Keeping Records For More Than Three Years

 

How long should you keep tax records?

We have heard that one should keep records for at least three years, as the IRS has three years to examine your return.

There is a lot of wiggle room there, however.

Let’s look at a wiggle that repeats with some frequency: a net operating loss (NOL) carryover.

An NOL occurs when a business’ tax deductions exceed its tax revenues.

I include the word “business” intentionally. Nonbusiness income - think interest, dividends, royalties – will not generate NOLs, unless you happen to own a bank or something. That would be rare, but it could happen.

An NOL is a negative (net) number from a business.

How does this negative number get on your personal return?

Several ways. Here is one: you own a piece of a passthrough business and receive a Schedule K-1.  

A passthrough normally does not pay taxes on its own power. Its owners do. If that passthrough had a big enough loss, your share of its loss might wipe out all the other income on your personal return. It happens. I have seen it.

You would go negative. Bingo, you have an NOL.

But what do you do with it?

The tax law has varied all over the place on what to do with it. Sometimes you could take it back five years. Sometimes two. Sometimes you could not take it back at all. What you could not take back you could take forward to future years. How many future years? That too has varied. Sometimes it has been fifteen years. Sometimes twenty. Right now, it is to infinity and beyond.

Let’s introduce Betty Amos.

Betty was a Miami CPA and restaurateur.  In the early 1980s she teamed up with two retired NFL players to own and operate Fuddruckers restaurants in Florida.

She wound up running 15 restaurants over the next 27 years.

She was honored in 1993 by the National Association of Women Business Owners. She was named to the University of Miami board of trustees, where she served as chair of the audit and compliance committee.

I am seeing some professional chops.

In 1999 her share of Fudddruckers generated a taxable loss. She filed a joint tax return with her husband showing an NOL of approximately $1.5 million.

In 2000 she went negative again. Her combined NOL over the two years was pushing $1.9 million.

Let’s fast forward a bit.

On her 2014 tax return she showed an NOL carryforward of $4.2 million.

We have gone from $1.9 to $4.2 million. Something is sinking somewhere.

On her 2015 tax return she showed an NOL carryforward of $4.1 million.

That tells me there was a positive $100 grand in 2014, as the NOL carryforward went down by a hundred grand.

Sure enough, the IRS audited her 2014 and 2015 tax years.

More specifically, the IRS was looking at the big negative number on those returns.

Prove it, said the IRS.

Think about this for a moment. This thing started in 1999. We are now talking 2014 and 2015. We are well outside that three-year period, and the IRS wants us to prove … what, specifically?

Just showing the IRS a copy of your 1999 return will probably be insufficient. Yes, that would show you claiming the loss, but it would not prove that you were entitled to the loss. If a K-1 triggered the loss, then substantiation might be simple: just give the IRS a copy of the K-1. If the loss was elsewhere – maybe gig work reported on Schedule C, for example - then substantiation might be more challenging. Hopefully you kept a bankers box containing bank statements, invoices, and other records for that gig activity.

But this happened 15 years ago. Should you hold onto records for 15 years?

Yep, in this case that is the wise thing to do.

Let me bring up one more thing. In truth, I think it is the thing that got Betty in hot water.

When you have an NOL, you are supposed to attach a schedule to your tax return every year that NOL is alive. The schedule shows the year the NOL occurred, its starting amount, how much has been absorbed during intervening years, and its remaining amount. The IRS likes to see this schedule. Granted, one could fudge the numbers and lie, but the fact that a schedule exists gives hope that one is correctly accounting for the NOL.

Betty did not do this.

Betty knew better.

Betty was a CPA. 

The IRS holds tax professionals to a higher standard.

BTW, are you wondering how the IRS reconciles its Indiana-Jones-like stance on Betty’s NOL with a three-year-statute-of-limitations?

Easy. The IRS cannot reach back to 1999 or 2020; that is agreed.

Back it can reach 2014 and 2015.

The IRS will not permit an NOL deduction for 2014 or 2015. Same effect as reaching back to 1999 or 2000, but it gets around the pesky statute-of-limitations issue.

