against which to multiply the per diem. I cannot vacation for two weeks in Europe and make it deductible just by wandering into an accountants’ office one afternoon in Budapest.  

Our pastor had a receipt or two. He elaborated that he visited the Apartheid Museum, the Robben Island Museum, Nelson Mandela’s and Bishop Tutu’s residences, and the botanical gardens.

Sounds like a vacation, murmured the IRS.

Not at all, corrected the pastor. I was working.

How were you working, asked the IRS hopefully.

I said a prayer of dedication during a ceremony.

And …?

I led daily devotions with the parishioners who travelled with me. There was also a naming ceremony. I chose Chloe for my name.

Can you get to any records? Daily schedules, appointments, anything to substantiate ….

For international travel to be deductible, the primary purpose of the trip has to be business related. It is somewhat harsh, but that is the rule. If the trip is 45% business, there is no deduction. You do not get to multiply the cost of the trip by 45 percent.

It was a really good prayer, gleamed the pastor.

He also went to the Dominican Republic. Twice. Turns out his wife has family there.

Of course, sighed the IRS. Let’s go over those records. Let’s start with how you got there.

I drove there, said the pastor.

Whaa…?

I have a log. You see, right here, yeah, in January, I drove there. I left on a Sunday and returned the next Wednesday. In September I also left on a Sunday and came back eight days later.

You can’t drive to …

Ah, here it is. You see, my log shows that I drove to South Africa too. That was in December, added the pastor, squinting his eyes while remembering.

And so it continued, including other items that we cannot discuss without sounding like The Onion.

The Court bounced pretty much everything.

The Court also kept the penalty.

This time we discussed Burden and Torres v Commissioner.

It may be my favorite case so far in 2019.

I Filed A Petition With The Tax Court

This week I put in a petition to the Tax Court.

It used to be that I could go for years without this step. Granted, I have become more specialized, but unfortunately this filing is becoming almost routine in practice. A tax CPA unwillingly to push back on the new IRS will have a frustrating career.

Heck, it is already frustrating enough.

The IRS caused this one.

We have a client. They received an audit notice near the end of 2018. They were traveling overseas. We requested and received an extension of time to reply.

Then happened the government shutdown.

We submitted our paperwork.

The client received a proposed assessment.

We contacted the IRS and were told that the assessment had been postdated and should not have gone out. Aww shucks, it was that IRS-computers-keep-churning-thing even though there were no people in the building. The examining agent had received our pack-o’-stuff and we should expect a revised assessment.

Sure. And I was drafted by the NFL in Nashville recently.

We received a 90-day notice, also known as a statutory notice of deficiency. The tax nerds refer to it as a “NOD” or “SNOD.” Believe it or not, it was dated April 15.

Let’s talk this through for a moment, shall we?

The IRS returned from the government shutdown on January 28^th.  We had an audit that had not started. Worst case scenario there should have been at least one exchange between the IRS and us if there were questions. There was no communication, but let’s continue. I am supposed to believe that an IRS agent (1) returned from the shutdown; (2) picked-up my client file immediately; (3) wanted additional paperwork and sent out a notice that never arrived requesting the same; (4) allowed time for said notice’s non-delivery, non-review and non-reply; (5) forgot to contact taxpayer’s representative, despite having my name, address, CAFR number, telephone number, fax number, waist size and favorite ice cream; (6) and yet manage to churn a SNOD by April 15^th?

I call BS.

I tell you what happened. Someone returned from the shutdown and cleared off his/her desk, consequences be damned. Forget about IRS procedure. Kick that can down the road. What are they going to do – fire a government employee? Hah! Tell me another funny story.

If you google, you will learn that there are two conventional ways to respond to a SNOD. One is to contact the IRS. The other is to file a petition with the Tax Court.

Thirty-plus years in the profession tells me that the first option is bogus. Go 91 days and the Tax Court will reject your petition. The 90 days is absolute; forget about so-and-so at the IRS told me….

What happens next? The case will return to Appeals and – if it proceeds as I expect – it will return to Examination. Yes, we would have wasted all that time to get back to where the initial examining agent failed to do his/her job.

