When Bidding Is Not Marketing

I was talking with a client recently. He is a real estate developer, and he was telling me about a tense run-in several years ago with the county about a proposed development. Think NIMBY (not in my backyard) and you have the context.

Believe it or not, there is a tax issue there.

Let’s set it up by discussing Hisham Ashkouri (HA).

HA was an architect. He was bidding on projects in Washington state and Utah. He was also bidding on projects in Libya and in the Republic of Tartarstan, which is in Russia.

Those last two are certainly off the beaten path.

Using different companies, he submitted development bid proposals. I am not sure what was in these bid proposals, but over three years (2009 – 2011), he deducted over $500 grand in bid expenses.

Sounds expensive.

The IRS audited the three years.

And disallowed the bid expenses.

That doesn’t sound right, thought I.

HA argued that he had deducted marketing and promotion expenses.

Then HA went foot-in-mouth:

“If any of those projects had resulted in ‘a real estate transaction …, I would be having 20 percent ownership.’”

Let’s introduce Code Section 263A. That bad boy generally deals with the acquisition of property, and its intention is to make you capitalize everything under the sun when you acquire – including constructing or developing – property. “Capitalize” is accounting-speak for depreciating something rather than deducting it immediately.

If you depreciate over one year, then I suppose the net effect is approximately the same. If you have to depreciate over 39 years, well, it is going to hurt.

HA fired off first and strong:

The deductions …"could not be capitalized as they were used for marketing and promotion with no real estate transaction." Although petitioners fail to cite any authority in support of that claim, they are correct that section 263A does not require the capitalization of "marketing, selling, advertising, and distribution costs." 

The Court however nailed the issue:

Mr. Ashkouri's testimony regarding the projects he pursued was not particularly detailed, but we take him as having acknowledged that, had he been awarded any of the projects, he would have acquired an ownership interest in the property being developed. He did not identify any project for which he claimed deductions in which he would not have received an ownership interest had he been awarded the contract.”

Every project would have resulted in the acquisition of an ownership interest. This is not marketing or promotion in a conventional sense. HA’s possible ownership interest at the end lands these transactions within the Section 263A dragnet.

So what? He did not win any of these bids, and he would get to deduct the bid costs when the contract was awarded to someone else. Granted, the deduction might be held-up a year or two – until the bid was awarded – but HA would eventually get his deduction.

Here comes the Scooby Doo mystery portion of the case:

But petitioners have not established when (if ever) the development contracts Mr. Ashkouri sought were awarded to others, when Mr. Ashkouri received written notice that no contract would be awarded, or when he abandoned his bid or proposal for each project.”

Seriously? He could not show that the bid went to someone else or was withdrawn entirely? I am not getting this at all.

The Tax Court then backed-up and ran over the body a second time – apparently to make sure that it had stopped breathing:

Even if we were to accept that the expenses in issue were not subject to deferral under section 1.263A-1(e)(3)(ii)(T), Income Tax Regs., we would still conclude that respondent properly disallowed the deductions for architectural or contract services claimed on the Schedules C for Mr. Ashkouri's proprietorship because petitioners did not adequately substantiate the expenses underlying the claimed deductions. In general, section 162(a) allows a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business". When called upon by the Commissioner, however, a taxpayer must substantiate his expenses.”

Bam! Even if HA provided evidence about the bid outcomes, the Court was still going to say “No.”

Back to my real estate guy.

What was the tax issue back when?

His transaction involved real estate development. There is no question that he would have had an ownership interest if the project went through; in fact, he would be the only owner.

Let’s say he incurred significant expenses – legal, engineering and the like – while battling the county.

Would have had to capitalize those expenses rather than deduct them right away?

A Mom Taking Care Of A Disabled Child And Payroll Taxes

We have a responsible person payroll tax story to tell.

You may know that I sardonically refer to this penalty as the “big-boy” penalty. It applies when you have some authority and control over the deposit of payroll withholding taxes but do not remit them to the IRS. The IRS views this as theft, and they can be quite unforgiving. The penalty alone is equal to 100% of the tax; in addition, the IRS will come after you personally, if necessary.

You do not want this penalty – for any reason.

How do people get into this situation? In many – if not most cases – it is because the business is failing. There isn’t enough cash, and it is easier to “delay” paying the IRS rather than a vendor who has you on COD. You wind up using the IRS as a bank. Now, you might be able to survive this predicament if we were talking about personal or business income taxes. Introduce payroll – and payroll withholding – and you have a different answer altogether.

