Losing Deductions By Not Filing A Tax Return

I have become increasingly reluctant to accept a nonfiler as a client. That said, a partner somehow sneaks one or two a year into Command Center, and I – reluctant or not – become involved. It would not be so bad if it was just a matter of catching-up with the paperwork, but often one needs to stave off Collections, establish a payment plan, request penalty abatement (done after the taxes are paid, meaning I have to monitor it in my spare time) and on-and-on.

Try doing this during IRSCOVID202020212022. It is zero fun.

I am looking at a nonfiler that took a self-inflicted wound.

Let’s talk about Shawn Salter.

Salter was a loss prevention manager over 10 Home Depot stores in Arizona.  He worked from home but drove regularly to his stores. Home Depot offered to reimburse his mileage, but he turned it down. He thought that claiming the mileage on his return would give him a bigger refund.

COMMENT: Well, yes, as he was paying out-of-pocket for gasoline and wear-and-tear on his car. Clearly he is not a Warren Buffet successor.

Salter got laid off in 2013.

He took money out of his IRA to get through, but that is not the point of our discussion today.

He needed to file a 2013 return so he could get that tax refund, especially since he turned down the opportunity to be reimbursed.

What did he not do?

He did not file a 2013 return.

Eventually the IRS figured it out and asked for a tax return.

Salter blew it off.

The IRS prepared a “substitute for return.” You do not want the IRS to do this, by the way. The IRS will file you as single with no dependents (whether you are or not), include all your gross income and do its very best to not spot you any deductions. It is intentionally designed to maximize your tax liability.

The IRS wanted over $6 grand in tax, with all the assorted interest and penalty toppings.

Now Salter cared.

He told the IRS that he had used H&R Block software to file his return.

The IRS clarified that it had no 2013 tax return, either from H&R Block or from anyone else. Send us a copy, they said.

He did not have a copy to send. He did not have certified mail receipts or record of electronic filing. He had nothing.

Hard to persuade anyone with nothing.

Here is the Court:

We find that the petitioner did not file a return for 2013, ...”

This created a problem.

Salter wanted to claim that mileage, meaning that he needed to itemize his deductions.

OK.

Not OK. There is a tax issue.

Which is …?

Did you know that itemizing your deductions is considered a tax election?

And …?

You have to file a tax return to make the election.

Easy, you say, Salter should prepare and file a 2013 return claiming itemized deductions. Doing so is the election.

Too late. That window closed when the IRS prepared the substitute for return. The substitute is considered a return, and it did not itemize. Remember how a substitute works: income is reported at gross; deductions are grudgingly given, if given at all. 

No mileage. No deduction. No refund. Tax due.

As we said: self-inflicted wound.

Our case this time was Salter v Commissioner, T.C. Memo 2022-29.

Should I Have A Separate Bank Account For …?

One of the accountants recently told me that a client had asked whether he/she should set-up a separate bank account for their business.

The short answer is: yes.

It is not always about taxes. An attorney might recommend that your corporation have annual meetings and written minutes – or that you memorialize in the minutes deferring a bonus for better cash flow.  It may seem silly when the company is just you and your brother. Fast forward to an IRS audit or unexpected litigation and you will realize (likely belatedly) why the recommendation was made.

I am skimming a case where the taxpayer:

·      Had three jobs

·      Was self-employed providing landscaping and janitorial services (Bass & Co)

·      Owned and operated a nonprofit that collected and distributed clothing and school supplies for disadvantaged individuals (Lend-A-Hand).

The fellow is Duncan Bass, and he sounds like an overachiever.

Since 2013, petitioner, Bass & Co …, and Lend-A-Hand have maintained a single bank account….”

That’s different. I cannot readily remember a nonprofit sharing a bank account in this manner. I anticipated that he blew up his 501(c)(3).

Nope. The Court was looking at his self-employment income.

He claimed over $8 thousand in revenues.

He deducted almost $29 thousand in expenses.