And in the spirit of bayoneting-the-dead, the IRS also wanted penalties.

Betty put up an immediate defense: she had reasonable cause. She had incurred those losses before Carter had liver pills. Things are lost to time. She was certain that she carried numbers correctly forward from year to year.

Remember what I said about tax professionals? Here is the Court:

More significantly, Ms. Amos is a longtime CPA who has worked for high-profile clients, owned her own accounting firm, and been involved with national and state CPA associations. It beggars belief that she would be unaware that each tax years stands alone and that it was her responsibility to demonstrate her entitlement to the deductions she claimed.”

Yep, she was liable for penalties too.

Our case this time was Betty Amos v Commissioner, T.C. Memo 2022-109.

Are Minimum Required Distribution Rules Changing Again?

I wonder what is going on at the IRS when it comes to IRA minimum required distributions.

You may recall that prior law allowed for something called a “stretch” IRA.  The idea was simple, but planners and advisors pushed on it so long and so hard that Congress changed the law.

An IRA (set aside Roth IRAs for this discussion) must start distributing at some point in time. The tax Code tells you the minimum you must distribute. If you want more, well, that is up to you and the tax Code has nothing further to say.  The minimum distribution uses actuarial life expectancies in its calculation. Here is an example:

                   Age of IRA Owner            Life Expectancy

                            72                                    27.4

                            73                                    26.5

                            74                                    25.5

                            75                                    24.6                                        

Let’s say that you are 75 years old, and you have a million dollars in your IRA. Your minimum required distribution (MRD) would be:

                  $1,000,000 divided by 24.6 = $40,650

There are all kinds of ancillary rules, but let’s stay with the big picture. You have to take out at least $40,650 from your IRA.

President Trump signed the SECURE Act in late 2019 and upset the apple cart. The new law changed the minimum distribution rules for everyone, except for special types of beneficiaries (such as a surviving spouse or a disabled person).

How did the rules change?

Everybody other than the specials has to empty the IRA in or by the 10^th year following the death.

OK.

Practitioners and advisors presumed that the 10-year rule meant that one could skip MRDs for years 1 through 9 and then drain the account in year 10. It might not be the most tax-efficient thing to do, but one could.

The IRS has a publication (Publication 590-B) that addresses IRA distributions. In March, 2021 it included an example of the new 10-year rule. The example had the beneficiary pulling MRDs in years 1 through 9 (just like before) and emptying the account in year 10.

Whoa! exclaimed the planners and advisors. It appeared that the IRS went a different direction than they expected. There was confusion, tension and likely some anger.

The IRS realized the firestorm it had created and revised Publication 590-B in May with a new example. Here is what it said:

For example, if the owner dies in 2020, the beneficiary would have to fully distribute the plan by December 31, 2030. The beneficiary is allowed, but not required, to take distributions prior to that date.”

The IRS, planners and advisors were back in accord.

Now I am skimming the new Proposed Regulations. Looks like the IRS is changing the rules again.

The Regs require one to separate the beneficiaries as before into two classes: those exempt from the 10-year rule (the surviving spouse, disabled individuals and so forth) and those subject to the 10-year rule.

Add a new step: for the subject-to group and divide them further by whether the deceased had started taking MRDs prior to death. If the decedent had, then there is one answer. If the decedent had not, then there is a different answer.

Let’s use an example to walk through this.

Clark (age 74) and Lois (age 69) are killed in an accident. Their only child (Jon) inherits their IRA accounts.

Jon is not a disabled individual or any of the other exceptions, so he will be subject to the 10-year rule.

One parent (Clark) was old enough to have started MRDs.

The other parent (Lois) was not old enough to have started MRDs.

Jon is going to see the effect of the proposed new rules.

Since Lois had not started MRDs, Jon can wait until the 10^th year before withdrawing any money. There is no need for MRDS because Lois herself had not started MRDs.

OK.

However, Clark had started MRDs. This means that Jon must take MRDs beginning the year following Clark’s death (the same rule as before the SECURE Act). The calculation is also the same as the old stretch IRA: Jon can use his life expectancy to slow down the required distributions – well, until year 10, of course.

