How Much Paperwork Does the IRS Want?

Sometimes practitioners disagree on how much supporting paperwork – if any – should go with a tax return.

The issue can take on a keener edge when one is working with amended returns or claims for refunds.

COMMENT: For the nerds, an amended return can technically be a claim for refund – if the amended return shows a refund.

It also can vary with the tax issue at play.

I am looking at two cases – the first being the initial hearing and the second the appeal – involving a research tax credit.

The research credit is easier to understand if we think of companies such as Johnson & Johnson or Pfizer. Lab coats, scientific equipment, people wearing safety glasses and so forth. The image screams research.

Mind you, there are accounting and recordkeeping issues that go with this credit.

A routine accounting system would capture functional costs (think payroll, rent, utilities), departmental costs (think auto parts versus auto service at a car dealership) and divisional costs (consumer and industrial, for example). The research credit wants even more detail from the accounting system. It wants detail at the research activity level.

What is a research activity?

You could be an activity. Say that you are an engineer. You work in manufacturing, but a portion of your time is spent on activities that might qualify for the credit. What would be an example? Let’s say improving a product or the process to manufacture that product.  

The accounting system easily captures your payroll as a functional cost.

The system also captures your payroll as a manufacturing cost.

What the system perhaps doesn’t do – at least without upgrades – is break-down your lab time into specific projects, some of which might qualify for the credit and others which might not. Yep, your time sheets going forward are going to be a bear.

Let’s be clear: if you are Pfizer, you likely have tweaked-out your accounting and reporting system to capture 360 degrees of data, including whatever is needed for the research credit. Our discussion here concerns more routine companies.

The Harpers owned a company that specializes in military design build projects. They initially filed returns not claiming a research tax credit.

Now pause and consider what they do.

Chances are that some of what they do has an element of uncertainty: what to, how to do it, what order to do it and so on. Depending upon, that uncertainty might trigger the research credit.

There are four principal requirements to the research credit:

(1)  There must be a reduction in uncertainty about the development or improvement of a product or process.

(2)  That development or improvement in turn involves experimentation – that is, there are different ways to get there from here. The experimentation involves determining which ways work and which ways do not.

(3)  The experimentation must involve hard sciences: engineering, chemistry and so forth. Experimenting with tax law, for example, will not work (sadly).

(4)  The purpose of the activity must be a new or improved product or process: performance, function, quality, reliability, that kind of thing.

The Harpers reviewed what they did and determined that the company had research activities qualifying for the credit. They amended their returns for 2008 and 2010. The credit amount was impressive:

         2008                    $437,632

         2010                    $388,325

The IRS reviewed the amended returns and denied the credit.

Off to Court they went. The first case was in California district court.

The IRS position was both straightforward and cynical:

The claim must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof.”

Let me rephrase the position: we (the IRS) decide when we have enough facts and in any event the facts you submit are not sufficient to apprise us of anything until we say that they are sufficient.

The district court agreed with the IRS.  The taxpayer was required to establish all facts and details for its refund claim. The IRS said that the taxpayer had not, and the Court said that was all it needed to know.

Wow. Let me think how can this standard can possibly be abused….

The Harpers appealed the case to the 9^th Circuit Court of Appeals.

Their argument?

• The IRS has the right to notice of a claim and its underlying facts so it can make an informed and appropriate determination. This is referred to as the “specificity” requirement.
• The IRS can always ask one more question. This makes attaching ALL possible paperwork to a claim virtually impossible.
• In practice, the IRS can review a claim with a taxpayer. One way is to audit the claim, of course. This act is considered a waiver of the specificity requirement.
• Why would the IRS review a claim and thereby waive anything? Consider the alternative. Tax practitioners would attach so much documentation to the research tax credit that the IRS would have to lease additional storage to house it all.  It is in both parties’ mutual interest to go along and get along.

The Harpers argued that the IRS had waived the specificity requirement.

How did the IRS do this?

By auditing the claim.

