A Penalty Against A Tax Preparer

 

Did you know that the IRS can assess penalties against a tax preparer as well as a taxpayer?

I am looking at an IRS Chief Counsel Memorandum recommending a preparer be penalized for a deduction on a client return.

You do not see that every day.

Let’s talk about it.

As is our way, we will streamline the issue so that it is something you might want to read and something I might want to write.

A taxpayer accrued expenses on its books for customer early payment discounts and estimated write-offs for disputed billing and shipping charges.

Sure, easy for a CPA to say.

Let’s clarify. The company sold stuff. It allowed discounts if a customer paid early. It also had routine billing disputes – for quantity, quality, price, damage and so on. As part of its general accounting, it estimated these charges and recorded them as expenses when the related sale was recorded.

Makes sense to me. Generally accepted accounting wants one to record all related expenses when the sale is recorded. This is called the “timing principle,” and the idea is to present net profit from a sales transaction as well as reasonably possible. What if all the expenses are not known at that precise moment - say, for example - the amount of product that will be returned because of damage in shipping? Generally accepted accounting will allow one to estimate that number, normally by statistical analysis of historical experience.

BTW you better do this if you expect to have your financial statements audited. Part of an audit is a review of your accounting method, and the “estimate that number” described above is considered a best-of-breed.

Generally accepted accounting might not work when you get to your tax return, however. Why? Well, generally accepted accounting is trying to get to the “best” number in an economic sense. Tax accounting is not trying to get to the “best” number; rather, it is trying to measure your ability to pay. Pay what? Taxes, of course.

Let’s go back to our taxpayer. They estimated a bunch of expenses when they recorded a sale. They included those numbers on their financial statements. They then wanted to deduct those same numbers on their tax return.

Problem:

The taxpayer utilized statistics to record the expenses for the two items. The courts held that statistics were not a valid method to record the amounts.”

Their CPA firm had to review the accounting method and decide whether it was acceptable for tax purposes.

There is even a Code section and Regulations:

           Reg § 1.461-1. General rules for taxable year of deduction

(a)(2) Taxpayer using an accrual method.

(i) In general. Under an accrual method of accounting, a liability (as defined in §1.446-1(c)(1)(ii)(B)) is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. 

 

You see that last sentence and its reference to “economic performance?”

 

For generally accepted accounting, one must:

        

·      Establish the fact of the liability.

·      Measure the amount of the liability with reasonable accuracy.

 

Tax then adds one more requirement:

        

·      Economic performance on the liability must have occurred.

 

That third requirement is what slows down the tax deduction.

 

What is an example of economic performance?

 

Say that you record expenses for services related to the sale. Economic performance wants to see those services performed before allowing the deduction. What if you know - because it has happened millions of times before and can be calculated with near-arithmetic certainty – that the services will occur? Tax doesn’t care.  

 

But the auditors signed-off on the financial statements, you say. Doesn’t that mean that experts agreed that the accounting method was valid?      

A taxpayer’s conformity with its accrual method used for financial accounting purposes does not create a presumption that its tax accrual method clearly reflects income.”

And there you have a brief introduction to why a company’s financial statements and its tax return might show different numbers. Financial statement accounting and tax accounting serve different purposes, and those differences have real-world consequences.

 

In this situation, I side with the IRS. Work in a CPA firm for any meaningful period and you will see tax people repetitively “tweak” the audit people’s numbers. It happens so often it has a term: “M-1.” Schedule M-1 is a tax schedule that reconciles the profit per the financial statements to the profit per the tax return. The possible list of differences is near endless:

 

·      Entertainment

·      Depreciation

·      Allowance for uncollectible receivables

·      Accrued bonuses

·      Reserve for warranties

·      Deferred rent

·      Controlled foreign corporation income

·      Opportunity zone income

 

And on and on. Knowing these differences is part of being a tax pro.

 

The Chief Counsel wanted to know why the tax pros at this particular CPA firm did not know that this generally accepted accounting method would not work for purposes of the tax return.

 

To be fair, methinks, because it is complicated …?

 

No dice, said the Counsel’s office. The preparer should have known.

 

The items deducted constituted a substantial part of the return. 

TRANSLATION: It was a big deduction.

And therefore the preparer penalty is appropriate.  

TRANSLATION: Someone has to pay.

Mind you, a Chief Counsel memorandum is internal to the IRS. The taxpayer – and by extension, its CPA firm – might appeal the matter to the Tax Court. I would expect them to, frankly. The memorandum is just the IRS’ side.

For the home gamers, today we have been discussing Chief Counsel Memorandum 20223301F.

 

A Failure To Keep Records

You have to keep records.

Depending upon, this can be easy. Say that you have a job and a money market account – two sources of income. At year-end you receive a W-2 and a 1099-INT. File them with your individual tax return and you have kept records.

Dial this up to business level and the recordkeeping requirement can be more substantial.

Maybe you do not need a bookkeeper or accountant, but you can open a separate business bank account, running all deposit and disbursements through it. You can buy an expanding file – one with a pocket for each month – and keep invoices and receipts throughout the year. That might not be sufficient were you a regional contractor, with equipment and employees and whatnot, but it may be more than enough for what you do.

