An IRS Employee And Unreported Income

 

You may have heard that Congress is tightening the 1099 reporting requirements for third party payment entities such as PayPal and Venmo. The ultimate goal is to report cumulative payments exceeding $600. Because of implementation issues, the IRS has adjusted this threshold to $5,000 for 2024.

Many, I suspect, will be caught by surprise.

Receiving a 1099-K does not necessarily mean that you have taxable income. It does mean that you were paid by one of the reporting organizations, and that payment will be presumed business-related. This is of concern with Venmo, for example, as a common use is payment of group-incurred personal expenses, such as the cost of dining out. Venmo will request one to identify a transaction as business or personal, using that as the criterion for IRS reporting  

What you cannot do, however, is ignore the matter. This IRS matching is wholly computerized; the notice does not pass by human eyes before being mailed. In fact, the first time the IRS reviews the notice is when you (or your tax preparer) respond to it. Ignore the notice however and you may wind up in Collections, wondering what happened.

The IRS adjusted the 2004 and 2005 returns for Andrea Orellana.

The IRS had spotted unreported income from eBay. Orellana had reported no eBay sales, so the computer match was easy.

There was a problem, though: Orellana worked for the IRS as a revenue officer.

COMMENT: A revenue officer is primarily concerned with Collections. A revenue agent, on the other hand, is the person who audits you.

Someone working at the IRS is expected to know and comply with his/her tax reporting obligations. As a revenue officer, she should have known about 1099-Ks and computer matching.

It started as a criminal tax investigation.

Way to give the benefit of the doubt there, IRS.

There were issues with identifying the cost of the items sold, so the criminal case was closed and a civil case opened in its place.

The agent requested and obtained copies of bank statements and some PayPal records. A best guess analysis indicated that over $36 thousand had been omitted over the two years.

Orellana was having none of this. She requested that the case be forwarded to Appeals.

Orellana hired an attorney. She was advised to document as many expenses as possible. The IRS meanwhile subpoenaed PayPal for relevant records.

Orellana did prepare a summary of expenses. She did not include much in the way of documentation, however.

The agent meanwhile was matching records from PayPal to her bank deposits. This proved an unexpected challenge, as there were numerous duplicates and Orellana had multiple accounts under different names with PayPal.

The agent also needed Orellana’s help with the expenses. She was selling dresses and shoes and makeup and the like. It was difficult to identify which purchases were for personal use and which were for sale on eBay.

Orellana walked out of the meeting with the agent.

COMMENT: I would think this a fireable offense if one works for the IRS.

This placed the agent in a tough spot. Without Orellana’s assistance, the best she could do was assume that all purchases were for personal use.

Off they went to Tax Court.

Orellana introduced a chart of deposits under dispute. She did not try to trace deposits to specific bank accounts nor did she try to explain – with one exception - why certain deposits were nontaxable.

Her chart of expenses was no better. She explained that any documents she used to prepare the chart had been lost.

Orellana maintained that she was not in business and that any eBay activity was akin to a garage sale. No one makes a “profit” from a garage sale, as nothing is sold for more than its purchase price.

The IRS pointed out that many items she bought were marketed as “new." Some still had tags attached.

Orellana explained that she liked to shop. In addition, she had health issues affecting her weight, so she always had stuff to sell.

As for “new”: just a marketing gimmick, she explained.

I always advertise as new only because you can get a better price for that.” 

… I document them as new if it appears new.”

Alright then.

If she can show that there was no profit, then there is no tax due.

Orellana submitted records of purchases from PayPal.

… but they could not be connected or traced to her.

She used a PayPal debit card.

The agent worked with that. She separated charges between those clearly business and those clearly personal. She requested Orellana’s help for those in between. We already know how that turned out.

How about receipts?

She testified that she purchased personal items and never kept receipts.

That would be ridiculous, unheard of. Unless there was some really bizarre reason why I keep a receipt, there were no receipts.”

The IRS spotted her expenses that were clearly business. They were not enough to create a loss. Orellana had unreported income.

And the Court wanted to know why an IRS Revenue Officer would have unreported income.

Frankly, so would I.

Petitioner testified that she ‘had prepared 1040s since she was 16’ and that she ‘would ‘never look at the instructions.’”

Good grief.

The IRS also asked for an accuracy penalty.

The Court agreed.

Our case this time was Orellana v Commissioner, T.C. Summary Opinion 2010-51.

A Charitable Deduction To An Estate

 

I had a difficult conversation with a client recently over an issue I had not seen in a while.

It involves an estate. The same issue would exist with a trust, as estates and trusts are (for the most part) taxed the same way.

Let’s set it up.

Someone passed away, hence the estate.