Jon gets two layers of rules for Clark’s IRA:

·      He has to take MRDs every year, and

·      He has to empty the account on or by the 10^th year following death

There is a part of me that gets it: there is some underlying rhyme or reason to the proposed rules.

However, arbitrarily changing rules that affect literally millions of people is not effective tax administration.

Perhaps there is something technical in the statute or Code that mandates this result. As a tax practitioner in mid-March, this is not my time to investigate the issue.  

The IRS is accepting comments on the proposed Regulations until May 25.

I suspect they will hear some.

Section 1202 Stock And A House Tax Proposal

I am not a fan of fickleness and caprice in the tax law.

I am seeing a tax proposal in the House Ways and Means Committee that represents one.

It has been several years since we spoke about qualified small business stock (QSBS). Tax practice is acronym rich, and one of the reasons is to shortcut who qualifies – and does not qualify – for a certain tax provision. Section 1202 defines QSBS as stock:

·      issued by a C corporation,

·      with less than $50 million in assets at time of stock issuance,

·      engaged in an active trade or business,

·      acquired at original issuance by an eligible shareholder in exchange for either cash or services provided, and

·      held for at least five years.

The purpose of this provision is to encourage – supposedly – business start-ups.

How?

A portion of the gain is not taxed when one sells the stock.

This provision has been out there for approximately 30 years, and the portion not taxed has changed over time. Early on, one excluded 50% (up to a point); it then became 75% and is now 100% (again, up to a point).

What is that point?

The amount of gain that can be excluded is the greater of:

·      $10 million, or

·      10 times the taxpayer’s basis in the stock disposed

Sweet.

Does that mean I sell my tax practice for megabucks, all the while excluding $10 million of gain?

Well, no. Accounting practices do not qualify for Section 1202. Not to feel singled- out, law and medical practices do not qualify either.

I have seen very few Section 1202 transactions over the years. I believe there are two primary reasons for this:

                 

(a)  I came into the profession near the time of the 1986 Tax Reform Act, which single-handedly tilted choice-of-entity for entrepreneurial companies from C to S corporations. Without going into details, the issue with a C corporation is getting money out without paying double tax. It is not an issue if one is talking about paying salary or rent, as one side deducts and the other side reports income. It is however an issue when the business is sold. The S corporation allows one to mitigate (or altogether avoid) the double tax in this situation. Overnight the S corporation became the entity of choice for entrepreneurial and closely-held companies. There has been some change in recent years as LLCs have gained popularity, but the C corporation continues to be out-of-favor for non-Wall Street companies. 

 

(b)  The sale of entrepreneurial and closely-held companies is rarely done as a stock purchase, a requirement for Section 1202 stock. These companies sell their assets, not their stock. Stock acquisitions are more a Wall Street phenomenon.

So, who benefits from Section 1202?

A company that would be acquired via a stock purchase. Someone like … a tech start-up, for example. How sweet it would have been to be an early investor in Uber or Ring, for example. And remember: the $10 million cap is per investor. Take hundreds of qualifying investors and you can multiply that $10 million by hundreds.

You can see the loss to the Treasury.

Is it worth it?

There has been criticism that perhaps the real-world beneficiaries of Section 1202 are not what was intended many years ago when this provision entered the tax Code.

I get it.

So what is the House Ways and Means Committee proposing concerning Section 1202?

They propose to cut the exclusion to 50% from 100% for taxpayers with adjusted gross income (AGI) over $400 grand and for sales after September 13, 2021.

Set aside the $400 grand AGI. That sale might be the only time in life that someone ever got close to or exceeded $400 grand of income.

The issue is sales after September 13, 2021.

It takes at least five years to even qualify for Section 1202. This means that the tax planning for a 2021 sale was done on or before 2016, and now the House wants to retroactively nullify tax law that people relied upon years ago.

Nonsense like this is damaging to normal business. I have made a career representing entrepreneurs and their closely-held businesses. I have been there – first person singular - where business decisions have been modified or scrapped because of tax disincentives. Taxing someone to death clearly qualifies as a business disincentive. So does retroactively changing the rules on a decision that takes years to play out. Mind you – I say that not as a fan of Section 1202.

