Navigating The Tax Code On Your Own

 

I received a phone call recently from the married daughter of a client. I spoke with the couple – mostly the son-in-law – about needing an accountant. They had bought property, converted property to rental status and were selling property the following (that is, this) year.

It sounds like a lot. It really isn’t. It was clear during our conversation that they were well-versed in the tax issues.

I told them: “you don’t need me.”

They were surprised to hear this.

Why would I say that?

They knew more than they gave themselves credit for. Why pay me? Let them put the money to better use.

Let’s take an aside before continuing our story.

We - like many firms - are facing staffing pressure. The profession has brought much of this upon itself – public accounting has a blemished past – and today’s graduates appear to be aware of the sweatshop mentality that has preceded them. Lose a talented accountant. Experience futility in hiring new talent. Ask those who remain to work even harder to make up the shortfall. Be surprised when they eventually leave because of overwork. Unchecked, this problem can be a death spiral for a firm.

Firms are addressing this in different ways. Many firms are dismissing clients or not accepting new ones. Many (if not most) have increased minimum fees for new clients. Some have released entire lines of business. There is a firm nearby, for example, which has released all or nearly all of its fiduciary tax practice.

We too are taking steps, one of which is to increase our minimum fee for new individual tax clients.

Back to the young couple.

I explained that I did not want to charge them that minimum fee, especially since it appeared they could prepare their return as well as I could. 

They explained they wanted certainty that it was done right.

Yeah, I want that for them too. We will work something out.

But I think there is a larger issue here.

The tax Code keeps becoming increasingly complex. That is fine if we are talking about Apple or Microsoft, as they can afford to hire teams of accountants and attorneys. It is not fine for ordinary people, hopefully experiencing some success in life, but unable – or fearful - to prepare their own returns. Couple this with an overburdened accounting profession, a sclerotic IRS, and a Congress that may be brewing a toxic stew with its never-ending disfigurement of the tax Code to solve all perceived ills since the days of Hammurabi.

How are people supposed to know that they do not know?

Let’s look at the Lucas case.

Robert Lucas was a software engineer who lost his job in 2017. He was assisting his son and daughter, and he withdrew approximately $20 grand from his 401(k) toward that end.

Problem: Lucas was not age 59 ½.

Generally speaking, that means one has taxable income.

One may also have a penalty for early distribution. While that may seem like double jeopardy, such is the law.

Sure enough, the plan administrator issued a Form 1099 showing the distribution as taxable to Lucas with no known penalty exception.

Lucas should have paid the tax and penalty. He did not, which is why we are talking about this.

The IRS computers caught the omission, of course, and off to Tax Court they went.

Lucas argued that he had been diagnosed with diabetes a couple of years earlier. He had read on a website that diabetes would make the distribution nontaxable.

Sigh. He had misread – or someone had written something wildly inaccurate about – being “unable to engage in any substantial gainful activity.”

That is a no.

Since he thought the distribution nontaxable, he also thought the early distribution penalty would not apply.

No … again.

Lucas tried.

He thought he knew, but he did not know.

He could have used a competent tax preparer.

But how was he to know that?

Our case this time was Robert B. Lucas v Commissioner T.C.M. 2023-009.

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.

Company’s Tuition Payment Was Not Deductible

 

Let me give you a fact pattern and you tell me whether there is a tax deduction.

·      You own a company.

·      A young man is dating your daughter.

·      The young man wants to take a computer course at Northwestern University. If it turns out he has both aptitude and interest, perhaps he can maintain the company’s website, at least for a while.

·      The company pays for the course.

Let me up the ante: is there a tax deduction to you and tax-free income to the young man?

You are thinking: maybe.

For example, my firm pays for my expenses when I attend professional seminars or conferences. Then again, my CPA license carries a continuing education requirement, so the seminars and conferences are necessary for me keep my gig as a practicing CPA.

Sounds like a working condition fringe benefit. The “working condition” qualifier means that the employer is paying for something that the employee could deduct (at least before the tax Code nixed miscellaneous itemized deductions) had the employee paid for it.

