Hockey Team Meals And Fairy Dust

Let’s say that you own a professional hockey team.

What is your biggest expense?

Your players, I would think.

You train them, coach them, house them, feed them, transport them.

Wait … did we say “feed them?”

Uh, yes. Here is an easy example: the team has an out-of-town game. I presume you are going to feed them while they are away from home and hearth.

We have walked into one of the tax Code’s nonsensicals.

Yes, I know: which one?

Are their on-the-road meals deductible?

Yes, but you may remember that only 50% of the meals and entertainment costs is deductible. The company has to eat the other 50%.

Why? Because of three-martini lunches and all that.

Fat cats. Write-offs. Loopholes. The Hallmark Channel.

Let’s say there is an uber-expensive – and secret - lunch in Georgetown between a media mouth and some cobbling bureaucrat. Why should you and I have to subsidize that behavior with a tax deduction?

But that is not your situation. You are feeding your players. Maybe you feed them because you want them present by a certain time, or you want your dietician to monitor their intake, or you want to minimize interruptions were they to go out for meals. Perhaps it gives everyone an opportunity to review game plans and prepare for media interviews.

But the tax Code lumps you in with those Georgetown pseudologists.

The Boston Bruins decided to push this issue. They deducted the full cost of their meals, not just 50%.

COMMENT: For the tax nerds, the issue before the Court was the “away” meals. The IRS was not concerned with “home” meals, for reasons we will not address here.

Two of their tax years – 2009 and 2010 – went to Court.

I had considered this is an uphill climb.

Code Section 274(n) waives the 50% axe.

(n)  Only 50 percent of meal and entertainment expenses allowed as deduction.

(1)  In general.

The amount allowable as a deduction under this chapter for-

(A)  any expense for food or beverages, and

(B)  any item with respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such activity,

shall not exceed 50 percent of the amount of such expense or item which would (but for this paragraph) be allowable as a deduction under this chapter.

But are there exceptions?

Yep.

For example, “de minimis” fringe benefits are not taxable to the employee.

Well, that is great for coffee and sodas at the office, but it seems that we are stretching the word too ….

Wait, a “employer-operated eating facility” can qualify as a de minimis fringe benefit.

Well, that is hay of a different barn. What does it take to be such a facility?

Here are two of several requirements:

(1) The facility has to cover its own direct costs on an annual basis.

(2)  The facility must be located on or near the employer’s business premises.

Hah, you say. There is no way that the Bruins can meet test one, as there is no “revenue” here. The whole thing is a “cost.”  

Would you believe me that there is a way – an obscure, head-scratching way – to string the tax Code together to spontaneously spark the required “revenue?”

There is and the Bruins made it. I will spare you the details.

On to test two.

Let’s say they are in Pittsburgh playing the Penguins.

Google tells me there is approximately 575 miles between Boston and Pittsburgh.

Seems a stretch that the Bruins are “on or near” their training facilities in Brighton, Massachusetts.

But have the Bruins rent-out a banquet room in a Pittsburgh hotel. Can one sprinkle fairy dust and argue that the rental transmogrifies the banquet room into Bruins “business premises” – at least for a while?

The Court really seemed to be in a favorable mood towards the Bruins. They emphasized the “function” of the banquet room rather than its actual location in space and time. Perhaps the banquet room identified as Bostonian.

We conclude that away city hotels were part of the Bruins’ business premises for the years in issue. In arriving at this conclusion we consider the traveling hockey employees’ performance of significant business duties at away city hotels along with the unique nature of the Bruins’ business (i.e., professional hockey).”

Having met that test, the Pittsburgh hotel in essence became “business premises” of the Bruins.

Bam! The Bruins have business premises in Pittsburgh.

The Court next considered whether the eating-facility-on-Bruins-business-premises-in-Pittsburgh qualified as a “de minimis” fringe benefit.

Well heck, I think the Court telegraphed its hand when it decided that a Pittsburgh hotel was “on or near” Brighton, Massachusetts.

To wrap this up, someone on the Court is a huge hockey fan and the Bruins got their 100% deduction.

I suspect that this type of meal expense is not what Congress was after with its Section 274(n) chop. It is nonsensical that the Code disallows a 50% deduction for employee meals when their job requires travel. This more resembles the histrionics of class envy than any rational tax argument.

However – and let’s be fair – that is what the tax Code says. 

Or said, more accurately.

All it takes is a court willing to sprinkle fairy dust.

Issuing 1099s In Anger

Several years ago, I received an angry call from another CPA.