To me it would make more sense to change the rules only for stock issued after a certain date – say September 13, 2021 – and not for sales after that date. One at least would be forewarned.   

Should bad-faith tax proposals like this concern you?

Well, yes. If our current kakistocracy can do this, what keeps them from retroactively revoking the current tax benefits of your Roth IRA?  How would you feel if you have been following the rules for 20 years, contributing to your Roth, paying taxes currently, all with the understanding that future withdrawals would be tax-free, and meanwhile a future Congress decides to revoke that rule - retroactively?

I can tell you how I would feel.

Wiping Out An Inherited IRA

I came across an unfortunate tax situation this week.

It has to do with IRAs and trusts.

More specifically, naming a trust as a beneficiary of an IRA.

This carried a bit more punch before the tax law change of the SECURE Act, effective for 2020. Prior to the change, best planning for an inherited IRA frequently included a much younger beneficiary. This would reset the required distribution table, with the result that the monies could stay in the IRA for decades longer than if the original owner had lived. This was referred to as the “stretch” IRA. The SECURE Act changed that result for most beneficiaries, and now IRAs have to distribute – in general – over no longer than 10 years. 

Trusts created a problem for stretch IRAs, as trusts do not have an age or life expectancy like people do. This led to something called the “look-through” or “conduit” trust, allowing one to look-through the trust to its beneficiary in arriving at an age and life expectancy to make the stretch work.

The steam has gone out of the conduit trust.

One might still want to use a trust as an IRA beneficiary, though. Why? Here is an example:

The individual beneficiary has special needs. There may be income and/or asset restrictions in order to obtain government benefits.

What is the point, you ask? Doesn’t the IRA have to distribute to the individual over no more than 10 years?

Well … not quite. The IRA has to distribute to the trust (which is the IRA beneficiary) over no more than 10 years. The trust, in turn, does not have to distribute anything to its individual beneficiary.

This is referred to as an accumulation trust. Yes, it gets expensive because the trust tax rates are unreasonably compressed. Still, the nontax objectives may well outweigh the taxes involved in accumulating.

There is something about an inherited IRA that can go wrong, however. Do you remember something called a “60-day rollover?” This is when you receive a check from your IRA and put the money back within 60 days. I am not a fan, and I can think of very few cases where I would use or recommend it.

Why?

Because of Murphy’s Law, what I do and have done for over 35 years.

You know who can do a 60-day rollover?

Only a surviving spouse can use a 60-day rollover on an inherited IRA.  

You know who cannot do a 60-day rollover on an inherited IRA?

Anyone other than a surviving spouse.

It is pretty clear-cut.  

I am looking at someone who did not get the memo.

Here are the highlights:

·      Husband died.

·      The wife rolled the IRA into her own name (this is a special rule only for surviving spouses).

·      The wife died.

·      A trust for the kids inherited the IRA.

No harm, no foul so far.

·      The kids wanted to trade stocks within the IRA.

So it begins.

·      The IRA custodian told the kids that they would have to transfer the money someplace else if they wanted to trade.

No prob. The kids should have the IRA custodian transfer the money directly to the custodian of a new IRA that will let them trade to their heart’s content.

·      The kids had the IRA custodian transfer the money to a non-IRA account owned by the trust.

And so it ends.

The kids were hosed. They tried a Hail Mary by filing a private letter request with the IRS, asking for permission to put the money back in the IRA. The IRS looked at the tax law for a split second … and said “No.”

The IRS was right.

And, as usual, I wonder what happened with calling the tax advisor before moving around not-insignificant amounts of money.  

One can point out that taxes would have been payable as the kids withdrew money, and an inherited IRA has to distribute. If mom died in 2020 or later, the IRA would have to be distributed over no more than 10 years anyway.

Still, 10 years is 10 years. If nothing else, it would have given the kids the opportunity to avoid bunching all IRA income into one taxable year.

