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.

When A Tax Audit Is Not An Audit

 

I am cleaning-up files here at Galactic Command. I saw an e-mail from earlier this year chastising someone for running business deposits through a personal account.

I remember.

He wanted to know why his extension payment came in higher than expected.

Umm, dude, you ran umpteen thousands of dollars through your personal account. I am a CPA, not a psychic.

Let’s spend some time in this yard.

If you are self-employed – think gig worker – and are audited, the IRS is almost certain to ask for copies of your bank accounts. Not just the business account(s), mind you, but all your accounts, business and personal.

I have standard advice for gig workers: open a separate business account. Make all business deposits to that account. Pay all business expenses from that account. When you need personal money, draw the needed amount from the business account and deposit to your personal account.

This gives the accountant a starting point: all deposits are income until shown otherwise. Expenses are trickier because of depreciation, mileage, and other factors.

Is it necessary?

No, but it is best practice.

I stopped counting how many audits I have represented over the years. I may not win the examiner’s trust with my record-keeping, but I assure you that I will win their distrust without it.

Does the examiner want to pry money from you? You bet. Examiners do not like to return to their managers with a no-change.

Will the examiner back-off if all the “i’s” are dotted? That varies per person, of course, but the odds are with you.

And sometimes unexpected things happen.

Let’s look at the Showalter case.

Richard Showalter (RS) owned a single-member LLC. The LLC in turn had one bank account with Wells Fargo.

This should be easy, I am thinking.

RS did not file a tax return for 2013.

Yep, horror stories often start with that line.

The IRS prepared a substitute for return (SFR) for 2013.

COMMENT: The IRS prepares the SFR with information available to it. It will add the 1099s for your interest and dividends, the sales price for any securities trades, any 1099s for your gig, and so forth. It considers the sum to be taxable income.

         Where is the issue?

Here’s one: the IRS does not spot you any cost for securities you sold. Your stock may have gone through the roof, but the odds that it has no cost is astronomical.

Here is another. You have a gig. You have gig expenses. Guess what the IRS does not include in its SFR? Yep, you get no gig expenses.

You may be thinking this has to be the worst tax return ever. It is leaving out obvious numbers.

Except that the IRS is not trying to prepare your tax return. It is trying to get your attention. The IRS throws an inflated number out there and hopes that you have enough savvy to finally file a tax return.

So, RS caught an SFR. The IRS sent him a 90-day notice (also known as a statutory notice of deficiency or SNOD), which is the procedure by which the IRS can move your file to Collections. You already know the tender mercies of IRS Collections.

RS responded to the SNOD by filing with the Tax Court. He wanted his business expenses.

Well, yeah.

RS provided bank statements. The IRS went through and – sure enough – found about $250 grand of deductions, either business or itemized.

That turned out rather well for RS. He should have done this up-front and spared himself the headache.

Then the IRS looked at his deposits. Lo and behold, they found another hundred grand or so that RS did not report as income.

It is not taxable, said RS.

Prove it, said the IRS.

RS did not.

COMMENT: It is unclear to me whether this disputed deposit was fully or partially taxable or wholly nontaxable. The deposit came from a closing statement. Maybe I am being pedantic, but I expect a cost for every sale. The closing statement for the sale is not going to show cost. Still, RS did not argue the point, so ….  

Now think about what RS did by getting into IRS dispute.

RS filed with the Tax Court because he wanted his deductions. Mind you, he could have gotten them by filing a return when required. But no, he did this the hard way.

He now submitted invoices and bank statements to support his deductions.

However, using bank statements is an audit procedure. Why is the IRS using an audit procedure?

Well, he is in Tax Court and all. He picked the battleground.

Had RS filed a return, the IRS might have processed the return without examination or further hassle. Since bank statements are an examination step, the IRS would never have seen them.

Just saying.

Was this this fair play by the IRS?

