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.

An IRS Examination And A New IRS Hire

 

I have gotten dragged into a rabbit hole.

I often get involved with clients on a one-off basis: they are buying a company, selling their business, expanding into other states, looking into oddball tax credits and so forth. Several of our clients have been selling their businesses. In some cases, they have been offered crazy money by a roll-up; in others it is the call of retirement. I was looking at the sale of a liquor store last fall. As business sales go, it was not remarkable. The owner is 75 years old and has been working there since he was a teenager. It was time. The sale happened this year.

Fast forward to a few weeks ago. The CPA who works with the liquor store was taking time off, but I was in the office. The owner remembered me.

“Can I see you this afternoon,” he asked.

“Of course. Let me know what works for you.”

He brought an IRS notice of appointment with a field revenue officer. I reviewed the notice: there was a payroll issue as well as an issue with the annual deposit to retain a fiscal year.

I had an educated guess about the annual deposit. This filing is required when a passthrough (think partnership or S corporation) has a year-end other than December. We do not see many of these, as passthroughs have mostly moved to calendar year-ends since the mid-eighties. The deposit is a paper-file, and clients have become so used to electronic filing they sometimes forget that some returns must still be filed via snail mail.

The payroll tax issue was more subtle. For some reason, the IRS had not posted a deposit for quarter 4, 2022. This set a penalty cascade into motion, as the IRS will unilaterally reorder subsequent tax deposits. Let this reordering go on for a couple of quarters or more and getting the matter corrected can border on a herculean task.

I spoke with the revenue officer. She sounded very much like a new hire. Her manager was on the call with her. Yep, new hire.

Let’s start the routine:

“Your client owes a [fill in the blank] dollars. Can they pay that today?”

“I disagree they owe that money. I suspect it is much less, if they owe at all.”

“I see. Why do you say that?”

I gave my spiel.

“I see. Once again, do you want to make payment arrangements?”

I have been through this many times, but it still tests my patience.

“No, I will recap the liabilities and deposits for the two quarters under discussion to assist your review. Once you credit the suspended payroll deposit to Q4, you will see the numbers fall into place.”

“What about the 8752 (the deposit for the non-calendar year-end)?

“I have record that it was prepared and provided to the taxpayer. Was it not filed?”

“I am not seeing one filed.”

“These forms are daft, as they are filed in May following the fiscal year in question. Let’s be precise which fiscal year is at issue, and I will send you a copy. Do you want it signed?”

The manager chimes in: that is incorrect. Those forms are due in December.”

Sigh.

New hire, poorly trained manager. Got it.

I ask for time to reply. I assemble documents, draft a walkthrough narration, and fax it to the field revenue officer. I figure we have one more call. Maybe the client owes a couple of bucks because … of course, but we should be close.

Then I received the following:

 

I am not amused.

The IRS has misstepped. They escalated what did not need to escalate, costing me additional time and the client additional professional fees. Here is something not included when discussing additional IRS funding for new hires: who is going to train the new hires? The brain drain at the IRS over the last decade and a half has been brutal. It is debatable whether there remains a deep enough lineup to properly train new hires in the numbers and time frame being presented. What is realistic – half as many? Twice as long? Bring people out of retirement to help with the training?

Mind you, I am pulling for the IRS. The better they do their job the easier my job becomes. That said, there are realities. CPA firms cannot find qualified hires in adequate numbers, and the situation does not change by substituting one set of letters (fill-in whatever word-salad firm name you want) for another (IRS). Money is an issue, of course, but money is not the only issue. There are enormous societal changes at work.

What is our next procedural move?

I requested a CDP hearing.

The Collections Due Process hearing is a breather as the IRS revs its Collections engines. It allows one to present alternatives to default Collections, such as:

·      An offer in compromise

·      An installment agreement

I have no intention of presenting Collections alternatives. If we owe a few dollars, I will ask the client to write a check to the IRS. No, what I want is the right to dispute the amount of tax liability.

A liability still under examination by a field revenue officer. I have agreed to nothing. I have not even had a follow-up phone call. A word to the new hires: it is considered best practice – and courteous - to not surprise the tax practitioner. A little social skill goes a long way.

The Notice of Intent to Levy was premature.

Someone was not properly trained.

Or supervised.

I question whether this would have happened 15 or more years ago.

But then again, 15 years from now the new hires will be the institutional memory at the IRS.

It is the years in between that are problematic.

The IRS Changes An In - Person Visit Policy

 

This afternoon I was reading the following:

As part of a larger transformation effort, the Internal Revenue Service today announced a major policy change that will end most unannounced visits to taxpayers by agency revenue officers to reduce public confusion and enhance overall safety measures for taxpayers and employees.”