He had lost a couple of key partners, to which he responded with an almost Game-of-Thrones vindictiveness. He had been charged with issuing false Form 1099s to his former partners.

They dragged him into Court for this and other reasons.

I had looked into the 1099 matter. It is not every day a CPA is charged with issuing false tax forms.

Why would somebody do this: issue false 1099s?

Because chum in the water.

Let’s talk about the Petrunak case.

Petrunak was a pyrotechnician.

This guy made fireworks. He owned a company called Abyss Special FX, Inc. (Abyss), and he could do both indoor and outdoor fireworks displays.

This also meant that he was under regulation by the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF).

A couple of ATF agents conducted a mandatory inspection and found a number of violations. Petrunak challenged their findings and had his day in administrative court. I do not know what the details were, but the judge revoked Petrunak’s fireworks license.

So much for Abyss and his paycheck.

Petrunak reckoned he lost a lot of money – both as real-money losses and as money he would have made except for the ATF agents.

He had time to think about it. He thought about it for five years.

He had Abyss send each of them a Form 1099-MISC for $250,000.

Half a million. He figured that was about what they had cost him.

Abyss deducted that half million. As Abyss was an S corporation, there was a big loss passed-through to Petrunak to use on his individual return.

Needless to say, both ATF agents omitted that 1099 from his/her individual tax return.

One agent however got pulled for audit.

The IRS wanted taxes of over $100 grand. She spent a lot of time contesting and unraveling that mess.

Exactly what Petrunak wanted. Forms 1099 are chum in the water to the IRS.

Problem is, the IRS pursued Petrunak after the ATF agent’s audit. He admitted to filing those 1099s, but he was right in doing so and those two had lied – to a judge, unbelievable! – and an IRS person told him that he might be able to issue 1099s for his business costs. He estimated his costs to be half a million.

The IRS charged him with three counts of making false and fraudulent IRS forms.

He fought back, going to the Seventh Circuit Court of Appeals.

How did it turn out?

Petrunak is going to prison for 24 months.

His accounting was fantastical, but I get his anger.

Circling back, the accountant who called me was angry because I did not agree with him.

To be kind, let’s say his side of story was … creative.

But then, have a CPA play in a field with accounts receivable, deferred compensation, cash transfers, buyout agreements and whatnot and a talented – and motivated - practitioner can get creative.

He did.

Problem was: he picked a fight with tax CPAs. Two of them.

Bad call. 

It cost him a few bucks.

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?

Bill And The Gig Economy

I am inclined to title this post “Bill.”

I have known Bill for years. He lost his W-2 job and has made up for it by taking one or two (or three) “independent contractor” gigs.

However, Bills get into tax trouble fast. Chances are they burned through savings upon losing the W-2 job. They turned to that 1099 gig when things got tight. At that point, they needed all the cash they could muster, meaning that replenishing savings had to wait.

The calendar turns. They come to see me for their taxes.

And we talk about self-employment tax for the first time.

You and I have FICA taken from our paycheck. We pay half and our employer pays half. It becomes almost invisible, like being robbed while on vacation.

Go self-employed and you have to pay both sides of FICA – now called self-employment tax – and it is anything but invisible. You are paying approximately 15% of what you make – off the top - and we haven’t even talked about income taxes.

You find yourself in a situation where you probably cannot pay – in full, at least – the tax from your first contractor/self-employment year.

We need a payment plan.

But there is a hitch.

What about taxes on your second contractor/self-employment year?

We need quarterly estimated taxes.

You start to question if I have lost my mind. You cannot even pay the first year, so how are you going to pay quarterly taxes for the second year?

And there you have Bill. Bills are legion.

We arrange a payment plan with the IRS.

You know what will likely blow-up a payment plan?

Filing another tax return with a large balance payable.

All right, maybe we can get the first and second year combined and work something out.

You know what will probably blow-up that payment plan?

Filing yet another tax return with a large balance payable.

Depending upon, the IRS will insist that you make estimated tax payments, as they have seen this movie too.

A taxpayer named Allen ran into that situation.

Allen owed big bucks – approximately $93,000.

The IRS issued an Intent to Levy.

He requested a CDP (Collections Due Process) hearing.

COMMENT: The CDP process was created by Congress in 1998 as a means to slow down a wild west IRS. The idea was that the IRS should not be permitted to move from compliance and assessment (receive your tax return; change your tax return) to collection (lien, levy and clear out your bank account) without an opportunity for you to have your day.  

Allen submitted financial information to the IRS. He proposed paying $500 per month.

The IRS reviewed the same information. They thought he could pay $809 per month.

