Kentucky To Tax Prediction Markets

 

Something landed in my inbox about Kentucky HB 757.

So I am reading about prediction markets.

You have probably heard of these things: they are being used as an oracle of a sort. What are the odds that so-and-so will be elected to the political office of such-and-such in whatever state this fall? It is more than a poll, as people are wagering hard cash. I may tell a pollster just about anything to wrap-up the call, but I am certainly not parting with money.

I read that Kentucky will impose a 14.25% transaction tax on “event contracts” beginning January 1, 2027.

I get the concept of an “event contract.” It is a binary arrangement between two parties, with the contract resolving as either a “yes” or a “no.” To me the perfect example is a sports game: either the Reds will win or they will lose when they play the Mets on May 27. Bet your heart out accordingly.

I would have thought that these transactions were already being taxed.

Here is the point: they are not.

It is due to technology.

The sports betting you and I grew up with involved a house, a handle and the house establishing the odds. The key here is that the house (or DraftKings, FanDuel or whatever) received the bets, determined the handle and odds, paid-out the winners, and kept the difference (the “juice”).

The above is called “betting,” folks. It was taboo in major professional sports until the 2018 Supreme Court decision in Murphy v NCAA. Those of us who have been around for a moment remember the NFL barring Tony Romo from attending a fantasy football convention in Las Vegas, which act seems quaint today as gambling commercials blare at us on football Sundays. Fantasy was considered too close to betting, and sports betting would diminish the integrity of the game. Fast forward and the NFL started partnering with DraftKings and FanDuel in 2021.  Heck, they have probably had a baby by now.

The “new” sports betting is cribbing on territory belonging to futures contracts: both are considered derivatives and both are regulated by the Commodity Futures Trading Commission (CFTC).

Let’s say you and I bet on the May 27 Reds game.

Here is Robinhood:

This is easy: I will pay you 49 cents on the dollar that the Reds will win. If the Reds win. I win a dollar. If the Reds lose, I lose 49 cents. There will also be commissions and such, because … of course.

The fiction here is that you and I are not betting. We are instead “investing” in “financial instruments” subject to the CFTC. Granted, one of us will win and the other lose as the “event contracts” settle, but we are not “betting.” We are competing against each other on future events. We are not betting against a house, as that would describe a sportsbook. Nothing to see here, officer. Have a good day.

Hit somebody’s wallet and they will deny the very law of gravity.  

Almost 90% of these “financial instruments” are tied to sports betting.

This my shocked face: 

           

The effect of this is to remove the prediction markets from the routine and customary state gambling regulatory apparatus.

Which means that state taxes are taking a hit as money leaves their sportsbooks.

Enter Kentucky.

Since 2023 Kentucky has levied a 9.75% tax for on-track wagers and 14.25% for online and mobile wagers.  The last time I checked, the horse racing industry was contributing upwards of $200 million annually to state tax revenue. You can bet your bippy Kentucky is going to protect it.

The new 14.25% tax on prediction markets is the same as for other online betting.

And the tax will apply whether one bets via DraftKings or DraftKings Predictions. Or FanDuel or FanDuel Predicts.

Yep, same companies but two platforms.

This is new frontier in state taxation, and you can be certain there will be litigation before the matter is settled.  I suspect this will go to the Supreme Court eventually.

The issue affects all states, of course. We limited our discussion today to Kentucky for one nontechnical reason: I live here.

 

Firing A Client

We fired a client.

Nice enough fellow, but he would not listen. To us, to the IRS, to getting out of harm’s way.

He brought us an examination that started with the following:

We filed in Tax Court. I was optimistic that we could resolve the matter when the file returned to Appeals. There was Thanos-level dumb there, but there was no intentional underreporting or anything like that.

It may have been one of the most demanding audits of my career. The demanding part was the client.

Folks, staring down a $700 grand-plus assessment from the IRS is not the time to rage against the machine.  An audit requires documentation: of receipts, of expenses. Yes, it is bothersome (if not embarrassing) to contact a supplier for their paperwork on your purchases in a prior year. Consider it an incentive to improve your recordkeeping.

At one point we drew a very harsh rebuke from the Appeals Officer over difficulties in providing documentation and adhering to schedules. This behavior, especially if repetitive, could be seen as the bob and weave of a tax protester, and the practitioner involved could also be seen as enabling said protestor.

As said practitioner I was not amused.

We offered to provide a cash roll to the AO. There was oddball cash movement between the client and a related family company, and one did not need a psychology degree to read  that the AO was uncomfortable. The roll would show that all numbers had been included on the return. I wanted the client to do the heavy lifting here, especially since he knew the transactions and I did not. There were a lot of transactions, and I had a remaining book of clients requiring attention. We needed to soothe the AO somehow.

He did not take my request well at all.

I in turn did not take his response well.

Voices may have been raised.

