Creating A Tax Practice

 

It has been a couple of months on the blog.

I have been helping a friend and fellow CPA, at least as much as I could.

He is approaching retirement. He sold his practice to a larger firm. I remember talking with him about it:

Him:  What do you think?

CTG: I see the Federation and the Borg. What is your win condition here?

Him:  Yes, but ….

A rationalization that begins with “yes, but” should be a sign that you are about to buy real estate in the dark.

It has gone poorly. Zero surprise. The Borg are like that.

It was a clash of cultures: entrepreneurial versus bureaucratic, advisory versus compliance, real fees versus “valued added.”

He will survive. He may yet be able to retain several clients, reopen an office, and resume practice. He however will never be the same. 

His story has given me pause.

It also reminds me of someone who recently applied for tax-exempt status with the IRS.

More specifically, 501(c)(4) status.

As we have discussed before, Section 501 is the master key - so to speak – to tax-exempt status. The gold standard is 501(c)(3), which is both tax-exempt and contributions to which are tax deductible. That is about as good as it gets. The (c)(4) is a different beast: it is tax-exempt but contributions are not tax deductible. Why the difference? A (c)(4) frequently has an active advocacy role: think AARP, for example. That advocacy can rise to the level that it equals – or exceeds – the nonprofit motivation behind the organization.

Someone had the idea to form a tax practice as a nonprofit.

The nonprofit employs tax professionals licensed as attorneys, CPAs, enrolled agents and tax preparers with years of experience practicing worldwide taxation.”

How will it generate revenues?

The Corporation is a full-time tax service company supported by memberships and donations.”

How does this thing work?

There is a three-tier membership-based structure.

The first tier includes US taxpayers having hardship. The organization will charge per hour for complicated cases but not charge for simple cases.

The second tier is membership-based. One pays X dollars and receives comprehensive tax services.

The third tier is gauzy “feet on the ground” personnel including support volunteers.

I am not seeing it. Tier one is fee-based except for some pro bono work. Tier two is a flat-out copy of a boutique medical practice. I do not even know what tier three is, other than some filler when completing the tax-exempt application.

Why would someone go through this effort?

One of the main reasons for you to apply for the tax-exempt status is to meet the requirements established by TAS (Taxpayer Advocate Service) to be eligible for LITC (Low Income Tax Clinic) grants.”

Ahhh!

Along with one of your Board members personal investment and professional involvements, you have already generated the interest of several high-net-worth prospective donors.”

Methinks we found the motivation here.

The IRS saw it too:

The benefits provided by you are primarily for your paying members and you operate in a manner like organizations operated for profit. Thus, you are not operated exclusively for the promotion of social welfare within the meaning of Section 501(c)(4).”

BTW this is referred to as an “adverse determination” by the IRS. If a practitioner is aware that the IRS will come in adverse, it is not uncommon to withdraw the application. It allows the opportunity to fight another day.

The taxpayer did not withdraw in this case, and the adverse determination was issued as final.

Does this mean that the taxpayer cannot operate an organization with the pro bono and boutique fees and whatever feet-on-the-ground? Of course not. It just means that it will have to file and pay taxes – just like any other profit-seeking business.

What it cannot do is pretend to be tax-exempt.

This time we discussed IRS TEGE Release Number 202539014 dtd 9.26.25.

A Paycheck As A Treasure Trove

 

I am looking at a case where the taxpayer was using Cesarini to argue her position.

COMMENT: Cesarini is one of my favorite tax decisions and a big reason this case caught my eye. The family purchased a piano at auction for $15. Seven years later – while cleaning the piano – they discovered approximately $4,500 in currency. The tax case addressed when the $4,500 was taxable – when they bought the piano, when they found the money, or some other date. It also introduced us to the “treasure trove” doctrine, addressing – not surprisingly – when finding a treasure is taxable.

COMMENT: $4,500 does not strike as that much money in 2025. Cesarini however was decided in 1964, when median U.S. household income was about $6,000. We probably would agree that finding 75% of your annual household income by fluke could be described as a treasure trove.

Let’s introduce Corri Fiege, who worked in Alaska for a U.S. subsidiary of an Australian corporation. She participated in a performance rights plan and was granted 60,000 unvested rights in parent company stock. The rights vested over three years, and she received 20,000 shares on each of July 31, 2011, 2012 and 2013.

There of course was tax involved. She had the company sell 1/3 of the stock and send the cash as federal tax withholding. She owed tax. She paid tax. There was no problem with these years.

In 2013 she received a fresh tranche of rights - 400,000 rights vesting over the four-years ending December 21, 2013, 2014, 2015 and 2016.

This time the grant was a handcuff. The parent company was in financial distress and was firing people left and right. However, they wanted to keep Corri - that is, until they let her go on November 24, 2014.