The IRS spent four years auditing the amended returns. The Harpers provided over 100,000 pages of supporting documentation. At no point in time did the IRS tell the Harpers that they had not provided ENOUGH documentation.

I am trying to be fair, but I am distressed by the IRS behavior.

It is common professional knowledge that the IRS can always ask for additional information. One can provide it and still get turned down, but the give and take allows the system – the IRS and tax practitioners - to function and not be overwhelmed.

Is that what happened here?

Nope.

The IRS did not go to Court arguing that it had reviewed 100,000 pages of supporting documentation and decided the Harpers did not qualify for the research credit.

The IRS argument was that the Harpers did not meet the specificity requirement – meaning the Harpers did not include enough paperwork.

The Appeals Court called out the IRS. It had waived the specificity requirement by auditing the amended returns.

The Appeals Court sent the case back to the district court. The case should never have been dismissed for the specificity requirement.

The Harpers may win or may lose, but they will have their day in court.

Our case this time for the home gamers was Harper v United States.

Researching For Deductions

I was skimming a Tax Court case that almost made me laugh out loud.

It initially caught my attention because it involved a deduction for research costs.

The tax surrounding research costs come in two flavors:

·      What is deductible as research?

·      And – perhaps more importantly – can you get a tax credit for it?

Let’s talk this time about the first question, which may not be what you anticipate. Here is an example:

You build a garage to store your business equipment. The garage’s claim to fame is that it is built from natural fibers rather than bricks and lumber. It is the Kon-Tiki of garages. Can you deduct the cost of the garage as you build it?

At the end of the day, you will have a building. Granted, it may be unusual, but it is still a building. Can you deduct a building as you go along? Or do you have to accumulate (and defer) the cost until the building is ready for use? And then what - do you deduct the accumulated cost at that time or do you deduct the cost over a period of years?

You will be deducting the cost over a period of years, otherwise known as depreciation. You self-constructed a long-lived asset, and the tax Code (barring the unusual) will not let you deduct it immediately.

Let’s swing back to research costs.

What if the research costs result in a patent?

You have legal rights for a period of years to intellectual property, and the patent may be worth a fortune.

So we rephrase the question: can you immediately deduct the research costs resulting in that patent?

But CTG, you say, the two are not the same. Chances are that salaries make-up most of the research costs. It doesn’t seem right to capitalize and depreciate salaries. Sticks and bricks have staying power; they last for years. It makes more sense to depreciate those rather than salaries.

Hmmm. What about the wages of the tradesmen-and-women that constructed the building? Do we get to carve those out from the sticks-and-bricks and deduct them immediately?

Of course not.

You now get the issue with research costs.

To answer it the tax Code gives us Section 174:

        (a)  Treatment as expenses.

(1)  In general.

A taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as a deduction.

As long as the costs meet the definition of “research or experimental expenditures,” you have the option of deducting them immediately.

Problem solved.

Our case this time is Bradley and Hayes-Hunter v Commissioner.

Mr. Bradley was a litigation consultant. He reviewed evidence, provided expert testimony and conducted legal research. He was self-employed, and on his 2014 individual income tax return he deducted $25,000 as “Research.”

The IRS was curious what “research and experimental expenditures” a litigation coach could possibly have. It is well-trod ground that Section 174 addresses research in an “experimental” or “laboratory” sense. While one does not have to be in a Pfizer lab wearing a white coat, one likewise cannot be in a library shepardizing law cases.

What did he deduct?

I will give you a clue: his billing rate was $250 per hour.

He deducted $25,000.

And $25,000 divided by $250 is 100 hours.

Not only was he nowhere near a Section 174 research cost, he was also deducting his own time.

How I wish.

Who knows how much tax research I do over an average year. If I could only deduct my time, I would never pay income taxes again.

It won’t work for me, and it did not work for Mr. Bradley.