Wouldn’t you know that the roll showed that the client had missed several expenses?

Eventually we settled with the IRS for about 4 percent of the above total. I knew he would have to pay something, even if only interest and penalties on taxes he had paid late. 

And that deal was threatened near the very end.

IRS counsel did not care for the condition of taxpayer’s signature on a signoff. I get it: at one point there was live ink, but that did not survive the copy/scan/PDF cycle all too well. Counsel wanted a fresh signature, meaning the AO wanted it and then I wanted it too.

Taxpayer was on a cruise.

I left a message: “Call me immediately upon return. There is a wobble with the IRS audit. It is easily resolved, but we have time pressure.”

He returned. He did not call immediately. Meanwhile the attorneys are calling the AO. The AO is calling me. She could tell that I was beyond annoyed with him, which noticeably changed her tone and interaction. We were both suffering by this point.

The client finally surfaced, complaining about having to stop everything when the IRS popped up.

Not so. The IRS reduced its preliminary assessment by 96%. We probably could have cut that remaining 4% in half had we done a better job responding and providing information. Some of that 4% was stupid tax.”

And second, you did not stop everything. You had been in town a week before calling me.”

We had a frank conversation about upping his accounting game. I understand that he does not make money doing accounting. I am not interested in repeating that audit. Perhaps  we could use a public bookkeeper. Perhaps we could use our accountants. Perhaps he (or someone working for him) could keep a bare-boned QuickBooks and our accountants would review and scrub it two or three times a year.

Would not listen.

We fired a client.

IRS Collection Alternatives: Pay Attention To Details

 

I was glancing over recent Tax Court cases when I noticed one that involved a rapper.

I’ll be honest: I do not know who this is. I am told that he used to date Kylie Jenner. There was something in the opinion, however, that caught my eye because it is so common.

Michael Stevenson filed his 2019 tax return showing federal tax liability over $2.1 million.

COMMENT: His stage name is Tyga, and the Court referred to him as “very successful.” Yep, with tax at $2.1-plus million for one year, I would say that he is very successful.

Stevenson had requested a Collection Due Process (CDP) hearing. It must have gone south, as he was now in Tax Court.

Why a CDP hearing, though?

Stevenson had a prior payment plan of $65 grand per month.

COMMENT: You and I could both live well on that.

His income had gone down, and he now needed to decrease his monthly payment.

COMMENT: I have had several of these over the years. Not impossible but not easy.

The Settlement Officer (SO) requested several things:

·      Form 433-A (think the IRS equivalent of personal financial statements)

·      Copies of bank statements

·      Copies of other relevant financial documents

·      Proof of current year estimated tax payments

Standard stuff.

The SO wanted the information on or by November 4, 2021.

Which came and went, but Stevenson had not submitted anything.

Strike One.

The SO was helpful, it appeared, and extended the due date to November 19.

Still nothing.

Strike Two.

Stevenson did send a letter to the SO on December 1.

He proposed payments of $13,000 per month. He also included Form 433-A and copies of bank statements and other documents.

COMMENT: Doing well. There is one more thing ….

The SO called Stevenson’s tax representative. She had researched and learned that Stevenson had not made estimated tax payments for the preceding nine years. She wanted an estimated tax payment for 2021, and she wanted it now.

COMMENT: Well, yes. After nine years people stop believing you.

Stevenson made an estimated tax payment on December 21. It was sizeable enough to cover his first three quarters.

COMMENT: He was learning.

The SO sent the paperwork off to a compliance unit. She requested Stevenson to continue his estimated payments into 2022 while the file was being worked. She also requested that he send her proof of payments.

The compliance unit did not work the file, and in July 2022 the SO restarted the case. She calculated a monthly payment MUCH higher than Stevenson had earlier proposed.

COMMENT: The SO estimated Stevenson’s future gross income by averaging his 2020 and (known) 2021 income. Granted, she needed a number, but this methodology may not work well with inconsistent (or declining) income. She also estimated his expenses, using his numbers when documented and tables or other sources when not.

The SO spoke with the tax representative, explaining her numbers and requesting any additional information or documentation for consideration.

COMMENT: This is code for “give me something to justify getting closer to your number than mine.”

Oh, she also wanted proof of 2022 estimated tax payments by August 22, 2022.

Yeah, you know what happened.

Strike Three.

So, Stevenson was in Tax Court charging the SO with abusing her discretion by rejecting his proposed collection alternatives.

Remember the something that caught my eye?

It is someone not understanding the weight the IRS gives to estimated tax payments while working collection alternatives.   

Hey, I get it: one is seeking collection alternatives because cash is tight. Still, within those limits, you must prioritize sending the IRS … something. I would rather argue that my client sent all he/she could than argue that he/she could not send anything at all.

And the amount of tax debt can be a factor.

How much did Stevenson owe?

$8 million.