Our story involves Christina Fitzpatrick (Christina). Her husband made the decision to start a restaurant in Jacksonville with James Stamps (Stamps). They would be equal partners, and Stamps would run the show. Fitzpatrick would be the silent wallet.

They formed Dey Corp., Inc to hold the franchise. The franchise was, of course, the restaurant itself.  

Sure enough, shortly after formation and before opening, Stamps was pulled to Puerto Rico for business. This left Fitzpatrick, who in turn passed on some of the pre-opening duties to his wife, Christina.

Fortunately, Stamps got back in town before the place opened. He hired a general manager, a chef and other employees. He then went off to franchise training school. Meanwhile, the employees wanted to be paid, so Stamps had Christina contact Paychex and engage their services. They would run the payroll, cut checks and make the tax deposits.

            OBSERVATION: Let’s call this IRS point (1)

He also had Christina open a business bank account and include herself as a signatory.

            OBSERVATION: IRS point (2) and (3)

Stamps and the general manager (Chislett) pretty much ran the place. Whether he was in or out of town, Stamps was in daily contact with Chislett. Chislett managed, hired and fired, oversaw purchases and so on. He was also the main contact with Paychex.

Except that …

Paychex started off by delivering paychecks weekly to the restaurant. There was a problem, though: the restaurant wasn’t open when they went by. Paychex then starting going to Christina’s house. Chislett told her to sign and drop-off the paychecks at the restaurant. Chislett could not do it because it was his day off.

            OBSERVATION: IRS point (4) and (5).

You can anticipate how the story goes from here. The restaurant lost money. Chislett was spending like a wild man, to the extent that the vendors put him on COD. Somewhen in there Paychex drew on the bank account and the check bounced. Paychex stopped making tax deposits for the restaurants because – well, they were not going to make deposits with rubber checks.

By the way, neither Stamps nor Chislett bothered to tell the Fitzpatricks that Paychex was no longer making tax deposits.

Sure enough, the IRS Revenue Officer (RO) showed up. She clued the Fitzpatricks that the restaurant was over two years behind on tax deposits.

Remember that the restaurant was short on cash. Who could the IRS chase for its money in its stead?  Let me think ….

The RO decided Christina was a responsible person and assessed big bucks (approximately $140,000) against her personally.

Off to Tax Court they went.

The Court introduces us to Christina.

·       She spent her time taking care of her disabled son, who suffered from a rare metabolic disorder. As a consequence, he had severe autism, cerebral palsy and limited mobility. He needed assistance for many basic functions, such as eating and going to the bathroom. He could not be left alone for any significant amount of time.

·       Taking care of him took its toll on her. She developed spinal stenosis from constantly having to lift him. She herself took regular injections and epidurals.

·       She truly did not have a ton of time to put into her husband’s money-losing restaurant. At start-up she had a flurry of sorts, but after that she visited maybe once a week, and that for less than an hour.

·       She could not hire or fire. She was not the bookkeeper or accountant. She did not see the bank statements.

She did, unfortunately, sign a few of the checks.

The IRS looks very closely at who has signatory authority on the bank account. As far as they are concerned, one could write a check to them as easily as a check to a vendor. Christina appears to be behind the eight ball.

The Court noted that the IRS was relying heavily on the testimony of Stamps and Chislett.

The Court did not like them:

Petitioner’s cross-examination of Mr. Stamps and Mr. Chislett revealed that their testimony was unreliable and unbelievable."

That is Court-speak to say they lied.

Mr. Stamps evaded many of the petitioner’s questions during cross-examination by repeatedly responding ‘I don’t remember.’”

Sounds like a possible presidential run in there for Stamps.

The Court was not amused with the IRS Revenue Officer either:

However, we believe that RO Wells did not conduct a thorough investigation. For instance, RO Wells made her determination before she received and reviewed the relevant bank records. She also failed to interview (or summon) Mr. Stamps, the president of the corporation.”

The IRS is supposed to interview all the corporate officers. Sounds like this RO did not.

The Court continued:

We are in fact puzzled that Mr. Stamps, the president of the corporation and a hands-on owner, an Mr. Chislett, the day-to-day manager, successfully evaded in the administrative phase any personal liability for these TFRPs.”

My, that is curious, considering they RAN the place. The use of the word “evaded” clarifies what the Court thought of these two.

But there is more required to big-boy pants than just signing a check. The Court reminded the IRS that a responsible person must have some control:

The inquiry must focus on actual authority to control, not on trivial duties.”