I wish there were a way to rate IRS employees. Let’s provide tax professionals - attorneys, CPAs and enrolled agents - a website to rate an IRS employee on their performance, providing reasons why. Allow for employee challenge and an impartial hearing, if requested. After enough negative ratings, perhaps these employees could be - at a minimum - removed from taxpayer contact. With the union, it probably is too much to expect them to be fired.

You can probably guess how I would rate this one.

The Abbott Laboratories 401(k)

Something caught my eye recently about student loans. A 401(k) is involved, so there is a tax angle.

Abbott Laboratories is using their “Freedom 2 Save” program to:

… enable full-time and part-time employees who qualify for the company's 401(k) – and who are also contributing 2 percent of their eligible pay toward student loans – to receive an amount equivalent to the company's traditional 5 percent "match" deposited into their 401(k) plans. Program recipients will receive the match without requiring any 401(k) contribution of their own.”

Abbott will put money into an employee’s 401(k), even if the employee is not himself/herself contributing.

As I understand it, the easiest way to substantiate that one’s student loan is 2% or more of one’s eligible pay is to allow Abbott to withhold and remit the monthly loan amount. For that modest disclosure of personal information, one receives a 5% employer “match” contribution.

I get it. It can be difficult to simultaneously service one’s student loan and save for retirement.

Let’s take this moment to discuss the three main ways to fund a 401(k) account.

(1)  What you contribute. Let’s say that you set aside 6% of your pay.

(2)  What your employer is committed to contributing. In this example, say that the company matches the first 4% and then ½ of the next 2%. This is called the “match,” and in this example it would be 5%.

(3)  A discretionary company contribution. Perhaps your employer had an excellent year and wants to throw a few extra dollars into the kitty. Do not be skeptical: I have seen it happen. Not with my own 401(k), mind you (I am a career CPA, and CPA firms are notorious), but by a client. 

Abbott is not the first, by the way. Prudential Retirement did something similar in 2016.

The reason we are talking about this is that the IRS recently blessed one of these plans in a Private Letter Ruling. A PLR is an IRS opinion requested by, and issued to, a specific taxpayer. One generally has to write a check (the amount varies depending upon the issue), but in return one receives some assurance from the IRS on how a transaction is going to work-out taxwise. Depending upon, a PLR is virtually required tax procedure. Consider certain corporate mergers or reorganizations. There may be billions of dollars and millions of shareholders involved. One gets a PLR – period – as the downside might be career-ending.

Tax and retirement pros were (and are) concerned how plans like Abbott’s will pass the “contingent benefits” prohibition. Under this rule, a company cannot make other employee benefits – say health insurance – contingent on an employee making elective deferrals into the company’s 401(k) plan.

The IRS decided that the prohibition did not apply as the employees were not contributing to the 401(k) plan. The employer was. The employees were just paying their student loans.

By the way, Abbott Laboratories has subsequently confirmed that it was they who requested and received the PLR.

Technically, a PLR is issued to a specific taxpayer and this one is good only for Abbott Laboratories. Not surprisingly there are already calls to codify this tax result. Once in the Code or Regulations, the result would be standardized and a conservative employer would not feel compelled to obtain its own PLR.

I doubt you and I will see this in our 401(k)s.  This strikes me as a “big company” thing, and a big company with a lot of younger employees to boot.

Great recruitment feature, though.

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.

Saying Goodbye To Employee Business Expenses

Let’s talk about miscellaneous itemized deductions - likely for the last time.

These are the deductions at the bottom of the form when you itemize, and you probably itemize if you own a house and have a mortgage. Common miscellaneous deductions include investment management fees (if someone, such as Simply Money, manages your savings) and employee business expenses.

These are the “bad” expenses that are deductible only to the extent they exceed 2% of your income (AGI), because … well, because the government wants more of your money.

I am reading a case concerning a bodyguard and his employee business expenses.

His name is Rick Colbert and he retired after 30 years from the Long Beach, California Police Department. He gigged-up with Screen International Security Service Ltd (SISS) in Beverly Hills. They assigned him celebrities. He chauffeured them, deflected paparazzi, installed and monitored security devices, patrolled their estates, performed access point control and responded to distress calls.