Tax Provisions Expiring on December 31, 2013

We have been reviewing tax provisions scheduled to expire at the end of this year, December 31, 2013. This is an unhappy, contemporary development in federal taxation. Taxpayers in recent years have waited on Congress to come to the rescue, even if that rescue was in January and retroactive.  I am not optimistic for any breakthrough this year. The Senate nuclear-option fiasco last week tells you that the parties will not be sending Christmas cards across the aisle this year.

 (1)  Mortgage debt relief

The tax code considers the forgiveness of debt to be similar to you receiving a paycheck. Your wealth has gone up (in this case, because your debts have gone down), so the IRS considers this income to you. There has been an exception for debt discharged on your principal residence.

 (2)  Deduction for mortgage insurance premiums

You buy this insurance when you put down less than 20% on the purchase of a house.

 (3)  Teachers classroom expenses

This is the $250 deduction for unreimbursed teacher school supplies.

(4) IRA distributions to Charity

 If you are age 70 ½, the IRS requires you to take “minimum required distributions” from your IRA (but not from your Roth IRA). This provision lets you donate that distribution to charity without counting it as income. You don’t get the charitable deduction, of course, but it can stop you from being pushed into tax phase-outs because of the increase to your gross income.

(5)  State sales taxes

If you live in a state without income taxes (Florida and Texas, for example), this provision allows you to deduct sales taxes in lieu of income taxes.

 (6)  Research & development tax credit  

 It seems that this credit has been “extended” as long as I have been in practice. It will again, if only because some very powerful interests (think Apple and Intel) will make it so.

 (7)  Credit for construction of new energy efficient homes

This $2,000 credit goes to the contractor for building your energy-efficient new home. Granted, it has not meant as much in recent years, except perhaps to the cash-strapped contractor.

(8)  Credit for energy efficient home improvements

This is the $500 credit for doors, windows, insulation and exterior doors. There are other, less recognizable, categories, such as a biomass stove.

 (9) Expensing of depreciable assets

Also referred to as the Section 179 deduction, it is scheduled to drop to $25,000 next year from $500,000 this year.

 (10)     50 percent depreciation

You are allowed (for a brief remaining time) to immediately deduct 50% of a wide range of business assets, other than real estate.

 (11)     Work opportunity tax credit

Many people associate this credit with hiring welfare recipients, but it also covers military veterans. The credit can be as much as $9,600 per employee.

 (12)     Depreciation for certain leasehold, restaurant and retail  improvements

 Depreciation on real estate is brutal: the tax Code requires one to depreciate over 39 years. This break allows a business or restaurant (think Applebee’s or Kroger) to depreciate their build-out over 15 rather than 39 years.

(13)     Deduction for qualified tuition and related expenses

This is the deduction of up to $4,000 (not to be confused with the tax credit!) for you or your child attending college.

 (14)     Child tax credit

This is the credit for a child under age 17. It is worth $1,000 this year. It drops to $500 in 2014.

This is just stuff that is going away. We haven’t talked about new tax stuff, such as the increase in the maximum individual tax rate, the new capital gains rate, the 3.8% Obama tax on investments, the 0.9% Obama tax on your W-2, the disallowance of your itemized deductions, the disallowance of your personal exemptions, the ObamaCare individual mandate penalty for 2014, the new dollar limits on your FSA, and so on and so on.

Senator Baucus Revs Up Tax Reform Discussion

Today (November 21, 2013) Senator Baucus released the third in a series of staff discussions on tax reform. This discussion focuses on depreciation (also called “cost recovery”) and tax accounting methods.

Not the most exciting topics, and I will not miss Thursday Night Football reading up on them. Let’s review them quickly.

The Senator leads off with:

America today is using a bloated tax code that was built for businesses close to 30 years ago. The code is completely outdated and acting as a brake on economic growth.  More must be done to simplify tax rules, lessen the burden on small businesses and jumpstart job growth.”