Here is the hammer:

Notwithstanding petitioner’s signatory authority and her spousal relationship to one of the corporation’s owners, the substance of petitioner’s position was largely ministerial and she lacked actual authority.”

The Court liked Christina. The Court did not like Stamps and Chislett. They especially did not like the IRS wasting their time. She was a responsible person they way I am a deep-sea diver because I have previously been on a boat.

The Court dismissed the case.

But we see several points about this penalty:

(1)  The IRS will chase you like Khan chased Kirk.

(2)  Note that the IRS did not chase Stamps or Chislett. This tells me those two had no money, and the IRS was chasing the wallet.

(3)  Following on the heels of (2), do not count on the IRS being “fair.” They IRS can cull one person from the herd and assess the penalty in full. There is no requirement to assess everyone involved or keep the liability proportional among the responsible parties.

We have a success story, but look at the facts that it took.

Getting ROBbed

I was skimming a Tax Court decision that leads with:

“… respondent issued a notice of deficiency … of $249,263.62, additions to tax … of $20,228.76 and $22,476.41, respectively and an enhanced accuracy-related penalty … of $63,918.33”

It was Roth IRA decision.

We have spoken before about putting a business in an IRA, and a Roth is just a type of IRA. This tax structure is sometimes referred to as a “ROBS” – roll-over as business start-up. 

Odds are the only one who is going to get robbed is you. I had earlier looked into and decided that I did not like the ROBS structure. There are too many ways that it can detonate. I do not practice high-wire tax.  

I have also noticed the IRS pursuing this area more aggressively. There often is complacency when a “new” tax idea takes, as the IRS may not respond immediately. That lag is not an imprimatur by the IRS, although self-interested parties may present it as such. I have been in practice long enough to have heard that sales pitch more than once.

Let’s discuss Polowniak v Commissioner.

Polowniak had over 35 years of marketing experience with Fortune 500 companies, including Proctor & Gamble, Johnson & Johnson and Kimberly Services. In 1997 he formed his own company – Solution Strategies, Inc. (Strategies). He was the sole shareholder and its only consultant.

In 2001 he received a nice contract - $680,000 – from Delphi Automotive Systems – which had him travel extensively to Europe, Asia and South America. 

Now the turn. His financial advisor recommended an attorney who pitched the idea of “privately owned Roth IRA corporations,” also known as PIRACs. These things are not rocket science. In most cases an individual already has an existing company, likely profitable or soon to be. Said individual sets up a Roth IRA. Said Roth purchases the stock of a new corporation (NewCo), which amazingly does exactly the same thing that the existing corporation did, and likely with the same customers, vendors, employee, office space and so on.

The idea of course is that NewCo is going to be very profitable, which allows the opportunity to stuff a lot of money into the Roth in a very short period of time.

So Polowniak sets up a NewCo, which he names Bevco Investments, Inc. (Bevco). There is a little flutter in the story as Bevco selects a January year-end, meaning that a sharp tax advisor may have the opportunity to move things back-and-forth between a calendar-year taxpayer and an entity that doesn’t file its tax return until a year later.

This is fairly routine tax work.

Polowniak owned 98 percent and his administrative assistant owned 2 percent.  His wife later purchased 6% of Bevco.

Strategies and Bevco entered into an agreement whereby it would receive 75% of Strategies revenues for 2002.

By the way, Delphi was never informed of Bevco. Neither was the administrative assistant.

The years passed. Polowniak let the subcontract with Bevco lapse.

And he started depositing all the Strategies revenue from Delphi into Bevco. There was no more pretense of 75 percent.

Bevco was finally dissolved in 2006.

And then came the IRS.

It went after Solutions, which did not report the $680,000 from Delhi. You remember, the same amount it was to share 75% with Bevco.

Sheesh.

It also came after Polowniak personally. The IRS wanted penalties for excess funding into a Roth.

Huh?

There are limits for funding a Roth. For example, the 2015 limit for someone age-50-and-over (ahem) is $6,500. If you go over, then there is a 6% penalty. Mind you, the 6% doesn’t sound like much, but it becomes pernicious, as it compounds on itself every year. Tax practitioners refer to this as “cascading,” and the math can be surprising.

How did he overfund?

Simple. He took existing money from Solutions and put it into Bevco. It is the equivalent of you depositing money at Key Bank rather than Fifth Third.