Not to mention paying for a private letter ruling, which is not cheap.

I hope they enjoy their stock trading.

The cite for the home gamers is PLR 202125007.

Happy New Year

 

Is It Income If You Pay It Back?

You receive unemployment benefits.

You repay unemployment benefits.

Do you have taxable income?

To start with: did you know that unemployment benefits are taxable? I have long considered this a dim bulb in taxation. Taxing the little you receive as unemployment seems cruel to me.

Back to our question: it depends.

It depends on when you pay it back.

Let’s look at the Yoklic case.

Yoklic applied for unemployment benefits in 2012.  He received $3,360, and then the state determined that he was not entitled to benefits. The state sent him a letter in October, 2012 requesting repayment.

Yoklic sent a check in September, 2013.

And he left the unemployment off of his 2012 return. How could it be income, he reasoned, if he had to pay it back. It was more of a loan, or alternatively monies that he received and to which he was not entitled.

Makes sense.

But tax theory does not look at it that way.

Enter the “claim of right” doctrine. It is an oldie, tracing back to a Supreme Court case in 1932.

The problem starts with accounting periods. You and I file taxes every year, so our accounting period is the calendar year. Sometimes something will start in one period (say October, 2012) but not resolve until another period (say September, 2013).

This creates a tax accounting issue: what do you do with that October, 2012 transaction? Do you wait until it resolves (in this case, until September, 2013) before you put it on a tax return? What if it doesn’t resolve for years? How many years do you wait? Does this transaction hang out there until the cows come home?

Enter the claim of right. If you receive monies – and you are not restricted in how you can use the monies – then you are taxable upon receipt. If it turns out that you are restricted – say by having to repay the monies - then you have a deduction in the year of repayment.

If you think about it, this is a reason that a bank loan is not income to you: you are immediately restricted by having to repay the bank. There is no need to wait until repayment, as the liability exists from the get go.

Find a bag of money in a Brooks Brothers parking lot, however, and you probably have a different answer.

Unless you repay it by the end of the year. Remember: you have a deduction in the year of repayment. If you find the bag of money and the police require you to return it, then the income and deduction happen in the same year and they fizzle out.

What if you promise to return the bag of money by year-end, but you do not get around to it until January 5^th? You may have an argument here, albeit a weak one. You could reduce your promise to writing, say by signing a contract. That seems a better argument.

What did Yoklic do wrong?

He repaid the monies in the following year.

He had income in 2012.

He had a deduction in 2013.

The problem, of course, is that the 2012 income may hurt more than the 2013 deduction may help.

There is – by the way - a Code section that addresses this situation: Section 1341, aptly described as the “claim of right” section. It allows an alternate calculation to mitigate the income-hurt-more-than-the-deduction-benefited-me issue. We have talked about Section 1341 before, but let me see if I can find a fresh story and we can revisit this area again.

How Do You Really Know If You Filed A Tax Return?

Here is what caught my attention:

The Internal Revenue Service … determined a deficiency of $541,552 in petitioner’s 2012 Federal income tax and an accuracy-related penalty of $107,995.”

This is the Whitsett case. She is a doctor and specializes in blood transfusions. Way back in 1982 she and her husband bought 4,000 shares of Immucor, Inc stock for $11,000. She kept it after the divorce.

Fast forward to 2011 and someone agreed to acquire Immucor for $27 per share.

She had almost 20 years for the stock to split and split again; she now owned 63,594 shares.

By my math 63,594 times $27 = $1,717,038.

How I wish I had those problems.

Come tax time she takes the paperwork to her accountant, whom she had used for decades. She showed him paperwork accompanying her $1.17 million check, captioned “Corporate Action Advice.” It said that …

·      The “payment date” was August 19, 2011

·      The “tax year” was 2012

·      The sale was “processed” on January, 2012

I have no idea what this “action advice” was trying to say. As a tax CPA, I report someone’s financial life to the IRS one year at a time. It is critical to me to know whether this sale took place in 2011 or 2012. Whoever wrote this “advice” must have been crazed or did not command the language.