Over $19 thousand was for

·      truck expenses

·      payment to Lend-A-Hand for advertising and rental of a storage unit

He handed the Court invoices from a couple of auto repair shops and a receipt from a vehicle emissions test.

Let’s give him the benefit of the doubt. Maybe he was trying to show mileage near the beginning and end of the year, so as to establish total mileage for the year.

Seems to me he next has to show the business portion of the total mileage.

Maybe he could go through his calendar and deposits and reconstruct where he was on certain days. He would still be at the mercy of the Court, as one is to keep these records contemporaneously.  At least he would field an argument, and the Court might give him the benefit of the doubt.

He gave the Court nothing.

His argument was: I reported income; you know I had to drive to the job to earn the income; spot me something.

True enough, but mileage is one of those deductions where you have to provide some documentation. This happened because people for years abused vehicle expenses. To give the IRS more firepower, Congress tightened-up Code Section 274 to require some level of substantiation in order to claim any vehicle expenses.

And then we get to the $9,360 payment to Lend-A-Hand.

Let’s not dwell on the advertising and storage unit thing.

I have a bigger question:

How do you prove that his business paid the nonprofit anything?

Think about it: there is one checking account. Do you write a check on the account and deposit it back in?

It borders on the unbelievable.

And the Tax Court did not believe him.

I am not saying that the Court would have sustained the deduction had he separated the bank accounts. I am saying that he could at least show a check on one account and a deposit to another.  The IRS could still challenge how much “advertising” a small charity could realistically provide.

As it was, he never got past whether money moved in the first place.

Saying Goodbye To Employee Business Expenses

Let’s talk about miscellaneous itemized deductions - likely for the last time.

These are the deductions at the bottom of the form when you itemize, and you probably itemize if you own a house and have a mortgage. Common miscellaneous deductions include investment management fees (if someone, such as Simply Money, manages your savings) and employee business expenses.

These are the “bad” expenses that are deductible only to the extent they exceed 2% of your income (AGI), because … well, because the government wants more of your money.

I am reading a case concerning a bodyguard and his employee business expenses.

His name is Rick Colbert and he retired after 30 years from the Long Beach, California Police Department. He gigged-up with Screen International Security Service Ltd (SISS) in Beverly Hills. They assigned him celebrities. He chauffeured them, deflected paparazzi, installed and monitored security devices, patrolled their estates, performed access point control and responded to distress calls.

SISS had a reimbursement policy. It did not cover everything, but it did cover a lot. Colbert did not seek any reimbursement.

He filed his 2013 tax return and reported SISS income of $25,546.

He then deducted employee business expenses of $23,965.

COMMENT: One can tell he is not in it for the money.

Those numbers are out-of-whack, and the IRS audited him. Like the IRS we know and love, they bounced all of his employee business expenses, arguing that he had not substantiated anything.

On to Tax Court they went.

The Court went through the list of expenses:

(1) $211,154 for a pistol and target practice.

Looks legit, said the Court.

(2) $86 for earbuds

To avoid annoying celebrities.

The Court grinned. OK.

(3) $1,711 for clothing and dry cleaning

Nope said the Court.

We have talked about this before. If you can wear the clothing about town and day-to-day, there is no deduction. It is just another personal expense, unless our protagonist wanted to dress up like “Macho Man" Randy Savage.

(4) $1,609 for a gym membership, weight loss pills and other stuff.

Uhh, no, said the Court, as these are the very definition of “personal, living, or family expenses.”

(5) Office in Home

This would have been nice, be he did not use space “exclusively” for the office, which is a requirement. This would hurt a send time when the Court got to his …

(6) iPad and printer

Computers are like cars when it comes to a tax deduction: you have to keep records to document business use. The reason you never hear about this requirement is because of a significant exception – if you keep the computer in an office you can skip the records requirement.

When Colbert lost his office-in-home, he picked-up a record-keeping requirement. He lost a deduction for his iPad, printer and supplies.

(7) $5,003 for his cellphone

It did not help that his internet and television were buried in the bill.