Polowniak’s job right now was to convince the Court that was a substantive reason for the Solutions –Bevco structure. If Bevco was just an alter ego, he was going to lose and lose big.

He trotted put Hellweg, a tax case featuring Roth IRAs and Domestic International Sales Corporations (DISCs). Whereas the taxpayer won that case, there was some arcane tax reasoning behind it, likely exacerbated by those DISCs.

The Court did not think Hellweg was on point. It thought that Repetto was much more applicable, pointing out:

·        All the services performed by Bevco had previously been performed by Polowniak through Strategies

·        Polowniak performed all the services under the contract with Delphi

·        Since he was the only person performing services, the transfer of payments between Strategies and Bevco had no substantive effect on the Delphi contract

·        Delphi did not know of the contract with Bevco; in fact, neither did the administrative assistant

·        The business dealing between Strategies and Bevco were not business-normative. For example, Bevco never kept time or accounting records of its services, nor did it ever invoice Strategies.

The Court decided against Polowniak. It did not respect the PIRAC, and as far as it was concerned all the Delphi money put into Bevco was an overfunding.

And that is how you blow through a third of a million dollars.

Is there something Polowniak could have done?

He could of course have respected business norms and treated both as separate companies with their own accounting systems, phone numbers, contracts and so forth. It would have helped had Strategies not been depositing and withdrawing monies from Bevco’s bank account.

Still, I do not think that would have been enough.

There are two major problems that I see:

(1) There was an existing contract in place with Delphi. This is not the same as starting Bevco and pounding the streets for work. There is a very strong assignment of income feel, and I suspect just about any Court would have been disquieted by it.

(2) There were not enough players on the field. If I own a company with 75 employees, I may be able to take a slice of its various activities and place it inside a PIRAC or ROBS or whatever, without the thing being seen as my alter ego. Polowniak however was a one-man show. This made it much easier for the IRS to argue substance over form, which the IRS successfully argued here.

 

My advice? Leave these things alone. There are a hundred ways that these IRA-owned companies can blow up, and the IRS has sounded the trumpet that it is pursuing them.

Helping Out A Family Member’s Business

Let’s say that you have a profitable business. You have a family member who has an unprofitable business. You want to help out the family member. You meet with your tax advisor to determine if there is tax angle to consider.

Here is your quiz question and it will account for 100% of your grade:

What should you to maximize the chances of a tax deduction?

Let’s discuss Espaillat and Lizardo v Commissioner.

Mr. Jose Espaillat was married to Ms. Mirian Lizardo. Jose owned a successful landscaping business in Phoenix for a number of years. In 2006 his brother (Leoncio Espaillat) opened a scrap metal business (Rocky Scrap Metal) in Texas. Rocky Scrap organized as a corporation with the Texas secretary of state and filed federal corporate tax returns for 2008 and 2009.

Being a good brother, Jose traveled regularly to help out Leoncio with the business. Regular travel reached the point where Jose purchased a home in Texas, as he was spending so much time there.

Rocky Scrap needed a big loan. The bank wanted to charge big interest, so Jose stepped in. He lent money; he also made direct purchases on behalf of Rocky Scrap. In 2007 and 2008 he contributed at least $285,000 to Rocky Scrap. Jose did not charge interest; he just wanted to be paid back.

Jose and Mirian met with their accountant to prepare their 2008 individual income tax return. Jose’s landscaping business was a Schedule C proprietorship/sole member LLC, and their accountant recommended they claim the Rocky Scrap monies on a second Schedule C. They would report Rocky Scrap the same way as they reported the landscaping business, which answer made sense to Jose and Mirian. Inexplicably, the $285,000 somehow became $359,000 when it got on their tax return.

In 2009 Rocky Scrap filed for bankruptcy. I doubt you would be surprised if I told you that Jose paid for the attorney. At least the bankruptcy listed Jose as a creditor.

In 2010 Jose entered into a stock purchase agreement with Leoncio. He was to receive 50% of the Rocky Scrap stock in exchange for the aforementioned $285,000 – plus another $50,000 Jose was to put in.

In 2011 Jose received $6,000 under the bankruptcy plan. It appears that the business did not improve all that much.

In 2011 Miriam and their son (Eduan) moved to Texas to work and help at Rocky Scrap. Jose stayed behind in Phoenix taking care of the landscaping business.

Then the family relationship deteriorated. In 2013 a judge entered a temporary restraining order prohibiting Jose, Miriam and Eduan from managing or otherwise directing the business operations of Rocky Scrap.  