The Court thought so. The IRS cannot run wild. There must be a “minimal evidentiary showing” tying the taxpayer to potential income. The IRS added up his deposits; that exceeded what he reported as income. Seems to me the IRS cleared the required “minimal” hurdle.

By my reckoning, RS should still come out ahead. The IRS bumped his income by a smidgeon less than a hundred grand, but they also spotted him around a quarter million in business and itemized deductions. Unless there is crazy in that return, this should have improved his tax compared to the SFR.

Our case this time was Richard Showalter v Commissioner, T.C. Memo 2022-114.

Botching An IRS Bank Deposit Analysis

 

What caught my eye was the taxpayer’s name. I am not sure how to pronounce it, and I am not going to try.

I skimmed the case. As cases go, it is virtually skeletal at only 6 pages long.

There is something happening here.

Let’s look at Haghnazarzadeh v Commissioner.

The IRS wanted taxes, penalties and interest of $2,424,100 and $1,152,786 for years 2011 and 2012, respectively.

Sounds like somebody is a heavy hitter.

Here is the Court:

“… the only remaining issue is whether certain deposits into petitioners’ nine bank accounts are ordinary income or nontaxable deposits.”

For the years at issue, Mr H was in the real estate business in California. Together, Mr and Mrs H had more bank accounts than there are days of the week. The IRS did a bank deposit analysis and determined there was unreported income of $4,854,84 and $1,868,212.

Got it.

Here is the set-up:

(1) The tax Code requires one to have records to substantiate their taxable income. For most of us, that is easy to do. We have a W-2, maybe an interest statement from the bank or a brokers’ statement from Fidelity. This does not have to be rocket science.

This may change, however, if one is in business. It depends. Say that you have a side gig reviewing articles before publication in a professional journal. What expenses do you have? I suspect that just depositing the money to your bank account might constitute adequate recordkeeping.

Say you have a transportation company, with a vehicle fleet and workforce. You are now in need of something substantial to track everything, perhaps QuickBooks or Sage, for example. 

(2) Let’s take a moment about being in business, especially as a side gig.

Many if not most tax practitioners will advise a separate bank account for the gig. All gig deposits should go into and all business expenses should be paid from the gig account. What about taking a draw? Transfer the money from the gig account to a personal account. You can see what we are doing: keep the gig account clean, traceable.

  (3) Bad things can happen if you need records and do not keep any.

We know the usual examples: you claim a deduction and the IRS says: prove it. Don’t prove it and the IRS disallows the deduction.

The tax Code allows the IRS to use reasonable means to determine someone’s income when the records are not there.  

(4) One of those methods is the bank deposit analysis.

It is just what it sounds like. The IRS will look at all your deposits, eliminating those that are just transfers from other accounts. If you agree that what is left over is taxable, the exercise is done. If you disagree, then you have to provide substantiation to the IRS that a deposit is not taxable income.

The substantiation can vary. Let’s say that you took a cash advance on a credit card. You would show the credit card statement – with the advance showing – as proof that the deposit is not taxable.

Let’s say that your parents gifted you money. A statement or letter from your parents to that effect might suffice, especially if followed-up with a copy of their cancelled check.

You might be wondering why you would deposit everything if you are going to be flogged you with this type of analysis. There are several reasons. The first is that it is just good financial and business practice, and you should do it as a responsible steward of money. Second, you are not going to wind up here as default by the IRS. Keep records; avoid this outcome. A third reason is that the absence of bank accounts – or minimal use of the same – might be construed as an indicator of fraud. Go there, and you may have leaped from being perceived as a lousy recordkeeper to something more sinister.

Back to the H’s.

They have to show something to the IRS to prove that the $4.8 million and $1.8 million does not represent taxable income.

Mr H swings:

For 2011 he mentioned deposits of $1,556,000 $130,000, and $60,000 for account number 8023 and $1,390,000, $875,000, and $327,000 for account number 4683”

All right! Show your cards, H.

Why would I need to do that? asks Mr H.

Because ……. that is the way it works, H-man. Trust but verify.