One can spend a lifetime and never interact with a Revenue Officer. We are more familiar with Revenue Agents, who examine or audit tax returns and filings. Revenue Officers, on the other hand, are more specialized: they collect money.

I deal with ROs often enough, but – then again – consider what I do. I rarely meet with one in person, though. The last time I met an RO was one late afternoon at northern Galactic Command. I was the only person in the office, until I realized that I was not. I encountered someone who claimed to be an RO, which I immediately and expressly disbelieved. He presented identification, which gave me pause. He then asked about a specific client, giving me grounds to believe him. The IRS could not contact a taxpayer, so the next step was to contact the last preparer associated with that taxpayer.

I was – BTW – not amused.

I wonder if the above IRS policy change has something to do with an event that occurred recently in Marion, Ohio. The following is cited from a recent House Judiciary Committee letter to IRS Commissioner Danny Werfel:

On April 25, 2023, an IRS agent—who identified himself as 'Bill Haus' with the IRS’s Criminal Division—visited the home of a taxpayer in Marion, Ohio. Agent 'Haus' informed the taxpayer he was at her home to discuss issues concerning an estate for which the taxpayer was the fiduciary. After Agent 'Haus' shared details about the estate only the IRS would know, the taxpayer let him in. Agent 'Haus' told the taxpayer that she did not properly complete the filings for the estate and that she owed the IRS 'a substantial amount.' Prior to the visit, however, the taxpayer had not received any notice from the IRS of an outstanding balance on the estate.
 
"During the visit, the taxpayer told Agent 'Haus' that the estate was resolved in January 2023, and provided him with proof that she had paid all taxes for the decedent's estate. At this point, Agent 'Haus' revealed that the true purpose of his visit was not due to any issue with the decedent’s estate, but rather because the decedent allegedly had several delinquent tax return filings. Agent 'Haus' provided several documents to the taxpayer for her to fill out, which included sensitive information about the decedent.
 
"The taxpayer called her attorney who immediately and repeatedly asked Agent 'Haus' to leave the taxpayer's home. Agent 'Haus' responded aggressively, insisting: 'I am an IRS agent, I can be at and go into anyone's house at any time I want to be.' Before finally leaving the taxpayer’s property, Agent 'Haus' said he would mail paperwork to the taxpayer, and threatened that she had one week to satisfy the remaining balance or he would freeze all her assets and put a lean [sic] on her house.
 
"On May 4, 2023, the taxpayer spoke with the supervisor of Agent 'Haus,' who clarified nothing was owed on the estate. The supervisor even admitted to the taxpayer that 'things never should have gotten this far.' On May 5, 2023, however, the taxpayer received a letter from the IRS— the first and only written notice the taxpayer received of the decedent’s delinquent tax filings—addressed to the decedent, which stated the decedent was delinquent on several 1040 filings. On May 15, 2023, the taxpayer spoke again with supervisor of Agent 'Haus,' who told the taxpayer to disregard the May 5 letter because nothing was due. On May 30, 2023, the taxpayer received a letter from the IRS that the case had been closed.”

Yeah, someone needs to be fired.

The IRS did point out the following in today’s release:

For IRS revenue officers, these unannounced visits to homes and businesses presented risks.

No doubt, especially for those who think they can go into “anyone’s house at any time.”

What will the IRS do instead?

In place of the unannounced visits, revenue officers will instead make contact with taxpayers through an appointment letter, known as a 725-B, and schedule a follow-up meeting. This will help taxpayers feel more prepared when it is time to meet.

Taxpayers whose cases are assigned to a revenue officer will now be able to schedule face-to-face meetings at a set place and time, with the necessary information and documents in hand to reach resolution of their cases more quickly and eliminate the burden of multiple future meetings.

There will be situations where the IRS simply must appear in person, of course:

The IRS noted there will still be extremely limited situations where unannounced visits will occur. These rare instances include service of summonses and subpoenas; and also sensitive enforcement activities involving seizure of assets, especially those at risk of being placed beyond the reach of the government.

These situations should be a fraction of the number under the previous policy, however.

Can A Business Start Before Having Revenue?

 

It is one of my least favorite issues: when does a business start?

The reason is that expenses incurred before the start-up date are considered either organizational or start-up expenses and cannot be immediately deducted. The IRS allows a small spot (of $5,000) and expenses over that amount are to be amortized over 15 years.

It used to be five years. The issue was less of a blood sport back then.