The Court decided against Stevenson.

Here is the door closing:

The Commissioner has moved for summary judgement, contending that the undisputed facts establish that Mr. Stevenson was not in compliance with his estimated tax payment obligations and the settlement officer thus was justified in sustaining the notice of intent to levy.”

Our case this time was Stevenson v Commissioner, TC Memo 2023-115.

Another Runaway FBAR Case

 

Let’s talk about the FBAR (Report of Foreign Bank and Financial Accounts). It currently goes by the name “FinCen Form 114.”

This thing has been with us since 1970. It came to life as an effort to identify foreign financial transactions that might indicate money laundering or tax evasion. 

Sounds benign.

The filing requirement applies to a United States person, defined as

·      A citizen or resident of the U.S.

·      A domestic partnership

·      A domestic corporation

·      A domestic trust or estate

 We’ll come back that first one in a moment.

Next, one needs a financial interest or signature authority in a foreign financial account to trigger this thing.

A foreign financial account includes a bank account, which is easy enough to understand. It would also include a broker account (think Charles Schwab, but overseas). Some are not so intuitive, though.

·      A foreign insurance policy with cash value is reportable.

·      A foreign hedge fund is not.

·      A foreign annuity policy is reportable.

·      A foreign private equity fund is not.

·      A foreign cryptocurrency account is not reportable.

Some require a google search to understand what is being said.

·      A Canadian registered retirement savings plan is reportable.

·      A Mexican fondo para retiro is reportable.

Next, the foreign financial account has to exceed a certain dollar balance ($10,000) at some point during the year.

That $10,000 balance has been there for as long as I can remember. You will have a hard time persuading me that $10,000 in 1986 is the same as $10,000 now, but that number is apparently eternal and unchanging.

The $10,000 is tested across all foreign financial accounts. If it takes your fourth foreign account to put you over $10 grand, then you are over. Testing is done. All your accounts are reportable on a FBAR.

Like so many things, the FBAR started with reasonable intentions but has morphed into something near unrecognizable.

Fail to file an FBAR and the standard penalty is $10 grand. Fail to file for two years and the penalty is $20 grand. Have two foreign accounts and fail to file for two years and the penalty is $40 grand.

And that is assuming the error is unintentional. Do it on purpose and I presume they will execute you.

I exaggerate, of course. They will just bankrupt you.

It puts a lot of pressure on defining “on purpose.”

Let’s look at Osamu Kurotaki (OK).

OK was born in Japan and lives in Japan. He obtained a U.S. green card, making him a U.S. permanent resident. One of the pleasures of being a permanent resident is filing an annual tax return with the United States, irrespective of whether you live in the U.S. or not. One can talk about a foreign income exclusion or foreign tax credit – which is fine – but that annual filing makes sense only if someone intends to eventually return to the U.S. It does not make as much sense if someone does not intend to return, someone like OK.

OK paid someone to prepare his annual U.S. tax return. He found a CPA who was bilingual.

In 2021 the U.S. Treasury assessed civil penalties against OK for more than $10 million. His footfall? He failed to file FBARs. Treasury also upped the ante by saying that his failure was “willful.”

Huh?

Treasury is requesting summary judgement that OK willfully failed to file FBARs, prefers waffle over sugar cones and rooted for the Diamondbacks in the World Series. 

The Court wanted to know how Treasury climbed the ladder to get to that “willful” step.

So do I.

Here is what the Court saw:

·      OK is a Japanese speaker and does not speak English “at all.”

·      OK relied on his bilingual CPA to make sense of U.S. tax filing obligations.

·      His CPA provided annual tax questionnaires in both English and Japanese. The English was for theater, I suppose, as OK could not read English.

·      The CPA’s translation now becomes critical. Here are instructions to the FBAR in English:

U.S. taxpayers are required to report their worldwide income; that is, income from both U.S. and foreign sources.”

·      Here is the Japanese translation:

U.S. resident taxpayers are required to report their worldwide income, that is, income from both US. and foreign sources."

OK told the Court that he did not think he had a filing obligation because he was not a “U.S. resident.”

I get it. He lives in Japan. He works in Japan. His kids go to school in Japan. He is as much a “U.S. resident” as I am a Nepalese Sherpa.

Except …

OK was green card – that is, a “permanent” resident of the U.S.

Technically …

The Court cut OK some slack. Technically - and in a law school vacuum - he was a “resident.” Meanwhile - in the real world – no one would think that. Furthermore, OK hired a CPA who made a mistake. Even a trained professional erred interpreting the Treasury’s word salad. 

The Court said “no” to summary judgement.

Treasury will have to argue its $10 million-plus proposed penalty.

And I believe the Court just outlined reasonable cause.

Perhaps OK should consider turning in that green card. 

Our case this time was Osamu Kurotaki v United States, U.S. District Court, District of Hawaii.

 

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.