COMMENT: If I were the CPA, I would be on the phone to shareholder services. Or I would ask you to call. Either way, we are investigating.

QUESTION: There is one more thing that could help with determining the tax year. Can you guess what it is?

Dr W’s accountant takes a look at the paperwork and decides that 2011 is the proper year to report the gain.

The accountant was also under the impression that she had been reinvesting dividends. He does a calculation (totaling $628,437), adds it to $11,000 and determines that her “basis” in the stock was $639,437.

And her gain is $1,077,601 (1,717,038 – 639,437).

He extends her return and has her send an extension payment of $154,776.

The return was extended until October 15, 2012. For some reason, he did not finish it on time. Instead he finished it in February, 2013. He sent Dr W a copy of her return as well as a letter explaining that he had “filed the return electronically.”

Happens all the time.

COMMENT: Except that a step is missing. Do you know what it is?

There was $5,393 due, and the Dr sent a check.

All done, right?

Nope.

The Dr gets a Form 1099-B reporting the sale of the stock in 2012.

COMMENT: Now he has to amend her 2011 to remove the sale.

The accountant reviewed the paperwork and decided that nothing needed to be reported in 2012, as she had reported the sale the year before. As if to provide an exclamation point, he did not even show the sale on her 2012 return with zero gain, if only to avoid tripping the IRS computers. He was pretty certain about his game. 

COMMENT: This is not done. Even if I was absolutely convinced that the 1099 was in error, I would report it on your return and then find a way to back it out. The IRS simply matches A to B; in the event of a mismatch, the IRS computers send out an automatic notice. The notice does not pass human eyeballs until you respond (or eventually, should you fail to respond).

Late in 2013 the IRS sent the Dr a notice asking where her 2011 return was. They were showing a credit of $165,562 but no return.

For some reason the Dr sent another check for $5,393. Why? Who knows.

She asked him about that 2011 return. He assured her that he filed it electronically.

COMMENT: If the IRS is asking, you did not file. You may have thought you did, but you are not going to win this fight. Send them a copy. Some practitioners even include a legend such as “Information Only – Previously Filed.” You can attach a note to this effect. No one is going to read the note and – more likely than not – you will receive a notice for late filing, but there is no harm.

Her accountant was so sure, however, that he sent the IRS nothing. Not a letter. Not a call. Nothing. What could possibly go wrong?

By October, 2014 the IRS sent the Dr a notice for big-time taxes due for 2012. Remember that - according to the IRS - she sold that stock in 2012.

In February 2015, the accountant backed down and admitted that the sale should have been reported in 2012. He also blew the calculation of her stock basis by adding $628,437 for reinvestments. Turns out that she had not reinvested. He promised to amend the 2011 and 2012 returns.

He amended nothing.

Finally – and fed up – she hired an attorney.

On April 10, 2015, the attorney amended the 2011 return, removing the sale of stock. 

QUESTION: Do you recognize the significance of the date: April 10, 2015?

Without the stock sale, she had a gigantic overpayment for 2011, which the attorney applied to 2012 and the stock sale.

The case, by the way, was not about the story we have just told. No sir. The case was because the IRS wanted gigantic penalties from Dr W.

Huh?

From their perspective, she refused to file a 2011 return, even after being reminded.

And – on top of that – she left out a big stock sale on her 2012 return.

If that was all you knew, she would look pretty bad.

From her side, the IRS looks like a bully. She reported the stock gain and paid the tax A YEAR EARLY.

Granted, the paperwork was a disaster, but the money was there before its time. If anything, the IRS should pay interest for banking her money.

The Tax Court fortunately reversed the penalties against Dr W. They felt she had acted with “reasonable cause” and “in good faith.” She relied on a long-standing tax advisor. He went off the rails, but how was she to know?

Remember that the penalty was over a hundred grand.

Back to our questions:

(1) The accountant should have questioned why he did not have a Form 1099-B for 2011. Anything can happen and paperwork gets lost, but the lack of one made me curious immediately.

(2) The accountant is not allowed to release her return without written permission from Dr W. Why? Because it not his return, that is why. He should have requested her to sign an authorization and mail it back to him before filing anything.