Vesting did not happen until December 21. She wasn’t going to make it.

But the company did something unexpected: it transferred 100,000 shares of stock into her Charles Schwab account. She assumed they made a mistake, and she was required by plan terms to report if there was a mistake. She called someone in Brisbane, Australia; that person had left. She called another in Houston, Texas. That person had left too. She gave up trying to report the matter to the company.

She received a W-2 showing an additional $75,660 from the stock.

But this time there was no selling 1/3 of the shares for tax withholding. She would be writing a check to Uncle Sam.

What to do?

She did not file a joint income tax return for 2014.

COMMENT: Worst. Possible. Decision.

This was easy picking for the IRS computers.

Off to Tax Court they went.

Corri and the IRS had two very different arguments.

She argued that the treasure trove doctrine applied.

Corri argued that the shares were transferred contrary to the performance rights plan, making the money subject to an ongoing claim by her employer under Alaska law.

I get it: she argued treasure trove because it would delay taxation until the taxpayer had undisputed possession.

This of course put a lot of pressure on her argument that she had disputed possession.

The IRS came from an altogether different angle.

·       Corri had an employment relationship.

·       She was compensated both in cash and property.

·       Under the tax Code, both cash and property are taxable.

·       The Code does have a specific provision (Section 83) for property transferred with restrictions on its further transfer or with a risk of forfeiture. This is what happened here. Corri was awarded rights, exercisable in the future. If she remained employed, the rights were exchangeable for actual shares, which she was free to keep or sell without further restriction. The rights were not taxable when awarded, as Corri had to remain employed until the exercise date. Once she reached that date, the restrictions came off and she had taxable compensation.

The IRS argument proved formidable against Corri. She had no further obligations to the company after she left. In addition, she was not required to refrain from acting (think a covenant not to compete). There was no risk of forfeiture from her acting or not acting. She was also free to sell or otherwise transfer the shares.

And it was there that she lost the argument of disputed possession. In Cesarini nobody knew who the cash had belonged to, and the matter of its possession had to be sorted out under state law. In this case all parties knew who the shares belonged to, and there remained nothing to be sorted out under Alaska law.

There was no treasure trove.

There was no delay.

The IRS won.

There are two things in this case that bother me. Neither are tax driven. I would describe them instead as common sense.

1. The Company had the right to overrule the terms of the performance rights plan and award shares even if plan terms were not met. To rephrase, the company was not allowed to remove a benefit already granted but it was allowed to grant a benefit an employee would otherwise not receive. I believe that is what happened here: Corri was a diligent and valued employee, and the company wanted to show appreciation, even if they had to release her.
2. If an employer gives me free money, why wouldn’t I pay tax? It seems to me that I am still better off than without the free money.

Our case this time was Corri Feige v Commissioner, T.C. Memo 2025-88.

Loan Warehousing And The Claim of Right

 

Tax returns are generally filed in one-year increments.

That raises an accounting question: what if the transaction being accounted for stretches over more than one year?

A variation is:

Set aside whether the whether the transaction resolved in the same period. Was there doubt as to a material fact affecting the transaction? If one were to redo the accounting knowing what one knows now, would there be a different answer?

This is the backdrop for the claim of right doctrine. Judge Brandeis referred to it in North American Oil Consolidated v Burnet (1932):

If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.”

You can immediately see a couple of requirements:

(1) The taxpayer is later required to return the money.

(2) The taxpayer, however, initially received the money without restriction upon its use.

If you are preparing a tax return and learn of the above, what do you do?

(1)  Amend the original tax return?

(2)  Deduct the repayment in the year of repayment?

It might not seem significant upon first hearing, but it can be. Here are two common ways it can be significant:

(1) The original year (that is, the year the income was reported) is closed under the statute of limitations.

(2) Tax rates have changed substantially between the years.

Congress finally passed a Code section codifying the claim of right doctrine in 1954:

26 U.S. Code § 1341 - Computation of tax where taxpayer restores substantial amount held under claim of right

(a) General rule If—

(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;

(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and

(3) the amount of such deduction exceeds $3,000,

then the tax imposed by this chapter for the taxable year shall be the lesser of the following:

(4) the tax for the taxable year computed with such deduction; or

(5) an amount equal to—

(A) the tax for the taxable year computed without such deduction, minus

(B) the decrease in tax under this chapter (or the corresponding provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).

This is a rare find in the tax Code, as Congress actually expanded the claim of right to make it more taxpayer friendly. The Code still allows a deduction in the year of repayment, but it also allows a recalculation using the original year’s tax rates. If tax rates have decreased (overall or yours personally), the recalculation of the original year may be the better way to go.

Let’s look at Norwich Commercial Group v Commissioner.

