Tax Mulligans and Tennessee Walking Horses

Here is the Court:

While a taxpayer is fee to organize [her] affairs as [she] chooses, nevertheless once having done so, [she] must accept the tax consequences of her choice, whether contemplated or not, and may not enjoy the benefit of some other route [she] might have chosen to follow but did not.”

This is the tax equivalent of “you made your bed, now lie in it.” The IRS reserves the right to challenge how you structure a transaction, but – once decided – you yourself are bound by your decision. 

Let’s talk about Stuller v Commissioner.  They were appealing a District Court decision.

The Stullers lived in Illinois, and they owned several Steak ‘n Shake franchises. Apparently they did relatively well, as they raised Tennessee walking horses. In 1985 they decided to move their horses to warmer climes, so they bought a farm in Tennessee. They entered into an agreement with a horse trainer addressing prize monies, breeding, ownership of foals and so on.

In 1992 they put the horse activity into an S corporation.

They soon needed a larger farm, so they purchased a house and 332 acres (again in Tennessee) for $800,000. They did not put the farm into the S corporation but rather kept it personally and charged the farm rent.

So far this is routine tax planning.

Between 1994 and 2005, the S corporation lost money, except for 1997 when it reported a $1,500 profit. All in all, the Stullers invested around $1.5 million to keep the horse activity afloat.

Let’s brush up on S corporations. The “classic” corporations – like McDonald’s and Pfizer – are “C” corporations. These entities pay tax on their profits, and when they pay what is left over (that is, pay dividends) their shareholders are taxed again.  The government loves C corporations. It is the tax gift that keeps giving and giving.

However C corporations have lost favor among entrepreneurs for the same reason the government loves them. Generally speaking, entrepreneurs are wagering their own money – at least at the start. They are generally of different temperament from the professional managers that run the Fortune 500. Entrepreneurs have increasingly favored S corporations over the C, as the S allows one level of income tax rather than two. In fact, while S corporations file a tax return, they themselves do not pay federal income tax (except in unusual circumstances).  The S corporation income is instead reported by the shareholders, who combine it with their own W-2s and other personal income and then pay tax on their individual tax returns.

Back to the Stullers.

They put in $1.5 million over the years and took a tax deduction for the same $1.5 million.

Somewhere in there this caught the IRS’ attention.

The IRS wanted to know if the farm was a real business or just somebody’s version of collecting coins or baseball cards. The IRS doesn’t care if you have a hobby, but it gets testy when you try to deduct your hobby. The IRS wants your hobby to be paid for with after-tax money.

So the IRS went after the Stullers, arguing that their horse activity was a hobby. An expensive hobby, granted, but still a hobby.

There is a decision grid of sorts that the courts use to determine whether an activity is a business or a hobby. We won’t get into the nitty gritty of it here, other than to point out a few examples:

·        Has the activity ever shown a profit?

·        Is the profit anywhere near the amount of losses from the activity?

·        Have you sought professional advice, especially when the activity starting losing buckets of money?

·        Do you have big bucks somewhere else that benefits from a tax deduction from this activity?

It appears the Stullers were rocking high income, so they probably could use the deduction. Any profit from the activity was negligible, especially considering the cumulative losses. The Court was not amused when they argued that land appreciation might bail-out the activity.

The Court decided the Stullers had a hobby, meaning NO deduction for those losses. This also meant there was a big check going to the IRS.

Do you remember the Tennessee farm?

The Stullers rented the farm to the S corporation. The S corporation would have deducted the rent. The Stullers would have reported rental income. It was a wash.

Until the hobby loss.

The Stullers switched gears and argued that they should not be required to report the rental income. It was not fair. They did not get a deduction for it, so to tax it would be to tax phantom income. The IRS cannot tax phantom income, right?

And with that we have looped back to the Court’s quote from National Alfalfa Dehydrating & Milling Co. at the beginning of this blog.

Uh, yes, the Stullers had to report the rental income.

Why? An S corporation is different from its shareholders. Its income might ultimately be taxed on an individual return, but it is considered a separate tax entity. It can select accounting periods, for example, and choose and change accounting methods. A shareholder cannot override those decisions on his/her personal return. Granted, 99 times out of 100 a shareholder’s return will change if the S corporation itself changes. This however was that one time.

Perhaps had they used a single-member LLC, which the tax Code disregards and considers the same as its member, there might have been a different answer.

But that is not what the Stullers did. They now have to live with the consequences of that decision.

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.