(3) The significance of the date is the statute of limitations. The original due date for a 2011 return was April 15, 2012. Add three years and make it April 15, 2015. If she wanted to get her 2011 refund (and she did), she had to get her amended return in by April 15, 2015. She made it by 5 days.

I am not sure what happened with the accountant. Was there a foul-up with his software? Did he attempt to electronically file but not recognize that the attempt failed? Why did he ignore a Form 1099, knowing that those things are chum-in-the-water for the IRS? Why did he not recognize that the statute of limitations was closing on a hundred-and-fifty grand?

And why not just send another copy of the return to the IRS and be done with it?

The Mary And Brad Story

"With respect to petitioner wife’s Federal income tax for 2008, the Internal Revenue Service … determined a deficiency of $106,733 and an accuracy-related penalty of $21,347 under section 6662(a). With respect to petitioners’ joint federal tax for 2010, the IRS determined a deficiency of $100,924 and a section 6662(a) penalty of $20,185.”

Someone went into Tax Court for a quarter of a million dollars. Let’s check it out.

Oh, oh. The issue was whether the taxpayers had a business or nonbusiness bad debt. If they did not, then other tax dominoes would tumble, such as whether a net operating loss existed.

We have Mary Bell. She was single in 2008. She married in 2010. They lived in Texas.

Mary had an MBA, and through 2010 she worked at Blockbuster Corp. You may recall how that turned out, and since 2011 Mary had been a partner with a private equity 

firm.

Her husband also brought some financial chops to the relationship. He was involved with real estate loans, but he lost his job with the 2009 crash. His health thereafter became an issue, but he hoped to get back into the business. His previous clients would eventually have their loans mature, and he wanted to be there when they refinanced.

Our story involves Mary.

Before marrying, Mary dated Brad. Brad was unemployed but full of hope and hype. He was working on a comic strip called “In the Rough,” involving golf.

Mary was making a couple of nickles, and she loaned Brad $75,000. Mary did not go through the due diligence a bank would do, though: investigate his credit rating, request tax returns, obtain other financial information.

She loaned him another $50,000. Brad, being a mature and responsible guy, bought a Hummer with it. He clearly was a keeper.

In all she loaned $430,500 to Brad.

She obtained a written note. It had interest at 5% and matured on December 31, 2007.

How did our tale turn out?

Yep. Our protagonist – the enigmatic, charismatic, problematic Brad – defaulted.

To be fair, he did repay $7,000, so it wasn’t a complete loss.

In 2010 Mary sent an e-mail demanding payment. Brad replied:

"I have no money.”

She continued trying.

In 2011 she filed suit for performance.

In 2012 she received a judgement against Brad.

In 2014 she reasoned that if Brad could get his comic strip syndicated, then he might have enough money to pay her back. She introduced Brad to people. She did not however get any interest, ride or other participation should Brad ever get the comic published.

In 2010 Mary set up an LLC to take-over the note. She then claimed it as a business bad debt on her/their 2010 joint tax return. The note, including interest, was over $600,000 at that time. Not surprisingly, this created a net operating loss, which she carried-back to 2008 for a refund.

We already know that they went to Tax Court.

While there were several issues in the case, we are concerned with only one today 

There are two pieces here:

You made a loan that went south, and

You are in the trade or business of making loans

The IRS quite agreed that Mary made a loan, but they argued that she did not meet the second requirement.

You do not need a building and employees to be in the trade or business of making loans, but you do need to make loans repetitively. That is what “trade or business” means: Jimmy John's does not make one sandwich and call it a day. One loan does not rise to the level of “repetitively.” It also helps to meet the routine requirements that banks and other lenders observe: perform credit checks, obtain financial information, obtain security for the loan, etc.

Mary in turn argued that she worked on content deals all the time at Blockbuster, and Brad’s comic strip was “content” by another name. She was in a “trade or business” because she had done something similar at work.

Not a bad argument, but it had two holes:

Mary did not loan money to Brad in the context of her job at Blockbuster. As a consequence, what she did at Blockbuster was not particularly relevant to the tax outcome of her loan.

