Why Does The IRS Want A Disabled Veteran To Work Faster?

Sometimes I read a tax case and ask myself “why did the IRS chase this?”

Lewis is one of those cases.

Let’s explain the context to understand what the IRS was after.

It will soon be three decades that Congress gave us the “passive activity” (PAL) rules. A PAL is a trade or business that you do not sufficiently participate in – that is, you are “passive” in the business. This means more when you have losses from the activity, as income is going to be taxed in any event. It was Congress’ intention to take the legs out from the tax shelters, and with PALs they have been largely successful.

The PAL rules got off to a rocky start. One of the early problems was Congress’ decision to classify real estate activities as passive activities. Now, that concept may make sense if one own a duplex a few streets over, but it doesn’t work so well if one is a home builder or property manager.

Say, for example, that a developer builds a hundred condo units. The real estate market reverses, and he/she cannot sell them as quickly as planned. The developer rents the units, waiting for the market to improve.

Most of us would see one activity. Congress saw two, as the rental had to be segregated. There was no harm if both were profitable. There was harm if only the development was profitable, however, as the rental loss would just hang in space until there was rental income to absorb it.

That was the point of the passive activity rules – to disallow the use of passive losses against nonpassive income.

Real estate professionals screamed about the unfairness of the law as it applied to their industry.

And Congress changed the law by making an exception for real estate people who:

(1) Work more than 750 hours during the year in real estate, and

(2) More than one-half of all hours worked were in real estate.

If you meet both of the above tests, you can deduct losses from your real estate activities to your heart’s content.

Bill Lewis is a Vietnam veteran. He took injuries as a Marine, retaining 50 percent use of his right arm and 70 percent of his feet, requiring him to wear orthopedic shoes. The military gave him a disability pension. He now needs knee surgery, and he has difficulty seeing. He is married.

He and his wife own a triplex next door to their residence. The property also has a washhouse, although I am uncertain what a washhouse is. There are six 64-gallon recycling bins, and several large walnut trees. Mr. Lewis does not ask anyone to take care of his property. He takes care of it himself.

1.  Every morning he walks around and inspects for trash, as they are located very close to a homeless area.  This takes him about a half hour daily.
2. Also on Mondays he scrubs down the washhouse. That requires him to haul water and takes him about three hours. 
3. On Tuesdays and Thursdays he landscapes, cleans the outside of the buildings and the garbage cans and rakes the yard. This takes about two hours on each day.
4. Depending on the season, he has more raking to do, as he has walnut trees on the property.
5. On Wednesdays he takes the recycling bins out to the curb. One by one, as he has mobility issues.
6. On Thursdays he returns the recycling bins. Same mobility issues.
7. He prefers to do repairs himself. If he needs outside help, he schedules and meets with that person. 
8. He follows a set routine, rarely if ever taking a vacation.

The Lewis’ claimed rental losses for 2010 and 2011. The IRS disallowed the losses and wanted almost $11,000 in taxes in return. The IRS said this was the classic passive activity.

The IRS should have also taken candy from a child and kicked a dog and made this a trifecta of bad choices.

Mr. Lewis was disabled. He did not have a job. As a consequence, he did not have to worry about spending more than half of his work hours in real estate. For him, all of his work hours were in real estate.

But Mr. Lewis ran into two issues:

(1)  He did not keep a journal, log or record of his activities and hours; and

(2)  The IRS did not believe it could possibly take more than 750 hours to do what he did.

Issue (1) is classic IRS. I have run into it myself in practice. The IRS wants contemporaneous records, and few people keep time sheets for their real estate activities. The IRS then jumps on after-the-fact records as “self-serving.” The IRS has been aided by people who truly could not have spent the hours they claimed (because, for example, they have a full-time job) as well as repetitively fabulist time records, and the courts now routinely side with the IRS on this issue.

But not this time. The judge was persuaded by the Lewis’ testimony and the few records they could provide. This was a rare win for the taxpayer.

The IRS had a second argument though: it should not have taken as long as it took Mr. Lewis to perform the tasks described.

The judge dismissed this point curtly:

Petitioner husband and petitioner wife testified credibly that because of petitioner husband’s disabilities all of the activities took him significantly longer than might ordinarily be expected.”

The Lewis’ won and the IRS lost.

Good.

These were very unique facts, though. Unless one truly works in the real estate industry, many if not most are going to lose when the IRS presses on contemporaneous records for the 750 hours. Mr. Lewis was a sympathetic party, and the judge clearly gravitated to his side.

Which raises the question: why did the IRS pursue this? They were anything but sympathetic chasing a disabled veteran for taking too long while performing his landlord responsibilities.

Yes, I am sympathetic to Mr. Lewis too.

Why Audit Veterans Organizations?

I suppose that any examination of an exempt organization by the IRS nowadays is going to be viewed in harsh light.

What got me thinking about this is the controversy concerning IRS audits of veterans organizations. While it hasn’t garnered the attention of the 501(c)(4) imbroglio, there has nonetheless been harsh criticism. U.S. Senator Moran (Kansas) for example has stated:

On the heels of Americans' anger over revelations that the IRS intentionally targeted certain groups, it has been brought to my attention that the IRS is now turning their sights toward our nation's veterans. The IRS seems to be auditing veteran service organizations by requiring private member military service forms. If a post is unable or not willing to turn over this personal information, it is possible they could face a fine of $1,000 per day.