For many of us, the start-up date is easy: it is when you open your doors to customers or clients. Let’s say you are a chiropractor. Your start-up date is when the office opens. What if you do not have a patient that day? Same answer: it is the day you open the doors.

Let’s kick it up a notch.

Say you open a restaurant. When is your start date?

The day you have first serve customers, right?

Yes, with a twist. Many restaurants have a soft opening, which is a seating for a limited number of people (think family, friends and media critics) to test service and the kitchen. This might be days or weeks before the actual grand opening – that is, when doors open to the general public.  

Many tax accountants – me included – consider a restaurant’s soft opening to be the start date.

The reason we want an earlier rather than a later date is to start deducting expenses. If you are reaching into your pocket or borrowing money to pay rent, utilities, promotion and staff, you want a tax deduction now. You might consider me to be crazy man Michael were I to talk about deducting over 15 years.

Let’s kick it up another notch. Let’s talk about a web-based business.

Gregg Kellett graduated from college in 2002 and opened a website. He went corporate in 2007, and in 2011 he moved to Bloomberg, a publisher of legal and business information. While there he saw an opportunity to better aggregate and access online demographic, social and economic data. If he could pull it off, he could offer a more user-friendly interface and make a couple of bucks in the process.

So in 2013 he bought a website (vizala.com). He formed a company by the same name. He hired remote computer engineers to develop features he wanted in the website. They finished core work in March 2015 and resolved bugs through September 2015. An example of a “bug” was an interactive table that would not presently correctly in the Firefox browser.

Kellett figured to make money at least four ways:

(1)  Selling advertising space

(2)  Implementing a paywall

(3)  Selling personalized charts and other information

(4)  Licensing data

He did not pursue any of those strategies during 2015.

However, he did deduct approximately $26 grand on his 2015 return.

He also did not earn any revenue until 2019.

Sure enough, the IRS disallowed the $26 grand because Kellett was not in an “active” trade or business. They wanted him to deduct the expenses over (almost) the same period as putting a kid though grade school and then college.

Off to Tax Court.

If we pull back to the general rule – the date of first revenues – this is going to hurt.

But the website was available by September 2015. It wasn’t rocking like Netflix upon release of the 2022 season’s second half of Stranger Things, but it was available.

The Court wanted to know what happened between 2015 and 2019.

Kellett explained that maximizing his long-term profit potential required building trust among users. After that would come the advertisers. He started building trust by promoting the website to over a hundred universities and professional organizations. This was enough work that he hired a marketing professional to assist him. The work paid-off, as about 50% on the institutions added Vizala to their lists of research databases. 

The Court understood what he did. The website was available by September 2015. It was not all it could be as Kellett had plans for its long-term profitability, but that did not gainsay that the website was available. Considering that the business was the website, that meant that the business also started in September 2015. Expenses before that date were startup expenses. Expenses after that date were immediately deductible.

Revenues did not play into the decision, fortunately.

It was the website version of the chiropractor opening his/her office, albeit with no patients on the first day.

Kellett won, but it cost a visit to Tax Court.

Our case this time was Kellett v Commissioner, T.C. Memo 2022-62.

Qualifying For Stock Loss Under Section 1244

 

I am looking at a case having to do with Section 1244 stock.

And I am thinking: it has been a while since I have seen a Section 1244.

Mind you; that is not a bad thing, as Section 1244 requires losses. The most recent corporate exit I have seen was a very sweet rollup of a professional practice for approximately $10 million. No loss = no Section 1244.

Let’s set up the issue.

We are talking about corporations. They can be either C or S corporations, but this is a corporate tax thing. BTW there is a technical issue with Section 1244 and S corporations, but let’s skip it for this discussion.

The corporation has gone out of business.

A corporation has stock. When the corporation goes out of business, that stock is worthless. This means that the shareholder has incurred a loss on that stock. If he/she acquired the stock for $5,000, then there is a loss of $5,000 when the corporation closes.

Next: that loss is – unless something else kicks-in – a capital loss.

Capital losses offset capital gains dollar-for-dollar.

Let’s say taxpayer has no capital gains.

Capital losses are then allowed to offset (up to) $3,000 of other income.

It will take this person a couple of years to use up that $5,000 loss.

Section 1244 is a pressure valve, of sorts, in this situation.