The Court disallowed his cellphone, which amazes me. Seems to me he could have gone through his bills and highlighted what was business-related.

He won some (primarily his mileage) but lost most.

And his case is now among the last of its kind.

Why?

The new tax bill does away with employee business expenses, beginning in 2018. There is NO DEDUCTION this year.

If you have significant employee business expenses, you really, really need to arrange a reimbursement plan with your employer. Your employer can deduct them, even though you cannot. Why the difference?

Because, to your employer, they are just “business expenses.” 

How To Lose All Of Your Auto Deduction

I am not a fan of dumb.

And I am reading big dumb.

The IRS wanted over $22 thousand in taxes and $4,000 in penalties. There were several issues, but there was one that racked up the money.

What do you need if you want to claim auto expenses on your tax return?

Answer: some kind of record, like a log.

There is a reason for this. It is not random, chaotic or unfathomable.

The reason has two parts:

(1)  There was a very famous case decided in the 1930s concerning George Cohan. George was a playwright, a composer, a singer, actor, dancer and producer. He was very famous. He was also a terrible record keeper. Given his day job, he spent a ton of money schmoozing people. He deducted some of those expenses on his tax return, as he had to wine and dine to maintain his recognition, connections and earning power. Problem was: he kept lousy records. One had to – essentially – take his word for the expenses.

The Court, knowing who he was, thought it believable that he had incurred significant entertainment expenses. The Court simply estimated what they were and allowed him a deduction.

Ever since, that guesstimate has been referred to in taxation as the “Cohan rule.”

Problem was: everything can be abused. What started out as common sense and mitigation for George Cohan became a loophole for many others.

(2)  Congress got a bit miffed about this, especially when it came to travel, transportation and entertainment expenses. These expenses can be “soft” to begin with, and the Cohan rule made them gelatinous. Congress eventually said “enough” and passed Code Section 274(d), which overrides the Cohan rule for this category of expenses.

BTW, “transportation” is just a fancy tax-word for mileage.

The tax-tao now is: no records = no mileage deduction. Forget any Cohan rule.

Now, you do not need to record every jot and tittle as soon as you get in the car. Records can include your Outlook calendar, for example. You could extend the appointment by mileage from MapQuest and (probably) have the IRS consider it adequate. The point is that you created some record, at or near the time you racked up the mileage, and that record can be reasonably translated into support for your deduction.

Enter Gary Roy.

He was a consultant in Los Angeles. He worked out of his home and drove all over the place for business. He must have made a couple of bucks, as he purchased an Aston Martin Vantage.

This is not a car you see every day. Chances are the last time you saw an Aston Martin was in a James Bond movie.

You know he deducted that car on his tax return.

There are multiple issues in the case, but the one we want to talk about is his car. Roy appeared before the Court and straight-facedly claimed that he kept a mileage record for the Aston. He presented a sheet of paper showing mileage at the beginning of the year and mileage at the end of the year. He helpfully added the description “business use” so the Court would know what they were looking at.

As far as he was concerned, this was all the record-keeping he needed, as the car was 100% business use.

I want to be sympathetic, I really do. I suppose it is possible that he did not understand the rules, but I read in the decision that he used a tax preparer. 

COMMENT: To whom he paid $250. Given that there were complexities in his tax return – the business and a gazillion-dollar car, for goodness’ sake – he really, really should have upgraded on his tax preparer selection.

Roy had no chance. That stretch of tax highway has a million miles on it, and he missed the pavement completely.

Without the Cohan rule, the Court was not going to spot him anything. He just got a big zero. That is what Section 274(d) says. 

And is what Congress wanted back when.

Worst case scenario for Mr. Roy.

Deducting Everything - The Tanzi Doctrine

I admit: I got a chuckle from reading the case.

The taxpayers (Tanzi's) are married, and for the year in question they were employed by Seminole State College, which is Sanford, Florida. I remember a conversation with a Sanford CPA a year or two ago lamenting that there no longer was separation between Orlando and Sanford. I was in Orlando this year, and he is right - there isn't.