Jose, Miriam and Eduan walked away. I presume they sold the Texas house, as they did not need it anymore.

The IRS looked at Jose and Mirian’s 2008 and 2009 individual tax returns.  There were several issues with the landscaping business and with their itemized deductions, but the big issue was the $359,000 Schedule C loss.

The IRS disallowed the whole thing.

On to Tax Court they went. Jose and Mirian’s petition asserted that they were involved in a business called “Second Hand Metal” and that the loss was $285,000. What happened to the earlier number of $359,000? Who knows.

What was the IRS’ argument?

Easy: there was no trade or business to put on a Schedule C. There was a corporation organized in Texas, and its name was Rocky Scrap Metals. It filed its own tax return.  The loss belonged to it. Jose and Mirian may have loaned it money, they may have worked there, they may have provided consulting expertise, but at no time were Jose and Mirian the same thing as Rocky Scrap Metal.

Jose and Mirian countered that they intended all along to be owners of Rocky Scrap. In fact, they thought that they were. They would not have bought a house in Texas otherwise. At a minimum, they were in partnership or joint venture with Rocky Scrap if they were not in fact owners of Rocky Scrap.

Unfortunately thinking and wanting are not the same as having and doing. It did not help that Leoncio represented himself as the sole owner when filing the federal corporate tax returns or the bankruptcy paperwork. The Court pointed out the obvious: they were not shareholders in 2008 and 2009. In fact, they were never shareholders.

OBSERVATION: Also keep in mind that Rocky Scrap filed its own corporate tax returns. That meant that it was a “C” corporation, and Jose and Mirian would not have been entitled to a share of its loss in any event. What Jose and Mirian may have hoped for was an “S” corporation, where the company passes-through its income or loss to its shareholders, who in turn report said income or loss on their individual tax return. 

 

The Court had two more options to consider.

First, perhaps Jose made a capital investment. If that investment had become worthless, then perhaps … 

Problem is that Rocky Scrap continued on. In fact, in 2013 it obtained a restraining order against Jose, Miriam and Eduan, so it must have still been in existence.  Granted, it filed for bankruptcy in 2009. While bankruptcy is a factor in evaluating worthlessness, it is not the only factor and it was offset by Rocky Metal continuing in business.  If Rocky Scrap became worthless, it did not happen in 2009.

Second, what if Jose made a loan that went uncollectible?

The Court went through the same reasoning as above, with the same conclusion.

OBSERVATION: In both cases, Jose would have netted only a $3,000 per year capital loss. This would have been small solace against the $285,000 the IRS disallowed.

The Court decided there was no $285,000 loss.

Then the IRS – as is its recent unattractive wont – wanted a $12,000 penalty on top of the $60-plus-thousand-dollar tax adjustment it just won. Obviously if the IRS can find a different answer in 74,000+ pages of tax Code, one must be a tax scofflaw and deserving of whatever fine the IRS deems appropriate.

The Court decided the IRS had gone too far on the penalty.

Here is the Court:

He [Jose] is familiar with running a business and keeping records but has a limited knowledge of the tax code. In sum, Mr. Espaillat is an experienced small business owner but not a sophisticated taxpayer.”

Jose and Mirian relied on their tax advisor, which is an allowable defense to the accuracy-related penalty. Granted, the tax advisor got it wrong, but that is not the same as Jose and Mirian getting it wrong. The point of seeing a dentist is not doing the dentistry yourself.

What should the tax advisor done way back when, when meeting with Jose and Mirian to prepare their 2008 tax return?

First, he should have known the long-standing doctrine that a taxpayer devoting time and energy to the affairs of a corporation is not engaged in his own trade or business. The taxpayer is an employee and is furthering the business of the corporation.

Granted Jose and Mirian put-in $285,000, but any tax advantage from a loan was extremely limited – unless they had massive unrealized capital gains somewhere. Otherwise that capital loss was releasing a tax deduction at the rate of $3,000 per year. One should live so long.

The advisor should have alerted them that they needed to be owners. Retroactively. They also needed Rocky Scrap to be an S corporation.  Retroactively. It would also have been money well-spent to have an attorney draw up corporate minutes and update any necessary paperwork.

That is also the answer to our quiz question: to maximize your chance of a tax deduction you and the business should become one-and-the-same. This means a passthrough entity: a proprietorship, a partnership, an LLC or an S corporation. You do not want that business filing its own tax return.  The best you could do then is have a worthless investment or uncollectible loan, with very limited tax benefits.