SISS had a reimbursement policy. It did not cover everything, but it did cover a lot. Colbert did not seek any reimbursement.

He filed his 2013 tax return and reported SISS income of $25,546.

He then deducted employee business expenses of $23,965.

COMMENT: One can tell he is not in it for the money.

Those numbers are out-of-whack, and the IRS audited him. Like the IRS we know and love, they bounced all of his employee business expenses, arguing that he had not substantiated anything.

On to Tax Court they went.

The Court went through the list of expenses:

(1) $211,154 for a pistol and target practice.

Looks legit, said the Court.

(2) $86 for earbuds

To avoid annoying celebrities.

The Court grinned. OK.

(3) $1,711 for clothing and dry cleaning

Nope said the Court.

We have talked about this before. If you can wear the clothing about town and day-to-day, there is no deduction. It is just another personal expense, unless our protagonist wanted to dress up like “Macho Man" Randy Savage.

(4) $1,609 for a gym membership, weight loss pills and other stuff.

Uhh, no, said the Court, as these are the very definition of “personal, living, or family expenses.”

(5) Office in Home

This would have been nice, be he did not use space “exclusively” for the office, which is a requirement. This would hurt a send time when the Court got to his …

(6) iPad and printer

Computers are like cars when it comes to a tax deduction: you have to keep records to document business use. The reason you never hear about this requirement is because of a significant exception – if you keep the computer in an office you can skip the records requirement.

When Colbert lost his office-in-home, he picked-up a record-keeping requirement. He lost a deduction for his iPad, printer and supplies.

(7) $5,003 for his cellphone

It did not help that his internet and television were buried in the bill.

The Court disallowed his cellphone, which amazes me. Seems to me he could have gone through his bills and highlighted what was business-related.

He won some (primarily his mileage) but lost most.

And his case is now among the last of its kind.

Why?

The new tax bill does away with employee business expenses, beginning in 2018. There is NO DEDUCTION this year.

If you have significant employee business expenses, you really, really need to arrange a reimbursement plan with your employer. Your employer can deduct them, even though you cannot. Why the difference?

Because, to your employer, they are just “business expenses.” 

When The IRS Says Loan Repayments Are Taxable Wages

Here is a common-enough fact pattern:

(1) You have a company.

(2) You loan the company money.

(3) The company has an unprofitable stretch.

(4) Your accountant tells you to reduce or stop your paycheck.

(5) You still have bills to pay. The company pays them for you, reporting them as repayments of your loan.

What could go wrong?

Let’s look at the Singer Installations, Inc v Commissioner case.

Mr. Singer started Singer Installations in 1981. It was primarily involved with servicing, repairing and modifying recreational vehicles, although it also sold cabinets used in the home construction.

After a rough start, the business started to grow. The company was short of working capital, so Mr. Singer borrowed personally and relent the money to the company. All in all, he put in around two-thirds of a million dollars.

PROBLEM: Forget about the formalities of debt: there was no written note, no interest, no repayment schedule, nothing. All that existed was a bookkeeping entry.

The business was growing. Singer had problems, but they were good problems.

Let’s fast-forward to 2008 and the Great Recession. No one was modifying recreational vehicles, and construction was drying up. Business went south. Singer had tapped-out his banks, and he was now borrowing from family.

He lost over $330 grand in 2010 and 2011 alone. The company stopped paying him a salary. The company paid approximately $180,000 in personal expenses, which were reported as loan repayments.

The IRS disagreed. They said the $180 grand was wages. He was drawing money before and after. And – anyway – that note did not walk or quack like a real note, so it could not be a loan repayment. It had to be wages. What else could it be?

Would his failure to observe the niceties of a loan cost him?

Here is the Court:

We recognize that Mr. Singer’s advances have some of the characteristics of equity – the lack of a promissory note, the lack of a definitive maturity date, and the lack of a repayment schedule …”

This is going to end poorly.

 … but we do not believe those factors outweigh the evidence of intent.”

Wait, is he going to pull this out …?

 … because intent of parties to create [a] loan was overwhelming and outweighed other factors.”