Why do this?

Because of taxes.

There is a repetitive phrase in tax cases - I have read it a thousand times:

Deductions are a matter of legislative grace, and the taxpayer must prove his or her entitlement to deductions.”

To phrase it another way:

Everything is taxable and nothing is deductible unless we say it is deductible.

One of the things the IRS says is that you must keep records. You can extrapolate what the IRS can do to you concerning deductions if you do not.

“But they can’t eat me, right, CTG?” you ask.

No, but here is what they can do.

Sam Fagenboym was a 50% owner of Alcor Electric, which provided electrical installation for midsize commercial projects. Alcor was a sub to a general contractor. Alcor in turn had suppliers and its own subs.

With the possible exception of the second round of subs, this is pretty routine stuff.

Alcor was an S corporation. It allocated Fagenboym a loss of approximately $110,000 on his 2015 Schedule K-1.

The IRS examined Alcor’s 2015 business return.

Alcor could not document over a quarter million dollars of purchases from a supplier.

Half of that audit adjustment went to Fagenboym, as he was a 50% owner.

The IRS next looked at Fagenboym’s personal return.

So much for the loss he had claimed from Alcor.

Fagenboym went to Tax Court. He went pro se, generally meaning that he was without tax representation.  As we have discussed before, that technically is not correct, as I could represent someone in Tax Court and they would be considered pro se.

Fagenboym argued for Cohan treatment of Alcor’s business expenses.

COMMENT: I would have expected Alcor to fight this issue during its business audit, but here is Fagenboym doing the fighting during his individual audit.    

Cohan is old tax case, going back to 1930 and involving someone who was known for entertaining but not for keeping receipts and records. The Court considered his situation, reasoning there was no doubt that Cohan had incurred expenses. It would be inequitable to disallow all expenses, so the question became: how much to allow?

Cohan has triggered tax changes ever since. It was responsible for the hyper-technical rules concerning meals and entertainment, for example, as well as business use of a vehicle.

Fagenboym wanted some of that Cohan.

I presume there truly were no records. There is no way that I would lead with Cohan if I had any other argument.

Why?

Think about it from the Court’s perspective.

(1) The Court will require a rational basis to estimate the expenses, and

(2)  The Court will consider the taxpayer’s culpability in creating this situation.

Perhaps if there were extenuating circumstances: illness of a key employee, a data loss, a pandemic, something that compromised the taxpayer.  The more one is responsible for causing the mess, the less likely the Court will be to clean-up the mess.

Fagenboym tried. He presented the Court with estimates of job profitability. He then subtracted labor and other known expenses to arrive at what the missing purchases should have been. He submitted four pages of handwritten analysis, but he did not or could not support it with business bank statements or other records, such as an accounts payable history for the supplier in question. Despite how earnest he seemed and how well he understood the business, there were no records backing him up.

Fagenboym could not overcome the two factors above. Even if the Court allowed some leniency on his culpability, it decided it could not independently arrive at a reasonable estimate of the costs involved.

No Cohan. No tax deduction. Bad day in Court for Fagenboym.

Estimated Taxes Matter

Sometimes I read a case and I wonder if the most interesting part was not included.

There is a couple – a doctor and a financial consultant - who are not keen on paying their taxes. Here is a quick recap:

          Year            Tax           Withheld         Due

          2014         $70,018      $24,148         $45,870

          2015         $58,293      $11,677         $45,995

          2016         $52,474      $20,230         $32,244

          2017         $37,001      $11,720         $25,281

This is not rocket science. Chances are that one person has withholdings and the other person is supposed to pay estimated taxes. No estimated taxes were paid. The solution? Simple: (1) pay estimated taxes, or (2) increase the other spouse’s withholdings to compensate for the lack of estimated taxes.

On November, 2016 the IRS sent a Notice of Intent to Levy.

COMMENT: This tells you the taxpayers had been in the system for a while.

The taxpayers requested for a Collection Due Process Hearing.

COMMENT: Good step. The CDP is a chance to halt the IRS automated machinery and allow the taxpayers an opportunity to speak with an Appeals Officer about their specific situation.

The taxpayers were interested in collection alternatives, including:

(a)  an installment agreement

(b)  an offer in compromise

(c)  a “cannot pay balance” status

Seems to me they covered the bases.

They did not submit financial data with the CDP request, but they did later when the Appeals Officer requested. Their information showed monthly income of $25,317 and monthly living expenses of $17,217, leaving a monthly net of $8,100.

The IRS wanted the $8,100.

Surprise factor: zero.

The taxpayers balked, arguing that it was beyond their means.

COMMENT: How can the $8,100 be beyond their means, if that is the amount they calculated? The likely reason is that the IRS has tables for certain expense categories, such as transportation. Say that you have an expensive monthly car payment. You will bump up against that limit, and good luck getting the IRS to spot you more. Mind you, the IRS says that it will consider specific circumstances, but they do not consider them for long. You may find yourself having to trade-down on your car or pulling your kid from private school.