The estate is being probated, meaning that at least some of its assets and liabilities are under court review before payment or distribution. The estate has income while this process is going on and so files its own income tax return.

Many times, accountants will refer to this tax return as the “estate” return, but it should not be confused with the following, also called the “estate” return:

What is the difference?

Form 706 is the tax – sometimes called the death tax – on net assets when someone passes away. It is hard to trigger the death tax, as the Code presently allows a $13.6 million lifetime exclusion for combined estate and gift taxes (and twice that if one is married). Let’s be honest: $13.6 million excludes almost all of us.

Form 1041 is the income tax for the estate. Dying does not save one from income taxes.

Let’s talk about the client.

Dr W passed away unexpectedly. At death he had bank and brokerage accounts, a residence, retirement accounts, collectibles, and a farm. The estate is being probated in two states, as there is real estate in the second state. The probate has been unnecessarily troublesome. Dr W recorded a holographic will, and one of the states will not accept it.

COMMENT: Not all estate assets go through probate, by the way. Assets passing under will must be probated, but many assets do not pass under will.

What is an example of an asset that can pass outside of a will?

An IRA or 401(k).

That is the point of naming a beneficiary to your IRA or 401(k). If something happens to you, the IRA transfers automatically to the beneficiary under contract law. It does not need the permission of a probate judge.

Back to Dr W.

Our accountant prepared the Form 1041, I saw interest, dividends, capitals gains, farm income and … a whopping charitable donation.

What did the estate give away?

Books. Tons of books. I am seeing titles like these:

·       Techniques of Chinese Lacquer

·       Vergoldete Bronzen I & II

·       Pendules et Bronzes d’Ameublement

Some of these books are expensive. The donation wiped out whatever income the estate had for the year.

If the donation was deductible.

Look at the following:

§ 642 Special rules for credits and deductions.

      (c)  Deduction for amounts paid or permanently set aside for a charitable purpose.

(1)  General rule.

In the case of an estate or trust ( other than a trust meeting the specifications of subpart B), there shall be allowed as a deduction in computing its taxable income (in lieu of the deduction allowed by section 170(a) , relating to deduction for charitable, etc., contributions and gifts) any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in section 170(c) (determined without regard to section 170(c)(2)(A) ). If a charitable contribution is paid after the close of such taxable year and on or before the last day of the year following the close of such taxable year, then the trustee or administrator may elect to treat such contribution as paid during such taxable year. The election shall be made at such time and in such manner as the Secretary prescribes by regulations.

This not one of the well-known Code sections.

It lays out three requirements for an estate or trust to get a charitable deduction:

• Must be paid out of gross income.
• Must be paid pursuant to the terms of the governing instrument.
• Must be paid for a purpose described in IRC Sec. 170(c) without regard to Section 170(c)(2)(A). 

Let’s work backwards.

The “170(c) without …” verbiage opens up donations to foreign charities.

In general, contributions must be paid to domestic charities to be income-tax deductible. There are workarounds, of course, but that discussion is for another day. This restriction does not apply to estates, meaning they can contribute directly to foreign charities without a workaround.

This issue does not apply to Dr W.

Next, the instrument governing the estate must permit payments to charity. Without this permission, there is no income tax deduction.

I am looking at the holographic will, and there is something in there about charities. Close enough, methinks.

Finally, the donation must be from gross income. This term is usually interpreted as meaning gross taxable income, meaning sources such as municipal interest or qualified small business stock would create an issue.

The gross income test has two parts:

(1)  The donation cannot exceed the estate’s cumulative (and previously undistributed) taxable income over its existence.

(2)  The donation involves an asset acquired by that accumulated taxable income. A cash donation easily meets the test (if it does not exceed accumulated taxable income). An in-kind distribution will also qualify if the asset was acquired with cash that itself would have qualified.

The second part of that test concerns me.

Dr W gave away a ton of books.

The books were transferred to the estate as part of its initial funding. The term for these assets is “corpus,” and corpus is not gross income. Mind you, you probably could trace the books back to the doctor’s gross income, but that is not the test here.

I am not seeing a charitable deduction.

“I would not have done this had I known,” said the frustrated client.

I know.

We have talked about a repetitive issue with taxes: you do not know what you do not know.

How should this have been done?

Distribute the books to the beneficiary and let him make the donation personally. Those rules about gross income and whatnot have no equivalent when discussing donations by individuals.

What if the beneficiary does not itemize?

Understood, but you have lost nothing. The estate was not getting a deduction anyway.

How Choosing The Correct Court Made The Difference

I am looking at a District Court case worth discussing, if only for the refresher on how to select a court of venue. Let’s set it up.