He won …!

However, we cannot find that all of the advances were loans.”

Then what would they be?

While we believe that Mr. Singer had a reasonable expectation of repayment for advances made between 2006 and 2008, we do not find that a similarly reasonable expectation of repayment existed for later advances.”

Why not, Sheldon?

 After 2008 the only source of capital was from Mr. Singer’s family and Mr. Singer’s personal credit cards.”

And …?

No reasonable creditor would lend to petitioner.”

Ouch.

The Court decided that advances in 2008 and earlier were bona fide loans. Business fortunes changed drastically, and advances made after 2008 were not loans but instead were capital contributions.

This “no reasonable creditor would lend” can be a difficult standard to work with. I have known multimillionaires who became such because they did not know when to give up. I remember one who became worth over $30 million – on his third try.

Still, the Court is not saying to fold the company. It is just saying that – past a certain point – you have injected capital rather than made a loan. That point is when an independent third party would refuse to lend money, no matter how sweet the deal.

Why would the IRS care?

The real-world difference is that it is more difficult tax-wise to withdraw capital from a business than it is to repay a loan. Repay a loan and you – with the exception of interest – have no tax consequence.

Withdraw capital – assuming state law even allows it – and the weight of the tax Code will grind you to dust trying to make it taxable – as a dividend, as a capital gain, as glitter from the tax fairy.

It was a mixed win for Singer, but at least he did not have to pay taxes on those phantom wages.

Worst. Tax. Advice. Ever.

Dad owned a tool and die company. Son-in-law worked there. The company was facing severe foreign competition, and - sure enough - in time the company closed. For a couple of years the son-in-law was considerably underpaid, and dad wanted to make it up to him.

The company's accountant had dad infuse capital into the business. The accountant even recommended that the money be kept in a separate bank account. Son-in-law was allowed to tap into that account near-weekly to supplement his W-2. The accountant reasoned that - since the money came from dad - the transaction represented a gift from dad to son-in-law.

Let's go through the tax give-and-take on this.

In general, corporations do not make gifts. Now, do not misunderstand me: corporations can make donations but almost never a gift. Gifts are different from donations. Donations are deductible (within limits) by the payor and can be tax-free to the payee, if the payee has obtained that coveted 501(c)(3) status. Donations stay within the income tax system.

Gifts leave the income tax system, although they may be subject to a separate gift tax. Corporations, by the way, do not pay gift taxes, so the idea of a gift by a corporation does not make tax sense.

The classic gift case is Duberstein, where the Supreme Court decided that a gift must be made under a "detached and disinterested generosity" or "out of affection, respect, admiration, charity or like impulses." The key factor the Court was looking for is intent.

And it has been generally held that corporations do not have that "detached and disinterested" intent that Duberstein wants.  Albeit comprised of individuals, corporations are separate legal entities, created and existing under state law for a profit-seeking purpose. Within that context, it becomes quite difficult to argue that corporations can be "detached and disinterested."

It similarly is the reason - for example - that almost every job-related benefit will be taxable to an employee - unless the benefit can fit under narrow exceptions for nontaxable fringes or awards. If I give an employee a $50 Christmas debit card, I must include it in his/her W-2. The IRS sees an employer, an employee and very little chance that a $50 debit card would be for any reason other than that employment relationship.   

What did the accountant advise?

Make a cash payment to the son-in-law from corporate funds.

But the monies came from dad, you say.

It does not matter. The money lost its "dad-stamp" when it went into the business.

What about the separate bank account?

You mean that separate account titled in the company's name?

It certainly did not help that the son-in-law was undercompensated. The tax Code already wants to say that all payments to employees are a reward for past service or an incentive for future effort. Throw in an undercompensated employee and there is no hope.

The case is Hajek and the taxpayer lost. The son-in-law had compensation, although I suppose the corporation would have an offsetting tax deduction. However, remember that compensation requires FICA and income tax withholding - and no withholdings on the separate funds were remitted to the IRS - and you can see this story quickly going south. Payroll penalties are some of the worst in the tax Code.

What should the advisor have done?

Simple: have dad write the check to son-in-law. Leave the company out of it.