Not for me, harumphs Mr H.

Here is the Court:

Petitioner husband did not present evidence substantiating his claim that any of these deposits should be treated as nontaxable.”

Maybe somebody does not understand the American tax system.

Or maybe there is something sinister after all.

What it is isn't exactly clear.

COMMENT: This was a pro se case. As we have discussed before, pro se generally means that the taxpayer was not represented by a tax professional. Technically, that is not correct, as someone could retain a CPA and the decision still remain pro se. With all that hedge talk, I believe that the H’s were truly pro se. No competent tax advisor would make a mistake this egregious.  

Our case (again) was Haghnazarzadeh v Commissioner, T.C. Memo 2021-47.

How To Hack Off An IRS Auditor

Let’s discuss an excellent way to anger a revenue agent auditing your tax return.

Eric and Mary Kahmann have owned a jewelry business for 45 years. They report the business on their personal return as a proprietorship (that is, a Schedule C). they primarily sell at shows throughout the United States, although they also sell through Amazon and PayPal.

PayPal introduces a tax variable: Form 1099-K.

Yep, another blasted 1099. This time Congress was concerned that people were selling stuff (through Amazon, for example) and not correctly reporting their income. Amazon will sell your stuff, but the cash is likely going through Pay Pal or its equivalent. Do enough business and PayPal will send you a 1099-K at the end of the year.

Issue number one.

In addition, Mr. Kahmann’s two brothers were also in the jewelry business. Whereas they did not work with or for him, they would use his two merchant accounts to process payments.

Issue number two.

The IRS audited the Kahmann’s 2011 year.

Why? Who knows. What did not help were the following numbers:

Gross sales reported by the Kahmanns     $128,070

Gross sales reported on the 1099-Ks         $151,834

Guess what? This happens quite a bit, and it does not necessarily mean shenanigans. I will give you one example:

Customer refunds

If one accounts for customer refunds by subtracting them from sales, one can have the above discrepancy. The 1099-K does not – of course – know about any refunds.

The revenue agent asked for bank statements.

COMMENT: This has become standard IRS procedure for a Schedule C audit. It means nothing. You can however flame it into roaring meaningfulness by …

The Kahmanns refused to provide the bank statements.

Brilliant!  

I would seriously consider firing a client who did that to me. Is it a pain? Yes. Will the bank charge you for the copies? Yep. Is it fair? Fair is beside the point. It is what it is.

The revenue agent issued a summons to the bank for the three accounts she knew about. 

COMMENT: Yes, the IRS can get to those accounts. In addition, now the agent has to question whether she knows about all your accounts. Your chances of getting her to believe anything you say are falling fast.

Let’s grade the Kahmanns’ conduct during this audit so far:

                  F

The agent got the bank statements and added up all the deposits. The total was $169,603.

Wait, it gets better.

She could not trace one of the 1099-Ks into the bank statements, so she added that number ($15,745) to the $169,603. She now calculated gross receipts as $188,073.

The Kahmanns have a problem.

They have to show that some of those deposits were not income. Could be. Perhaps they borrowed money. Perhaps they transferred monies between accounts. Perhaps they received family gifts.

Perhaps Mr. Kahmann deposited his brothers’ PayPal transactions, given that they were using his merchant accounts.

There are two technical issues here that a tax nerd would recognize:

(1) There is recourse to having the IRS add-in $15,745 from a 1099-K just because the agent could not figure-out how it was deposited. A taxpayer can shift the burden of proof back to the IRS, meaning that the IRS is going to need something more than a piece of paper with “1099-K” printed somewhere on it.

There is a catch: you must cooperate with the IRS during the exam. Guess who did not cooperate by refusing to provide bank statements?

Bingo!

(2) Alternatively, a taxpayer can show that the deposits are not income.

Say that a deposit belonged to Kahmann’s brother. You can have the brother (or his accountant, more likely) show that the deposit was included in gross sales reported on the brother’s tax return.