I am deeply concerned about this revelation and will insist on answers. This policy ... deserves, at a minimum, a thorough look to make certain the IRS is not overstepping bounds of privacy and respect for our nation's heroes."

For its part, the House Veterans Affairs committee has threated to investigate what the IRS is up to.

So why would the IRS – in a time of budget restraints – be auditing these groups?

A couple of reasons come to mind:

•  The IRS has to audit exempt groups occasionally, if only in the interest of enforcing tax compliance among all exempt groups.

• Veterans organizations have unique tax requirements that are relatively easy to run afoul of.

Reason (1) is easy to understand, even if we would rather have a root canal than undergo a tax audit. Reason (2) is a bit more involved.

Tax-exempt organizations come in multiple flavors, depending on what the organization does. For example, a veterans organization could qualify as a social welfare group – that is, a 501(c)(4) – given its purpose of promoting patriotism, championing the issues of veterans, assisting needy and disabled veterans and conducting social and recreational activities among its membership.   

Let’s go a step further, and you will understand how the sausage of tax law comes to be.

Let’s say the veterans organization buys a building. Let’s say it puts a kitchen and bar in said building. We may now have a social club under Sec 501(c)(7), the same as a college fraternity or private golf course. Had you and I gotten together and built our own golf course, our activity (of playing golf) would not be taxable. The tax Code acknowledges this and allows for larger groups to do what you and I could have done together if only we were multibillionaires. There could be tax consequences if we did other things, but let’s keep our discussion general.

In 1969 Congress expanded the reach of the unrelated business income tax (UBT). UBT by definition relates to tax-exempt organizations, and it means that the organization has to pay tax on profitable business activities that are not in furtherance of its tax-exempt purpose.

What does that mean? Let’s go back to that golf course you and I built. Let’s say that we rent out our course to the PGA annually for a major tournament. We of course charge the PGA big bucks for using our course. We apply as a (c)(7), albeit a small one, considering it is only you and me. The IRS is not going to let us pocket all that money and not pay tax. Why? Because it is not our exempt purpose to rent our course to the PGA.

The veterans organizations became upset with the UBT. It was not even the kitchen and bar, truthfully, as much as it was the insurances – life, health and so on – that they were offering to their members. That was a big deal, and their insurance activity was now being pulled into the orbit of the UBT because of that (c)(4) or (c)(7) status.

Congress, thinking that the answer to everything problem is yet another law, passed Code section 501(c)(19): 

(19)  A post or organization of past or present members of the Armed Forces of the United States, or an auxiliary unit or society of, or a trust or foundation for, any such post or organization—

(A)  organized in the United States or any of its possessions,

(B)  at least 75 percent of the members of which are past or present members of the Armed Forces of the United States and substantially all of the other members of which are individuals who are cadets or are spouses, widows, widowers, ancestors, or lineal descendants of past or present members of the Armed Forces of the United States or of cadets, and

(C)  no part of the net earnings of which inures to the benefit of any private shareholder or individual.

And veterans organizations now had an escape clause from the UBT – as long as they could fit into (c)(19).

It worked well enough for long enough. And now it is starting to work less well.

Why?

It’s the math. Code section (c)(19) states that at least 75% of the members must be veterans  and substantially all other members  (generally defined as 90% or more) must be spouses, widows and descendants. Let’s go through the math. To start, at least 75% of the members must be veterans. Of the remaining, 90% or more must be related to a veteran. Doing the math, only 2.5% of the total membership (25% times 10%) may consist of non-veterans or persons unelated to a veteran.

That is a tight window.

Statistics show over 19 million veterans in the United States. More than 9 million are age 65 or over. Veterans are aging, and every year there are fewer of them. Those demographics are pushing on the percentage tests of (c)(19).

Let’s point out another problem.

How do you prove the 75%? I suppose you could (and probably should) obtain documentation from the veterans. The same could be said for proving the other 90%.  It would be business- standard procedure to keep files and maintain a policy and post signs that only members and families are admitted. I suppose we could boost documentation even more by requiring sign-in books, but you get the idea.

Is it intrusive? You bet. We are talking about IDs and proof of military service, for example. The IRS aggravated the matter recently by asking for DD 214 forms, which is the paperwork accompanying military discharge. The IRS had not routinely asked for this before, so many organizations were caught flat-footed. To exacerbate the matter, the IRS then threatened $1,000 per day penalties.

Cue the resentment and anger of organizations like the American Legion. These generally are not organizations that can easily accommodate drastic changes in tax rules. Many are small, reliant on volunteers and operating on a tight budget.  One cannot approach them as though one were dealing with the tax department of an Apple or Pfizer.

What is the answer? I don’t know. The 501(c) area is a motley of tax grab-bag accreted over the years. Some (c)’s can receive tax-exempt contributions; others cannot. Some organizations are (c)’s just by existing; others have to formally apply and get approval. Some do not pay income tax unless they get carried away and flat-out run a for-profit business. Others pay tax on income “not sufficiently related” to their exempt purpose, a standard sometimes bordering on the mystical. Some are huge, own buildings and have tens of thousands of employees. Others are tiny, have space donated and do everything through volunteers.

It is maddening, but they all have to be (at least in theory) auditable by the IRS.

And there is the rub.