Even allowing for that, she did not have an interest, royalty, or other equity participation in the comic strip. She could have demanded it from Brad, but she did not. The only thing she had was a creditor interest, the same as Fifth Third or SunTrust have when they lend money. We are still talking about a loan.

The Court decided that Mary had a nonbusiness bad debt.

The tax difference is huge.

If you have a business bad debt, you can deduct the loan the same way you would deduct your rent, payroll or any other expense. If the sum goes negative, you might have a net operating loss that you can carryback and/or carryforward, offsetting taxable income in other years. If you can carryback, you might even get a refund of taxes previously paid.

If you have a nonbusiness bad debt, the most you can do is offset your capital gains plus $3,000. That’s it. The biggest net subtraction you get can on your tax return is $3 grand. And there is no carryback. Mind you, you can carryforward indefinitely, but at $600 grand Mary would be carrying-forward until the cows came home.

Which is why Mary wanted the business bad debt so badly.

But she was not in the business of making loans. The best she could do was the $3,000. 

She owed the tax. She owed the penalty. It was a loser for her all around.

Travel Expenses And Your “Tax” Home

I have a friend who used to commute from northern Kentucky to San Francisco.

He has a unique skill set, and the California employer wanted that skill set badly enough to allow him to work a  week there and a week here.

While his employer paid for his commute - and his lodging and meals while in California - let us frame a tax question for more ordinary taxpayers like you and me:

   Can you deduct your expenses while working out of town?

We will use the Collodi decision to walk through this issue.

Mario Collodi lived in northern California - Paradise, California, to be precise. In 2011 he was working for an employer in southern California. He would work a week of 12-16 hour workdays, and then he would return home for a week off. His wife and children lived in Paradise year-round. He was not trying to find work closer to home.

When he filed their 2011 tax return he claimed almost $30 thousand in travel expenses.

The IRS pulled their return and disallowed his travel expenses.

Off to Tax Court they went.

Let's go through Collodi's argument:

• He was a motor hand on an oil rig, meaning that he took care of the motors on the rig.
• The uncertainty of his job made it unreasonable to relocate the family.
• Which meant that he had to travel for work.

He makes a certain amount of sense. 

The IRS fired back with the following:

• The Code allows a taxpayer to deduct ordinary and necessary expenses, including traveling expenses while away from home.
• Which means that one has to determine the location of the taxpayer's home.
• Which is not what you would immediately think. The Code considers your tax home to be where you work, not where you live. For most of us, that is one and the same, but that was not the case for Collodi. He lived in northern California but worked in southern California.

COMMENT: It is odd to think of one's tax home that way, but it makes more sense if you consider that the term "home" is being used in an income-tax context. If one's purpose to tax your income, then it makes sense that “home” would be redefined to where you earn that income.

• Collodi immediately had a problem, as his work-home was in southern - not northern - California. He cannot be away from home under this definition.
• But there is an exception: if you can expect to start and end that out-of-town job in a year or less, the IRS will consider you to be temporarily away from your home, now defined to mean where your wife and kids are. That would cover, for example, the consultant constantly on the road.
• The flip side is that - if you expect to be there more than a year - then you are hosed. You are considered "indefinitely" away from home, meaning your tax home moved with you and there are no travel deductions.

It all came down to this: how long was Collodi in southern California?

He started in 2010, worked all through 2011 and ended in October, 2012.

More than a year, way more than a year. He was not "temporary." He was "indefinite" and did not qualify for any travel deduction.

At least the Court did not pop them for penalties, reasoning that they relied on a tax professional to prepare the return.

OBSERVATION: The professional should have known better, though. While not said, I wonder whether he/she drew a preparer penalty.

Circling back to my commuting friend, he would not have been able to deduct his northern Kentucky - California travel expenses as he worked there for well over a year. He would have been deemed "indefinite," meaning his tax home moved with him when he traveled to San Francisco.

Why did he not move?

His wife refused.

How did the story turn out?

He changed jobs eventually. The commute and hassle wasn't worth it.