It’s a pain, but it is not brain surgery.

The Kahmanns provided letters from the brothers.

The IRS wanted to meet with the brothers.

The brothers did not want to meet with the IRS.

The Kahmanns submitted books and records to support their tax return. The handwriting appeared to have been written all at once rather than over the year. The ink was also the same throughout.

Unlikely. Suspicious. Dumb.

You can guess how this wound up.

The Court agreed with the IRS recalculation of income. The Kahmanns owed big bucks. There were penalties too. 

Normally I am quite pro-taxpayer.  Am I sympathetic this time?

Not a bit.

Beany Baby Billionaire Caught With Secret Swiss Bank Account

I cannot understand people who go to great lengths to underreport income. I am not talking about tax planning – perhaps even aggressive tax planning – to reduce one’s tax under the law. Some actions are so routine one may not even see them as tax planning, such as moving from a higher-tax state (say Ohio) to a lower-tax state (say Florida or Nevada). 

What I am talking about is flat-out tax evasion. We have now crossed a line. The Supreme Court has acknowledged that no one is under compulsion to pay more tax than necessary, but likewise all are under compulsion to pay the appropriate tax.

Enter Ty Warner. He was responsible for the “beanie babies” from the 1990s and is the 100% owner of TY Inc and other business interests. There must be a LOT of money in beanie babies, as Forbes has ranked him as the 209th wealthiest American, with a net worth estimated at $2.6 billion.

He opens a secret bank account with UBS in 1996. In 2002 he transfers over $93 million from there to another Swiss Bank. He obfuscates the ownership of the account by tagging it with the name “Molani Foundation.” The UBS account threw off $3.2 million in income for 2002.  This income is not reported to the accountants and is not included on his tax return. Mind you, he had already reported $49.1 million on his income tax return.

QUESTION: Is it possible to have so much income that one forgets some of his/her income?

You can pretty much guess that there was no FBAR filed. How could there be? There apparently was no "foreign" account, at least to Warner.

Fast forward the conversation and UBS gets dragged into the IRS and Justice Department hunt for secret Swiss bank accounts.

Oh, oh, Warner realizes the jig is up. He tries to enter the IRS Offshore Voluntary Disclosure Program, but he was denied entry. A likely reason is that the IRS had already identified him as owner of one or more unreported accounts.

Now he has a serious problem. Could there be tax fraud? I cannot say. I can say that I recall sitting across a conference table from a client who could not tell you (or me) if his tax return – showing $33 million in gross income – included all his income for the year. Is it possible that $3.2 million got lost in Warner’s reported income of $49.1 million? It is possible, but the other actions – like fudging the name of the Swiss account or not telling the accountants – look bad.

What Warner did run into face-first is the FBAR reporting. This is the filing for foreign accounts over $10 thousand. It is mailed separately from the tax return, and it is due July 1. For decades no one paid much attention to these reports, but in the aughts the IRS decided that there was money to be found. They began the crackdown on foreign bank accounts, starting with UBS - eventually ensnaring Ty Warner. The penalties for an FBAR are confiscatorily insane, as the government somehow justifies that they can take up to half of whatever is in the account. For multiple years. Reflect for a moment that the government is saying that – should they press beyond two years - they can take from you more than you have – or ever had – in the account.

This has nothing to do with the earnings from the account. For example, for 2002 Warner’s secret account generated approximately $3.2 million in income. Did the government want taxes on the $3.2 million, which would be about $1 million? Nope. Did they want all of that $3.2 million? Nope.

What they wanted was one-half of the highest balance in the account. What was that amount for Warner? Try $53.6 million.

Warner doesn’t pay taxes on $3.2 million. Let’s be generous and say that it was $3.2 million for several years. It now costs him $53.6 million to cash-out?

Set aside whether this is confiscatory. I cannot understand why Warner –or anyone - would even go there. Let’s be honest: would he even have noticed the taxes had he correctly reported the $3.2 million to begin with?