Our taxpayer was an adjunct instructor teaching communications, and his wife worked at the campus library. Although an adjunct, he held a PhD in communications, so we can presume he was hoping for a permanent full-time position.

On their 2011 return they deducted the following as employee expenses:

            (1) 100% of their telephone, internet and television

            (2) depreciation

            (3) books, CDs and DVDs

            (4) computer expenses

The IRS bounced the employee expenses and sent them a notice for approximately $3,000.

Employee expenses are a subset of "miscellaneous deductions." One has to itemize to get to miscellaneous deductions, and even then these miscellaneous deductions are not what they used to be. The common itemized deductions are mortgage interest, real estate taxes and contributions. Living in Florida, our taxpayers did not have to concern themselves with another common itemized deduction - state income taxes. Chances are the first three got them into itemized deduction range, and their miscellaneous deductions then became usable. It is rare that miscellaneous deductions by themselves will be enough to get you to itemize.

Miscellaneous deductions are not tax-efficient, though. The Code requires that you reduce your miscellaneous deductions by 2% of your adjusted gross income, so that portion is immediately forfeited.

EXAMPLE: You and your spouse make a combined $150,000. You would have to immediately reduce your miscellaneous deductions by $3,000 (i.e., $150,000 times 2%). If your miscellaneous deductions totaled $3,500, only $500 would be deductible. And yes, it is intentional. It is a way for Congress to pry a few more tax dollars from everyone who incurs employee expenses.

COMMENT: My daughter is working before returning to graduate school. She is required to use her car for work. Although reimbursed something for mileage, it is not the full rate permitted by the IRS. Her employer explained to her that she could deduct the difference come tax time. As her dad and tax advisor, I explained that this was not true. She would not have enough to itemize, and her unreimbursed mileage would be deductible only if she itemized.

By the way, you forfeit all miscellaneous deductions if you are subject to the AMT (alternative minimum tax). As I said, they are not efficient.

The Tanzi's were deducting employee business expenses. The IRS was questioning how 100% of their telephone and internet - just to start - became business. There is a long-standing doctrine that an employee is "in the business" of being an employee, but one still has to show some nexus between the expenses and being an employee. I receive a W-2, for example, but I cannot deduct my Starbucks tab solely for the reason that I am an employee. I would have a business nexus if I met a client there, but not because I was picking up coffee for my commute to the office.

The IRS wanted to know what that nexus was.

The Tanzi's argued that they must constantly expand their "general knowledge" to be effective at their jobs. Mr Tanzi explained that individuals holding terminal degrees - such as himself, coincidently - especially bear a lifelong burden of "developing knowledge, exploring [and] essentially self-educating."   Mr. Tanzi insisted that all expenses paid in pursuing his general knowledge should be deductible as unreimbursed business expenses.

COMMENT: If Mr Tanzi won this argument, I would immediately try to expand the Tanzi doctrine to include tax CPAs with Masters degrees who also maintain a tax blog. Our burdened ranks must constantly expand our general knowledge to be effective at our jobs. I for example sometimes work with and write about international tax matters. Seems to me that a trip overseas to visit my wife's family should be deductible, as it expands my knowledge of being overseas, or some reasoning along those lines.

The tax Code recognizes that some expenses are simply personal in nature. There is even a Code section that says this out loud:

  Section 262 - Personal, living, and family expenses

      (a) General rule

Except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses.

Here is the Court:

While we find credible the Tanzi's testimony that they spent significant time and resources educating themselves, we do not believe the expenses are ordinary and necessary for the trades of being a professor or a campus librarian but rather are personal, living or family expenses nondeductible under section 262(a)."

No surprise for the Tanzi's, but I am a bit disappointed. Looks like I won't be able to deduct my life expenses as ordinary and necessary to the business of being a tax CPA and blogger. Those tax refunds would have been sweet.

There Are New Deductible Mileage Rates

The IRS has revised the deductible mileage rates for the second half of 2011.