I cannot disagree with him, but I am not optimistic about politicians – today, tomorrow – keeping their hands off any tax reform. Remember that Chief Justice Roberts deemed ObamaCare to be a “tax” – even though the White House itself did not present brief or argue it to be a tax. With that level of verbal schizophrenia, I would wager that any “reform” would last about as long as when the first politician needs to get reelected.

Baucus is proposing the following depreciation changes:

(1) Reduce the number of depreciation classes to four: three for short- to mid-term property and one for longer-lived assets. There would be only one permitted depreciation method.

a.     By longer-lived, think real estate, which Baucus proposes to depreciate over 43 years.

COMMENT: There goes the never-worked-in-the-real-world-crowd again. I have thirty years in this business, and I have never seen a proposed real estate investment analyzed over a 43-year recovery. Doesn’t happen, folks.

(2) Slow depreciation from double-declining balance to declining balance. Real estate would remain straight-line.

(3)  Allow expanded general asset accounting. This means that asset categories are pooled, and depreciation is calculated by…

a.     Starting with last year’s asset pool balance

b.     Increased by additions and improvements

c.      Decreased by proceeds from asset sales and dispositions

d.     And multiplying the result by a depreciation factor

(4)  Repeal like-kind exchanges.

COMMENT: Yipes.

(5) Repeal depreciation recapture for pooled assets.

COMMENT: Yay!

Treat all gain from disposition of pooled assets as ordinary income.

          COMMENT: Nay!

(6)  The maximum cost of mixed- use vehicles is capped at $45,000.

a.     That means that – if a car is used for both business and personal use – the maximum cost that can be depreciated is $45,000. That amount in turn is depreciated over 5 years.

b.     I am not overly surprised. There is still a lot of abuse – truly – in this area.

Then there are some tax accounting changes:

(7) Repeal expensing for research and development expenses. The default treatment will be to capitalize and depreciate over 5 years.

COMMENT: This cannot make business sense. You want to explain this proposal change to Apple, Samsung, Pfizer, or any number of research-intensive companies?

(8) Disallow the deduction for advertising. In its place, you would deduct one-half immediately and then amortize the balance over 5 years.

COMMENT:  This makes no sense to an accountant. I associate depreciation and amortization with assets that have use or value over more than one year. Advertising doesn’t make that cut. Does anyone talk about the commercials from last year’s Super Bowl, for example?

(9) Treat “qualified extraction expenditures” the same way as research and development.

COMMENT: Think fracking. The United States is increasingly moving to energy independence (Bakken Shale, for example), even under a hostile Administration. Do you think this change is going to help or hurt that effort?

(10)  Repeal percentage depletion.

COMMENT: Same comment as (9).

(11)  Make permanent Section 179 expensing.

a.     The maximum expensing would be set at $1,000,000, with the phase-out beginning at $2,000,000.

COMMENT: Frankly, it’s about time.

(12)  The Section 197 amortization period is increased from 15 to 20 years.

(13)  All business with less than $10 million in annual gross receipts can use the cash basis of accounting and not account for inventory.

          COMMENT: Wait for it...

(14)  If you are not described in (13) then you are on the accrual basis of accounting.

COMMENT: When the government talks about accrual basis, they means that they want you to pay taxes on your receivables before you actually collect them.

(15)  Businesses described in (13) do not have to suffer through the Section 263A uniform capitalization calculations.

        COMMENT: Good. 

(16)  LIFO is repealed.  

COMMENT: I do not particularly care for LIFO, but I acknowledge that major industries use it extensively, and it is considered GAAP when auditors render their auditors’ report. The government is not chasing this down because they had brilliant debates while in accounting theory class. They want the jack.

(17) The completed contract method of accounting (think contractors) is repealed, except for small construction contracts.

Overall, Baucus is trying to reduce corporate tax rates. At 35%, the United States has the dubious distinction of having the highest corporate tax rate in the world. There are consequences to having the highest rate, such as having less business.  To reduce rates, he has to raise money somewhere, and we see some of those sources above.

And remember folks: these are only proposals.