Alternatively, there are companies who pay (or help pay) tuition for employees who go to college. There are hitches to this educational assistance arrangement, though: it has to be available to everybody, cannot discriminate in favor of highly-compensated employees, and so on.

I am not seeing a tax deduction down either path. Why? Notice that a fringe benefit or assistance program requires an employer:employee relationship. You have no such relationship with the young man.

I suppose you could make him an employee.

No, you say.  Dating your daughter does not put him on the payroll.

You circle back to the possibility that he could take care of your website, at least for a while. That costs money to do. If he did so for free, or at a substantially reduced rate, the cost of that course could be a drop in the bucket compared to what you would have paid a webmaster.

OK. I am certain that the tuition is more than $600, so you pay for the course, send him a 1099 and he will have to settle-up while he files his tax return. On the upside, he should get a tax credit for taking that course.

Nope, you say. You want to deduct it as a business expense but not issue a W-2 or a 1099. None of that.

And that is how Robert and Swanette Ward appeared before the Tax Court. Clearly the IRS disagreed with the tax outcome they wanted.

Here is the Court:

While [] has provided services to Sherwin [CTG: Mrs Ward’s company] free of charge that would likely have cost Sherwin more than the amount of the tuition, we nonetheless find that the petitioners have not established that Sherwin is entitled to deduct the tuition.”

Why not?

Mr [] was not an employee of Sherwin.”

Yes, but what of the possibility that he would help with the website?

The Wards did not have an agreement with Mr [] that he would perform any services in exchange for the tuition payment.”

What, do you want a written contract or something?

Sherwin paid the tuition without any expectation of a return and thus did not have a business purpose for the payment. The tuition was a personal expense, and Sherwin is not entitled to deduct it.”

Why is the Court is circling the wagons on this one?

Folks, sometimes tax law occurs in the folds and the corners. There is something I have not yet told you that might explain the Court’s obstinacy.

That young man eventually married your daughter.

The Court saw a personal expense all the way.

I get it.

There is a distinction in the Code between deductible business expenses and nondeductible personal expenses. One could reason that showing some business angle or benefit – however abstract or hypothetical – can make the expense deductible, even if the primary factor for incurring the expense was personal. One would be wrong, but one could reason.

Our case this time was Sherwin Community Painters Inc v Commissioner, T.C. Memo 2022-19.

IRS Does Not Want You To Call Next Week

So I am reading the following headline:

      IRS Asks Taxpayers to Resist Calling Next Week

I am wondering when our tax system became a Saturday Night Live skit.

The IRS does have a point. Next week includes Presidents Day and is usually one of the busiest weeks for the IRS phone lines.

The IRS wants people to instead to visit the website www.irs.gov and take advantage of the online tools there.

I try to be sympathetic – I truly do. However I cannot help reflect that we never see the following headlines:

Chick fil-A Asks Customers To Stay Away

Apple Has Nothing To Sell You

Honda Asks Potential Buyers Not To Visit Dealerships

Why the difference between the government and an actual-operating-accountable- produce-something-legitimate-or-we-go-out-of-business company?

If you even have to ask ….

IRS Refund Processing Delays

If you are wondering whether the IRS is taking longer to process and issue refunds, you are correct. This has been aggravated by a glitch in the “Where’s My Refund?” tool on the IRS website. The glitch occurs when you file your return electronically, wait a few days and then go to “Where’s My Refund,” which tells you that the IRS is not aware of your return. This is unnerving, of course. It is also incorrect.

What has occurred is that the IRS is tweaking its filters to counter identity fraud. Each year the IRS revises the Electronic Fraud Detection System (EFDS) to reflect fraud patterns detected the previous filing season. Last year, for example, over one million returns were flagged. The returns then go to personnel for review, and therein is the problem. There are not enough people to review the returns.  The ideal time for identity theft is early in the filing season, as the thief is trying to beat you to your refund. The IRS therefore has its fraud filters at their highest setting early in the season.

The IRS has released the customary “we are working on it” statement. It has also reinforced its commitment to getting refunds out within 21 days or less.