What Does It Take To Get Reasonable Cause Around Here?

My partner has a difficult IRS penalty issue.

He expects a client to be penalized for more than one year. This complicates how we handle the first year.

The IRS has reorganized its penalty review function to a system called the Reasonable Cause Assistant (RCA). There however is a problem: the system does not work well. The Treasury Inspector General for Tax Administration (TIGTA) reported that RCA was inaccurate 89% of the time in 2012.

Step away from RCA and you still have the following:

 * It used to be that penalties were assessed as a means to encourage voluntary compliance. Many tax pros feel that is no longer the case, and penalties are being used as a means to raise revenue.  An example is the penalty assessed for late filing of a partnership return: $195 per month per partner. Take a 10-person partnership, file a week late and face a $1,950 penalty. There is little consideration for the size of the partnership, its total assets or revenues - or the fact that partnerships do not pay federal taxes.            

* Penalties are assessed even when taxpayers are trying to do the right thing. For example, enter into a reportable transaction, disclose it on your tax return but forget to file a copy with a second office and you will be assessed a penalty. Fail to disclose the transaction at all and you will be subject to the same penalty.

 * The IRS is automatically asserting penalties. For example, for fiscal year 2015, the IRS assessed over 40 million penalties on individuals and businesses. To put that in context, there were approximately 243 million returns filed for the period.

* Many penalties can be waived if the taxpayer can show "reasonable cause," but many tax professionals believe the IRS has so narrowed the definition as to be almost unreachable, unless you are willing to die. To aggravate the matter, the IRS has also instructed its personnel to substitute "first time abatement" (FTA) for reasonable cause as a matter of policy. While the IRS argues that FTA is easier to review and administer than reasonable cause, there exists a high degree of skepticism. Why would a taxpayer automatically burn a "get out of penalty-jail free" card if the taxpayer otherwise has reasonable cause? Wouldn't a taxpayer want to keep that card available just in case?

My partner - by the way - has that last situation: burning his FTA chip without a reasonable-cause backup for the second year. Ironically, he may have reasonable cause for the first year, but that sequence does not follow IRS policy. I anticipate going to Appeals to obtain reasonable cause and preserve the FTA for the second year.

Let's talk about the Carolyn Rogers (Rogers v Commissioner) case.

Carolyn lived in New York. In 2006 she had a small business (Talk of the Town Singles) which she operated from her cooperative. In 2006 there was a fire which rendered the place uninhabitable.

She moved. In 2007 there was another fire, one she appears to have caused herself. The local newspaper called her out, and she was thereafter harassed by people in her neighborhood.

She moved to the YWCA until 2010. She did not have a pleasant time there, and in 2009 she fell off a subway platform and fractured her skull on the rails. She was in the hospital for days, and she continued to suffer from dizzy spells thereafter.

Prior to this period, she had a record of filing timely returns. She also made significant efforts to correctly prepare her tax returns, consulting books and references and more than once contacting the IRS. She did not use a paid preparer.

The IRS penalized her for not filing a 2009 return.

She explained that the insurance company settled the second fire in 2009, and she lost a bundle. According to her research, the casualty loss would wipe out her income, and she was therefore below the filing threshold. She did not need to file.

The IRS then trotted technical guidance on a casualty loss. While the layperson might think that the loss would be deferred until the insurance is settled, the tax Code uses a different test:

* If an insurance claim is not paid in the year of casualty AND there is a reasonable prospect of recovery, then the loss is deferred until one can determine the amount of recovery.

* If there is no hope for insurance - or the prospect of recovery is unreasonable - then the loss is deductible in the year of the casualty.

 The IRS said that she came under the second rule. She knew that insurance would not cover the full loss from the 2007 fire. The loss was therefore deductible in 2007.

COMMENT: There is enough "what if" to this rule that even a tax professional could blow it.

The IRS wanted penalties for not filing that 2009 return.  

The Tax Court reviewed her filing history and her chaotic life. It noted:

Petitioner's error (regarding the proper year of deduction of the portion of a casualty loss for which there is no reasonable prospect of recovery from insurance) is considerably different from the errors made by a taxpayer whose failure to file, late filing, or late payment is chronic. Erroneously deducting a loss in a year later than the correct year is not usually considered to be a blatant tax avoidance technique ..."