Here is the first sentence of the decision:

P overreported more than $7 million in income on its 2007 through 2013 federal income tax returns."

Big number. It caught my attention.

Norwich was a residential mortgage loan originator. It engaged in warehouse lending, a term that may sound mysterious but is really not. Here is what warehousing means in a lending context: 

• Norwich (call it the warehouse) borrows money, likely on a line of credit, to start the transaction. 
• The warehouse lends the money to a customer (in this case, a home buyer) in exchange for a promissory note. 
• The warehouse sells the promissory note to an investor. The money received from the sale is (almost certainly) deposited with the lender the warehouse itself borrowed the money from. 
• The lender does its calculations: how much is owed, how much interest is due and other charges, if any. It subtracts this amount from the amount deposited. Whatever is leftover is returned to the warehouse as gross profit (in this context called: mortgage fee income).

If you think about it, this is an inventory accounting of sorts, except that the inventory is money lent.

So, Norwich was a warehouse.

Liberty was Norwich’s primary lender. There were others, but let’s sidestep as they are not necessary to understand the tax issue at play.

Norwich had to design an accounting procedure for its mortgage fee income. It did the following: 

• First, all mortgage deposits were posted to Mortgage Fee Income.
• Second, the amounts kept by Liberty reduced Mortgage Fee Income.
• Third, Norwich would adjust Mortgage Fee Income to whatever Liberty said it was.
• Fourth, the difference was assumed to be Unsold Mortgages.

I get it, but Norwich should backstop its critical accounts.

Let’s see:

(1)  Cash

a.     Well, that is easy to backstop with a bank statement.

(2)  Loan payable to Liberty.

a.     Again: easy. Liberty should be able to tell them that number.

(3)  Unsold Mortgages.

a.     Liberty cannot help Norwich here, as these have not entered Liberty’s accounting system. They are off the radar as far as Liberty is concerned.

We have identified the weak spot in the accounting, as Unsold Mortgages are just a subtraction. Best practice would involve keeping detail – more or less, as required – to have a reality check on the running balance.

In 2014 Norwich started using new accounting software.

It could not reconcile certain accounts.

COMMENT: This is my shocked face.

Norwich contacted Liberty, who in turn provided detail and balances to help with reconciliations. One of those numbers was collateral held by Liberty to secure the line of credit. The collateral included everything, including loans in process or otherwise but not yet sold by Norwich.

If that sounds a lot like Norwich’s Unsold Mortgages account, that is because it is.

Liberty’s number was significantly less than Norwich’s – by over $7 million. Mind you, all this stuff was collateral for the line of credit. If the actual Unsold Mortgages balance was substantially less than previously reported, Norwich might be undercollateralized. The term for this is “out of trust,” and it could also cause problems for Liberty on the regulator side.

BTW Liberty did not initially believe that Norwich was correct or that the situation was urgent. Norwich tried repeatedly to schedule meetings with Liberty. Liberty in turn delayed, expecting nothing to be amiss.

We will fast forward through the banking side of this.

Norwich filed its claim of right refund – for $7.5 million – on its 2014 tax return.

The IRS denied the refund entirely.

You know this went to Court.

And the arguments are easy to predict:

Norwich: We had an unrestricted right to that income in prior years. It was not until 2014 that we discovered otherwise. Under claim of right, 2014 is the proper year for the deduction.

IRS: Everything here is a loan. Norwich issued loans. Norwich borrowed on loans. When originated loans were sold, Norwich in turn paid back its loans. Everything that happened here circles around loans of one type or another. The claim of right has nothing to do with loans.

Both sides had a point.

Here is the Court:

This, the Commissioner focuses on the origin of the funds rather than the origin of the transaction ….”

I agree. The business activity required extensive use of loans, but the intended result of all the loans was to generate a profit, not to maintain a loan into perpetuity.

The Court noted that everybody - including Liberty - thought that Norwich was entitled to the money when Norwich received it.

The repayment was also deductible as an ordinary and necessary business expense and was not barred by another Code section.

2014 was also the correct year for the deduction. It was the year Norwich found the error, which discovery was memorialized in paperwork between Norwich and Liberty. Norwich agreed to either (1) provide more collateral or (2) pay down its line of credit with Liberty.

The Court did tweak some numbers, but overall Norwich prevailed in its claim of right refund request.

Our case this time was Norwich Commercial Group v Commissioner, T.C. Memo 2025-43.

Recurring Proposal For Estate Beneficiary’s Basis In An Asset

There is an ongoing proposal in estate taxation to require the use of carryover basis by an inheriting beneficiary.

I am not a fan.

There is no need to go into the grand cosmology of the proposal. My retort is simple: it will fail often enough to be an unviable substitute for the current system.

You might be surprised how difficult it can be sometimes to obtain routine tax reports. I have backed into a social security 1099 more times than I care to count.