The taxpayers indicated they were going to file an offer in compromise.

They did – eight months later.

COMMENT: Folks, seriously, do not do this. If you are hip deep in a CDP hearing with the IRS, it is a very poor decision to stall.

The Appeals Officer – not willing to wait the better part of a year – sustained the proposed levy.

Next stop: Tax Court.

From the Court we learn that the taxpayers withdrew the offer in compromise because they were “unable” to make estimated tax payments.

Huh?

Folks, this act is fatal. Here is a requirement for an offer:

“Proof of sufficient withholding or estimated tax payments”

The Tax Court’s purview can be broad or narrow, depending on the issue. If there is an issue of tax law, the Court generally has broad powers. This case was not an issue of tax law; rather it was an issue of IRS procedure. Did the IRS follow its own rules? To phrase it another way, did the IRS abuse its authority?

This narrows the Court’s reach – a lot.

It means the Court is not reviewing whether the taxpayers should have received an installment plan, an offer in compromise or whatnot. Rather, the Court is reviewing whether the IRS abused its authority by not allowing said installment plan, offer in compromise or whatnot.

The Court decided the IRS had not.

Why?

“Proof of sufficient withholding or estimated tax payments”

To me, the take-away question is: what are these people doing with their money?

Our case this time was Reid v Commissioner.

Bill And The Gig Economy

I am inclined to title this post “Bill.”

I have known Bill for years. He lost his W-2 job and has made up for it by taking one or two (or three) “independent contractor” gigs.

However, Bills get into tax trouble fast. Chances are they burned through savings upon losing the W-2 job. They turned to that 1099 gig when things got tight. At that point, they needed all the cash they could muster, meaning that replenishing savings had to wait.

The calendar turns. They come to see me for their taxes.

And we talk about self-employment tax for the first time.

You and I have FICA taken from our paycheck. We pay half and our employer pays half. It becomes almost invisible, like being robbed while on vacation.

Go self-employed and you have to pay both sides of FICA – now called self-employment tax – and it is anything but invisible. You are paying approximately 15% of what you make – off the top - and we haven’t even talked about income taxes.

You find yourself in a situation where you probably cannot pay – in full, at least – the tax from your first contractor/self-employment year.

We need a payment plan.

But there is a hitch.

What about taxes on your second contractor/self-employment year?

We need quarterly estimated taxes.

You start to question if I have lost my mind. You cannot even pay the first year, so how are you going to pay quarterly taxes for the second year?

And there you have Bill. Bills are legion.

We arrange a payment plan with the IRS.

You know what will likely blow-up a payment plan?

Filing another tax return with a large balance payable.

All right, maybe we can get the first and second year combined and work something out.

You know what will probably blow-up that payment plan?

Filing yet another tax return with a large balance payable.

Depending upon, the IRS will insist that you make estimated tax payments, as they have seen this movie too.

A taxpayer named Allen ran into that situation.

Allen owed big bucks – approximately $93,000.

The IRS issued an Intent to Levy.

He requested a CDP (Collections Due Process) hearing.

COMMENT: The CDP process was created by Congress in 1998 as a means to slow down a wild west IRS. The idea was that the IRS should not be permitted to move from compliance and assessment (receive your tax return; change your tax return) to collection (lien, levy and clear out your bank account) without an opportunity for you to have your day.  

Allen submitted financial information to the IRS. He proposed paying $500 per month.

The IRS reviewed the same information. They thought he could pay $809 per month.

COMMENT: You would be surprised what the IRS disallows when they calculate how much you can repay. You can have a pet, for example, but they will not allow veterinarian bills.

There was a hitch. Monthly payments of $809 over the remaining statute of limitations period would not sum to $93,000. The IRS can authorize this, however, and it is referred to as a partial-pay installment agreement (PPIA).

EXPLANATION: Any payment plan that does not pay the government in full over the remaining statutory collection period is referred to as a “partial pay.” The IRS looks at it more closely, as they know – going in – that they are writing-off some of the balance due.

The IRS settlement officer (SO) read the Internal Revenue Manual to say that a taxpayer could not receive a partial pay if he/she was behind on their current year estimated taxes. Allen of course was behind.

Allen said that he could not pay the estimate.

The SO closed the file.

Allen filed with the Tax Court.

Mind you, Allen was challenging IRS procedure and not the tax law itself. 

He had to show that the IRS “abused” its discretion.

It would be easier to get a rhinoceros on a park swing.

I get it, I really do. Take two SO’s. One denies you a partial pay because you are behind on estimated taxes; the other SO does not. That however is the meaning of “discretion.”

Did Allen’s SO “abuse” discretion?

The Tax Court did not think so.

Allen lost.

But there is something here I do not understand.

Why didn’t Allen make the estimated tax payment, revise his financial information (to show the depletion of cash) and forward the revised financials to the SO?

I presume that he couldn’t: he must not have had enough cash on hand.

If so, then abuse of discretion makes more sense to me: someone in Allen’s situation could NEVER meet that SO’s requirement for a payment plan.

Why?

Because he/she could never make that estimated tax payment.