Ouch. The Court did not appreciate the IRS wasting its time.

Taking into account all of the facts and circumstances, we conclude that petitioner exercised ordinary business care and prudence under the difficult circumstances in which she was living at the time leading up to the due date of her 2009 return...."

The Court found reasonable cause. She owed the tax, but she did not owe the penalties.

The IRS should have found reasonable cause too. It is troubling that it didn't.

Can You Deduct Burning Down Your House?

Can you take a deduction for burning your house to the ground?

You may laugh, but I was reviewing a recent case on this issue. It is the third case involving a home barbeque I can remember over as many years.

The case from 3 years ago was Rolfs v Commissioner. It was – understandably – considered quite outside the box.

Theodore Rolfs and his wife (the Rolfs) owned a house on a 3-acre lakefront property in Wisconsin. The house was modest, built around 1900 and it would be fair to say that it was in need of an upgrade.

The Rolfs wanted to renovate, but the work required was so extensive that tearing down the house and constructing anew was a very viable option.

They estimated it would cost $10,000 to $15,000 to demolish the house and remove the debris.

They went a different path and donated the house to the fire department. There were restrictions on the donation: the fire department was to use the house for training exercises, with the understanding that the training would happen shortly after the donation. The Rolfs donated only the house. They did not donate the land on which the house sat.

The Rolfs needed a value for their donation. They contacted Richard Larkin, president of Larkin Appraisals, Inc. who valued the house at $76,000.

The Rolfs donated the house and took a charitable deduction of $76,000 on their tax return. They attached the appraisal report and a letter from the fire chief thanking them for the donation.

The IRS disallowed the charitable contribution.

The IRS argued that a charitable donor does not expect a financial benefit in exchange for the donation. The Rolfs however expected a substantial benefit: the $10,000 to $15,000 in avoided demolition costs, for example, not to mention the benefit of the tax deduction itself.

The IRS further argued that the restrictions the Rolfs imposed affected the value of any donation. The fire department could only use the house for training purposes, and the house was to be destroyed shortly after the donation.

The Rolfs countered that they had an appraisal for $76,000.  And what was the IRS talking about with “restrictions?” After the fire department did its thing, there was NO house standing. The fire department did not want a house. They wanted a house they could burn to the ground. Whatever “restrictions” the IRS was talking about went up in smoke.

The case went to Tax Court.

In a Solomonic gesture, the Court reasoned that there might be a donation, but the amount of any donation would be the value of the house over the value of any demolition and clean-up services received.

The Court observed that the Rolfs donated the house without its underlying land. This meant that an independent buyer would have to move the house. The house was very old and badly in need of renovation. What would someone pay for this? Not surprisingly, the house was almost worthless.

The house was not worth more than the demolition and removal services received from the fire department. The Court decided there was no donation. The Rolfs lost their case.

But they made the tax literature.

There are variations that might have resulted in a different outcome. For example, what if the house had enough value to make it worth the cost and effort of moving?

There is another way to help tax-subsidize a house demolition, however. Have you heard of “deconstruction?” This involves dismantling the house rather than razing it under a bulldozer. It is more expensive, but with deconstruction more home materials remain in usable condition. The materials are then donated, generating a tax deduction. If the value of the tax deduction exceeds the additional cost of the teardown, one has effectively tax-subsidized his/her demolition costs.

The value of the materials can add up. I was reading an article where the lighting fixtures alone were worth over $100 thousand. Can you imagine?

IRS Fires Revenue Agent Who Lost Own Case in Tax Court

Would you be aggressive on your taxes if your job was on the line?

I am reading Agbaniyaka v Commissioner. Benjamin Agbaniyaka (Ben) started with the IRS in 1986. He received excellent evaluations, several promotions and a Master’s Degree in taxation from Long Island University. Between the years 1988 and 2006 Ben engaged in a side business selling African arts and crafts.  Here are the business results for selected years;

            2001    no sales and a loss of $5,661

            2002    sales of $3,216 and a loss of $15,232

            2003    sales of $1,372 and a loss of $7,624

            2004    sales of $200 and a loss of $6,383

He also claimed itemized deductions, including annual expenses for “Union Dues” and “Accounting Journals.”