And that 1099 is at best a few months old.

Let’s talk stocks.

Question: what should you do if you do not know your basis in a stock?

In the old days – when tax CPAs used to carve numbers into rock with a chisel – the rule of thumb was to use 50% of selling price as cost. There was some elegance to it: you and the IRS shared equally in any gain.

This issue lost much of its steam when Congress required brokers to track stock basis for their customers in 2011. Mutual funds came under the same rule the following year.

There is still some steam, though. One client comes immediately to mind.

How did it happen?

Easy: someone gifted him stock years ago.

So?  Find out when the stock was gifted and do a historical price search.

The family member who gifted the stock is deceased.

So? Does your client remember - approximately - when the gift happened?

When he was a boy.

All right, already. How much difference can it make?

The stock was Apple.

Then you have the following vapid observation:

Someone should have provided him with that information years ago.

The planet is crammed with should haves. Take a number and sit down, pal.

Do you know the default IRS position when you cannot prove your basis in a stock?

The IRS assumes zero basis. Your proceeds are 100% gain.

I can see the IRS position (it is not their responsibility to track your cost or basis), but that number is no better than the 50% many of us learned when we entered the profession.

You have something similar with real estate.

 Let’s look at the Smith case.

Sherman Darrell Smith (Smith) recently went before the Tax Court on a pro se basis.

COMMENT: We have spoken of pro se many times. It is commonly described as going to Tax Court without an attorney, but that is incorrect. It means going to Tax Court represented by someone not recognized to practice before the Tax Court. How does one become recognized? By passing an exam. Why would someone not take the exam? Perhaps Tax Court is but a fragment of their practice and the effort and cost to be expended thereon is inordinate for the benefits to be received. The practitioner can still represent you, but you would nonetheless be considered pro se.

Smith’s brother bought real property in 2002. There appears to have been a mortgage. His brother may or may not have lived there.

Apparently, this family follows an oral history tradition.

In 2011 Smith took over the mortgage.

The brother may or may not have continued to live there.

Several years later Smith’s brother conveyed an ownership interest to Smith.

The brother transferred a tenancy in common.

So?

A tenancy in common is when two or more people own a single property.

Thanks, Mr. Obvious. Again: so?

Ownership does not need to be equal.

Explain, Mr. O.

One cannot assume that the real estate was owned 50:50. It probably was but saying that there was a tenancy in common does not automatically mean the brothers owned the property equally.

Shouldn’t there be something in writing about this?

You now see the problem with an oral history tradition.

Can this get any worse?

Puhleeeze.

The property was first rented in 2017.

COMMENT: I suspect every accountant that has been through at least one tax course has heard the following:

The basis for depreciation when an asset is placed in service (meaning used for business or at least in a for-profit activity) is the lower of the property’s adjusted basis or fair market value at the time of conversion.

One could go on Zillow or similar websites and obtain an estimate of what the property is worth. One would compare that to basis and use the lower number for purposes of depreciation.

Here is the Court:

Petitioner used real estate valuation sources available in 2024 to estimate the rental property’s fair market value at the time of conversion.”

Sounds like the Court did not like Smith researching Zillow in 2024 for a number from 2017. Smith should have done this in 2017.

If only he had used someone who prepares taxes routinely: an accountant, maybe.

Let’s continue:

But even if we were to accept his estimate …, his claim to the deduction would fail because of the lack of proof on the rental property’s basis.”

The tenancy in common kneecapped the basis issue.

Zillow from 2024 kneecapped the fair market value issue.

Here is the Court:

Petitioner has failed to establish that the depreciation deduction here in dispute was calculated by taking into account the lesser of (1) the rental property’s fair market value or (2) his basis in the rental property.”

And …

That being so, he is not entitled to the depreciation deduction shown on his untimely 2018 federal tax return.”

Again, we can agree that zero is inarguably wrong.

But such is tax law.

And yes, the Court mentioned that Smith failed to timely file his 2018 tax return, which is how this mess started.

Here is the Court:

Given the many items agreed to between the parties, we suspect that if the return had been timely filed, then this case would not have materialized.”

Let’s go back to my diatribe.

How many years from purchase to Tax Court?

Fifteen years.

Let’s return to the estate tax proposal.

Allow for:

• Years if not decades
• Deaths of relevant parties
• Failure to create or maintain records, either by the parties in interest or by municipalities tasked with such matters
• Soap opera fact patterns

And there is why I object to cost carryover to a beneficiary.

Because I have to work with this. My classroom days are over.

And because – sooner or later – the IRS will bring this number back to zero. You know they will. It is chiseled in stone.

And that zero is zero improvement over the system we have now.

Our case this time was Smith v Commissioner, T.C. Memo 2025-24.