A Wake for Flanagans

Have you got a restaurant to sell? If you do, you may want to hear the story of John Psihos (JP) and Flanagan’s Restaurant.

JP was a Greek immigrant who came to the U.S. in his 20s. He did very well and eventually owned three restaurants in the north Chicago area: Flanagan's, Cafe Oceana and Full Moon. Flanagan's was the most successful. He seemed to be a good employer, willing to help his employees. He was also generous in his charitable pursuits.

The problem was that JP was keeping a double set of books on Flanagan’s. He used the second set to prepare his tax returns, a ruse undetected until he tried to sell the restaurant. JP listed the restaurant through a broker, providing a fact sheet showing his average monthly receipts at $170,000 and average yearly operating profit at approximately $554,000. These numbers were from the first set of books.

This caught the IRS’s attention.

The IRS dispatched two special agents who posed as husband and wife. They met three times with JP, who explained how he kept track of the actual receipts at Flanagan’s. Each night at closing the managers would assemble envelopes with all of the money, as well as receipts, register tapes and payout sheets. Standard stuff for a restaurant. JP then provided this material to one of his managers, who prepared weekly summaries. JP, feeling brave, provided these summary sheets to the two “buyers,” stating further that he had these records going back to 2001 showing what he “really got” from Flanagan’s.

The two agents executed a search warrant on one of JP’s restaurants, seizing, among other things, the weekly summary sheets. They also seized records detailing Flanagan’s nightly sales and cash payouts. The IRS reviewed these records to recalculate the actual gross receipts for years 2001 through 2004. They determined that JP had underreported his receipts by over $3 million over the four years. He was indicted on felony charges by a federal grand jury.

One has to give JP credit for the chutzpah he displayed before the District Court. He argued that he had left out all kinds of expenses, such as:

·        Amounts paid to DJ’s

·        Cash wages

·        Complimentary food and drinks

·        Payments to Café Oceana for food supplied

He even prepared a chart which he presented to the Court. According to his analysis, the actual loss to the government was approximately $22 thousand. He argued that the Court had to give him credit for the expenses he didn’t claim because, well, you know, he hadn’t wanted to double dip. He had a conscience, after all. The Court was having none of this and observed that the expenses were undocumented except for his word and that his word was not credible. The Court ordered him to pay more than $800 grand and go to jail for a couple of years

My Take: JP could not have this both ways. Once he decided to underreport his gross receipts to the IRS, he then had to consistently underreport for all purposes, including any sale listing. I am not making a moral call here, just observing how this works.

Once caught, there was little hope that anyone would believe him about unclaimed expenses. How credible was he at that moment? 

And why would someone go to all this effort if the end result was only $22 thousand?

What does it tell you that the IRS became aware of (a) the sale listing and (b) correlated it to gross receipts on Flanagan’s tax return? Remember: tax information is supposed to be confidential. Returns are not supposed to be laying around on someone’s desk or kitchen table. Are you telling me that someone “remembered” Flanagan’s gross receipts? Could it be that JP was already under scrutiny? The court decision does not give us background on this point, although it is this point that I find chilling. I can almost hear JP saying “how would they ever know?” I agree: how did they know?

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.