He gets audited for 2001.

Let’s go over what the IRS expects when it sees that Schedule C on your return. It expects you to maintain records so that you can compile a tax return at the end of the year. Records can be as simple as a checkbook with a year-sheet recapping everything by category. The IRS also wants you to keep invoices and receipts, to allow a third party to trace a check to something. There are some expenses where Congress itself tells the IRS what documentation to review. Meals and car expenses are two of the most common examples. With those two, the IRS is somewhat limited in its flexibility because Congress called the tune.

Then we have the hobby loss rules. The idea here is that a business activity is expected to show a profit every so often. If the activity has always shown losses, it is difficult to buy-into the argument that it is a business. An actual business would eventually shut down and not throw good money after bad. There are exceptions, of course, but it is a good starting point.

The third point is that a revenue agent is going to be held to a higher standard. There is the education and training involved, as well as that whole working for the IRS thing.

The IRS audits 2001. It finds the following:

(1)   Ben deducted expenses for a course on trust and estates. He cannot provide any documentation, however. He also has other unsubstantiated education expenses, including his journals.

(2)   Ben claimed a deduction for union expenses. He cannot present any proof he paid the union.

(3)   Ben is hard-pressed to persuade the IRS that there was any profit intent to his arts and crafts activity. The problem is that Ben never reported a profit – ever. The IRS simply disallowed the loss.

(4)   The IRS is now miffed at Ben, especially since Ben is one of their own. They argue that the Ben’s failure to make any reasonable attempt to comply with the tax code is negligence. In fact, failure to keep records shows not only negligence but also Ben’s intentional disregard of the regulations. The IRS slapped Ben with a substantial understatement penalty.

The IRS expands the audit to 2002, 2003 and 2004, with similar results.

Can this get worse? You bet. The 1998 IRS Restructuring and Reform Act requires termination of an IRS employee found to have willfully understated his federal tax liability, unless such understatement is due to reasonable cause and not willful neglect.

Let’s go back to the substantial understatement penalty. One of the exceptions to the penalty is reasonable cause. Ben goes to Tax Court. He pretty much has to. He has to win, at least on the penalty issue. If he can get the court to see reasonable cause, he might be able to save his job.  

The Tax Court is unimpressed. Here are some comments:

We found Mr. Agbaniyaka’s testimony to be general, vague, conclusory, uncorroborated, self-serving and/or questionable in all material respects.”

During the years at issue, Mr [] was a trained revenue agent and was fully aware of the requirements imposed by …. Nonetheless, petitioners failed to maintain sufficient records for each of their taxable years 2001 through 2004 to establish their position with respect to any of the issues presented.”

On the record before us, we find that petitioners have failed to carry their burden of showing that they were not negligent and did not disregard rules and regulations, or otherwise did what a reasonable person would do, with respect to the underpayment for each of the years at issue.”

After the Tax Court’s decision, the IRS ended Ben’s employment effective April 15, 2008.

Ben appeals to the Federal Court of Appeals. That too fell on deaf ears:

“… he was undoubtedly aware that he had to substantiate his efforts to conduct a business in 2001 and beyond. Being an experienced and knowledgeable Agency employee, he had to have been aware that he could not substantiate his alleged business activities. By claiming deductions on Schedule C, he knowingly and willfully submitted tax filings to which he was not entitled.”

Ben next tried other channels. In the end, he lost and stayed fired.

How much money are we talking about? The court does not come out and specifically give a dollar amount, but there is enough to approximate the taxes as little more than $10,000.

I question the lack of documentation for some of these claimed expenses. The bank can provide cancelled checks for the subscriptions or seminars, and the union will provide a letter of membership and dues activity.  The court doesn’t elaborate, but it is clear that Ben wasn’t trying too hard.

Would you gamble your job for $10,000? Ben did.

I wouldn’t.