The new and old rates are as follows:

                                                          NEW                                               OLD
Business mileage                          55.5 cents/mi                                   51 cents/mi
Medical or moving                         23 cents/mi                                      19 cents/mi
Charitable mileage                        14 cents/mi                                      14 cents/mi

The charitable mileage rate did not change because that rate is set by statute and not regulation. It requires Congress to change the charitable mileage rate.

Another Warning on Deducting Auto Expenses

There is a very recent case concerning tax deductions for business use of a vehicle that I am considering as mandatory reading for many of our clients.

The pattern is repetitive. Either the business provides the car or the employee uses his/her car for business and is not reimbursed. Tax time we ask the following questions: what is your mileage? What do you have as documentation to support that mileage? We review the danger associated with this tax deduction (the IRS will disallow it if you cannot back it up), to which it seems most of the clients roll their eyes and go “yea, yea.”

Well, Jessica Solomon just got schooled. It’s a shame, too, as it sounds like Jessica was trying to do the right thing, but she just didn’t know what that meant. Let’s look at Jessica Solomon v Commissioner.

Jessica Solomon moved from Illinois to Missouri in 2006. First, let me say that I went to the University of Missouri, so I approve of her move. Second, she started work as a commission-only salesperson for seven months – June through December. She was peddling office supplies. Every day she started the morning at the company office in St Louis, and at the end of the day she finished with an evening meeting there. She only made $3,307 in commissions. Considering that she was reimbursed for NOTHING, it sounds to me like this was a waste of her time.

She kept a log in her car. At the start of the day she wrote down her mileage, and at the end she noted her mileage. Unfortunately, there was no other information, such as the towns, prospects or customers she was visiting. It was bare-boned, but it was something.

At the end of the year she went to H&R Block. They deducted her business expenses, including 18,741 business miles.

In January, 2009 the IRS issued a statutory notice disallowing all her mileage and employee expenses for 2006. Jessica, bless her heart, went to Tax Court representing herself (this is called “pro se”). It did not go well for Jessica.

Unfortunately, the court was right. Let’ go through this…

* It is an axiom in tax practice that deductions are a matter of legislative grace. This is fancy way of saying that there is no deduction just because you really, really want there to be one.
* If a taxpayer presents credible evidence on a factual issue concerning tax liability, Code Section 7491(a) shifts the burden of proof to the IRS.
* If Section 7491(a) kicks in, the IRS (or Court) may even estimate the amount of expenses, if the supporting documentation is poor or even nonexistent.
* There are some expenses where the burden of proof does not shift under Section 7491(a).
* A car is one of those expenses. Car expenses are addressed under Section 274(n).
* Section 274(n) says that no deductions are allowed with respect to listed property (think a car) unless very specific documentation requirements are met:

** The amount
** The time and place
** The business purpose
** The taxpayer’s relationship with the persons involved

The Court looked at her log. The court had several problems;

(1) The log noted only the beginning and ending mileage for each day

(2) The log included a 27 mile commute

(3) The log may have included personal trips

So far, I could have worked with this. I would ask Jessica for a Day Runner or some other record of who she visited, where and etc. In fact, had she submitted contact reports to the company, I would ask the company to provide copies for her tax audit. I need corroborating evidence. The evidence does not have to be on the same sheet of paper. In truth, it need not even had been created at the time, although that would of course carry more weight.

Unfortunately Jessica could not do this. Here is the Court:

Petitioner did not present any evidence at trial, such as appointment books, calendars, or maps of her sales territories, to corroborate the bare information contained in the mileage log…”

But the court KNEW that she had to use her car – right? Surely the Court would spot her something.

Although we do not doubt that petitioner used her Chevrolet Cavalier for business between June and December, 2006, we have no choice but to deny in full petitioner’s deduction for mileage expenses. For reasons discussed …, petitioner’s mileage log does not satisfy the adequate records requirement of Section 274(d).”

No mileage deduction for Jessica.

As I said, perhaps this case should be mandatory reading for many of our clients.