A shareholder can claim up to $50,000 of ordinary loss ($100,000 if married filing joint) upon the sale, liquidation or worthlessness of stock if:

 

(1)  The stock is be either common or preferred, voting or nonvoting, but stock acquired via convertible securities will not qualify;

(2)  The stock was initially issued to an individual or partnership;

(3)  The initial capitalization of the corporation did not exceed $1 million;

(4)  The initial capitalization was done with stock and property (other than stock and securities);

(5)  Only persons acquiring stock directly from the corporation will qualify; and

(6)  For the five tax years preceding the loss, the corporation received more than 50% of its aggregate gross receipts from sources other than interest, dividends, rents, royalties, and the sale or exchange of stocks or securities.

The advantage is that the ordinary loss can offset other income and will probably be used right away, as opposed to that $3,000 year-by-year capital loss thing.

Mind you, there can also be part Section 1244/part capital loss.

Say a married couple lost $130,000 on the bankruptcy of their corporation.

Seems to me you have:

                      Section 1244                     100,000

                      Capital loss                         30,000

Let’s look at the Ushio case.

Mr Ushio acquired the stock of PCHG, a South Carolina corporation, for $50,000.

PCHG intended to was looking to get involved with alternative energy. It made agreements with a Nevada company and other efforts, but nothing ever came of it. PCHG folded in 2012.

Ushio claimed a $50,000 Section 1244 loss.

The IRS denied it.

There were a couple of reasons:

(1)  Mr. Ushio still had to prove that $1 million limit.

 

The issue here was the number at the corporate level: was the corporation initially capitalized (for cash and property other than stock and securities) for $1 million or less? If yes, then all the issued stock qualified. If no, the corporation must identify which shares qualified and which shares did not.

        

It is possible that PCHG was not even close to $1 million in capitalization, in which a copy of its initial tax return might be sufficient. Alternatively, PCHG’s attorney or accountant might/should have records to document this requirement.        

 

(2)  PCHG never had gross receipts.

 

This means that PHGC could not meet the 50% of gross receipts requirement, as it had no gross receipts at all.

 

Note that opening a savings or money market account would not have helped. PCHG might then have had gross receipts, but 100% of its gross receipts would have been interest income – the wrong kind of income.

Mr Ushio did not have a Section 1244 loss, as PCHG did not qualify due to the gross-receipts requirement. You cannot do percentages off a denominator of zero.

My first thought when reviewing the case was the long odds of the IRS even looking at the return, much less disallowing a Section 1244 loss on said return. That is not what happened. The IRS was initially looking at other areas of the Ushio return. In fact, Ushio had not even claimed a capital loss – much less a Section 1244 loss – on the original return. The issue came up during the examination, making it easy for the IRS to say “prove it.”

How would a tax advisor deal with this gross-receipts hurdle in practice?

Well, the initial and planned activity of PCHG failed to produce any revenues. It seems to me that an advisor would look to parachute-in another activity that would produce some – any – revenues, in order to meet the Section 1244 requirement. The tax Code wants to see an operating business, and it uses gross receipts as its screen for operations.

Could the IRS challenge such effort as failing to rise to the level of a trade or business or otherwise lacking economic substance? Well, yes, but consider the alternative: a slam-dunk failure to qualify under Section 1244.

Our case this time was Ushio v Commissioner, TC Summary Opinion 2021-27.

IRS Small Business Audit Areas

The IRS has announced selected business areas it is prioritizing for audit this upcoming fiscal year. The IRS is increasingly focused on small business underreporting, which it considers responsible for the majority of a $450 billion tax gap. Here are the areas:

1.      Fringe benefits, especially use of company cars

The IRS is finding that employers are not correctly reporting employees’ personal use of company vehicles on Forms W-2.

2.      Higher income taxpayers

The IRS will focus on self-employed taxpayers with gross receipts (that is, before expenses) of more than $1 million.

3.      Form 1099-K matching

Forms 1099-K report payments from credit cards and payment clearinghouses (such as PayPal). The IRS granted a reprieve for 2012, but it announced that it will start Form 1099-K matching in 2013.

4.      The small business employee health insurance tax credit

The IRS wants to make sure that small business employers and tax exempts are complying with credit eligibility requirements.

5.      International transactions

The IRS has announced its third voluntary foreign bank account initiative and intends to look for offshore transactions.

6.      Partnership returns reporting losses  

This is a new area of emphasis. Expect the IRS to look into partnerships reporting large losses.

7.      S corporations reporting losses and reasonable officer compensation

The IRS will be looking at S corporations claiming losses, looking for losses taken in excess of shareholder basis.

The IRS is also interested in profitable S corporations reporting little or no salary to officers.

8.      Proper worker classification

The IRS is interested in employer treatment of worker versus independent contractor status. The IRS thinks there is significant noncompliance in this area.