ABC Beverage Corporation (ABC) makes and distributes soft drinks and non-alcoholic beverages for the Dr Pepper Snapple Group Inc. Through a subsidiary it acquired a company in Missouri. Shortly afterwards it determined that the lease it acquired was noneconomic. An appraisal determined that the fair market rent for the facility was approximately $356,000 per year, but the lease required annual rent of $1.1 million. The lease had an unexpired term of 40 years, so the total dollars under discussion were considerable.

The first thing you may wonder is why the lease could be so disadvantageous. There are any number of reasons. If one is distributing a high-weight low-value product (such as soft drinks), proximity to customers could be paramount. If one owns a franchise territory, one may be willing to pay a premium for the right road access. Perhaps one’s needs are so specific that the decision process compares the lease cost to the replacement cost of building a facility, which in turn may be even more expensive. There are multiple ways to get into this situation.

ABC obtained three appraisals, each of which valued the property without the lease at $2.75 million. With the lease the property was worth considerably more.

NOTE: Worth more to the landlord, of course. 

ABC approached the landlord and offered to buy the facility for $9 million. The landlord wanted $14.8 million. Eventually they agreed on $11 million. ABC capitalized the property at $2.75 million and deducted the $6.25 million difference.

How? ABC was looking at the Cleveland Allerton Hotel decision, a Sixth Circuit decision from 1948. In that case, a hotel operator had a disastrous lease, which it bought out. The IRS argued that that the entire buyout price should be capitalized and depreciated. The Circuit Court decided that only the fair market value of the property could be capitalized, and the rest could be deducted immediately. Since 1948, other courts have decided differently, including the Tax Court. One of the advantages of taking a case to Tax Court is that one does not have to pay the tax and then sue for refund. A Tax Court filing suspends the IRS’ ability to collect. The Tax Court is therefore the preferred venue for many if not most tax cases.

However and unfortunately for ABC, the Tax Court had decided opposite of Cleveland Allerton (CA), so there was virtually no point in taking the case there. ABC was in Michigan, which is in the Sixth Circuit. CA had been decided in the Sixth Circuit. To get the case into the District Court (and thus the Circuit), ABC would have to pay the tax and sue for refund. It did so.

The IRS came out with guns blazing. It pointed to Code Section 167(c)(2), which reads:

            (2) Special rule for property subject to lease

If any property is acquired subject to a lease—

(A) no portion of the adjusted basis shall be allocated to the leasehold interest, and

(B) the entire adjusted basis shall be taken into account in determining the depreciation deduction (if any) with respect to the property subject to the lease.

The IRS argued that the Section meant what it said, and that ABC had to capitalize the entire buyout, not just the fair market value.  It trotted out several cases, including Millinery Center and Woodward v Commissioner. It argued that the CA decision had been modified – to the point of reversal – over time. CA was no longer good precedent.

The IRS had a second argument: Section 167(c)(2) entered the tax Code after CA, with the presumption that it was addressing – and overturning – the CA decision.

The Circuit Court took a look at the cases. In Millinery Center, the Second Circuit refused to allow a deduction for the excess over fair market value. The Sixth Circuit pointed out that the Second Circuit had decided that way because the taxpayer had failed its responsibility of proving that the lease was burdensome. In other words, the taxpayer had not gotten to the evidentiary point where ABC was.

In Woodward the IRS argued that professional fees pursuant to a stockholder buyout had to be capitalized, as the underlying transaction was capital in nature. Any ancillary costs to the transaction (such as attorneys and accountants) likewise had to be capitalized. The Sixth Circuit pointed out the obvious: ABC was not deducting ancillary costs. ABC was deducting the transaction itself, so Woodward did not come into play.

The Court then looked at Section 167(c)(2) – “if property is acquired subject to a lease.” That wording is key, and the question is: when do you look at the property? If the Court looked before ABC bought out the lease, then the property was subject to a lease. If it looked after, then the property was not. The IRS of course argued that the correct time to look was before. The Court agreed that the wording was ambiguous.

The Court reasoned that a third party purchaser looking to acquire a building with an extant lease is different from a lessee purchaser. The third party acquires a building with an income stream – two distinct assets - whereas the lessee purchaser is paying to eliminate a liability – the lease. Had the lessee left the property and bought-out the lease, the buy-out would be deductible.

The Court decided that the time to look was after. There was no lease, as ABC at that point had unified its fee simple interest. Section 167(c)(2) did not apply, and ABC could deduct the $6.25 million. The Court decided that its CA decision from 1948 was still precedent, at least in the Sixth Circuit.

ABC won the case, and kudos to its attorneys. Their decision to take the case to District Court rather than Tax Court made the case appealable to the Sixth Circuit, which venue made all the difference.