COMMENT: You would be surprised what the IRS disallows when they calculate how much you can repay. You can have a pet, for example, but they will not allow veterinarian bills.

There was a hitch. Monthly payments of $809 over the remaining statute of limitations period would not sum to $93,000. The IRS can authorize this, however, and it is referred to as a partial-pay installment agreement (PPIA).

EXPLANATION: Any payment plan that does not pay the government in full over the remaining statutory collection period is referred to as a “partial pay.” The IRS looks at it more closely, as they know – going in – that they are writing-off some of the balance due.

The IRS settlement officer (SO) read the Internal Revenue Manual to say that a taxpayer could not receive a partial pay if he/she was behind on their current year estimated taxes. Allen of course was behind.

Allen said that he could not pay the estimate.

The SO closed the file.

Allen filed with the Tax Court.

Mind you, Allen was challenging IRS procedure and not the tax law itself. 

He had to show that the IRS “abused” its discretion.

It would be easier to get a rhinoceros on a park swing.

I get it, I really do. Take two SO’s. One denies you a partial pay because you are behind on estimated taxes; the other SO does not. That however is the meaning of “discretion.”

Did Allen’s SO “abuse” discretion?

The Tax Court did not think so.

Allen lost.

But there is something here I do not understand.

Why didn’t Allen make the estimated tax payment, revise his financial information (to show the depletion of cash) and forward the revised financials to the SO?

I presume that he couldn’t: he must not have had enough cash on hand.

If so, then abuse of discretion makes more sense to me: someone in Allen’s situation could NEVER meet that SO’s requirement for a payment plan.

Why?

Because he/she could never make that estimated tax payment.

No Soup For You!

“No soup for you!”

The reference of course is to the soup Nazi in the Seinfield television series. His name is Al Yegeneh. You can still buy his soup should you find yourself in New York or New Jersey.

However, it is not Al who we are interested in.

We instead are interested in Robert Bertrand, the CEO of Soupman, Inc, a company that licenses Al’s likeness and recipes. Think franchise and you are on the right track.

Bertrand however has drawn the ire of the IRS. He has been charged with disbursing approximately $3 million of unreported payroll, in the form of cash and stock.

The IRS says that $3 million of payroll is about $600,000 of unpaid federal payroll taxes.    

Payroll taxes – as we have discussed before – have some of the nastiest penalties going.

And that is just for paying the taxes late.

Do not pay the taxes – as Bertrand is charged – and the problem only escalates. He faces up to five years in prison. His daughter co-signed a $50,000 bond so he could get out of jail.

BTW the judge also ordered him to hire an attorney.

COMMENT: I don’t get it either. One of the first things I would have done was to hire a tax attorney.

I have not been able to discover which flavor of stock-as-compensation Soupman, Inc used, although I have a guess.

My guess is that Soupman Inc used nonqualified stock options.

COMMENT: There are multiple ways to incorporate stock into a compensation package. Nonqualified options (“nonquals” or “NSO’s”) are one, but qualified stock options (“ISO’s”) or restricted stock awards (“RSA’s”) are also available. Today we are talking only about nonquals.

Using nonquals, Soupman Inc would not grant stock immediately. The options would have a delay – such as requiring one to work there for a certain number of years before being able to exercise the option. Then there is the matter of price: will the option exercise for stock value at the time (not much of an incentive, if you ask me) or at some reduced price (zero, for example, would be a great incentive).

Let’s use some numbers to understand how nonquals work.

• Let’s start with a great key employee that we are very interested in retaining. We will call him Steve.
• Let’s grant Steve nonqualified options for 50,000 shares. Steve can buy stock at $10/share. As the stock is presently selling at $20/share, this is a good deal for Steve.
• But Steve cannot buy the stock right now. No, no, he has to wait at least 4 years, then he has six years after that to exercise. He can exercise once a year, after which he has to wait until next year. He can exercise as much of the stock as he likes, up to the 50,000-share maximum.
• There is a serious tax trap in here that we need to avoid, and it has to do with Steve having unfettered discretion over the option. For example, we cannot allow Steve to borrow against the option or allow him to sell the option to another person. The IRS could then argue that Steve is so close to actually having cash that he is taxable – right now. That would be bad.

Let’s fast forward six years and Steve exercises the option in full. The stock is worth $110 per share.

Steve has federal income tax withholding.

Steve has FICA withholding.

Steve has state tax withholding.

Where is the cash coming from for all this withholding?

The easiest solution is if Steve is still getting a regular paycheck. The employer would dip into that paycheck to take out all the withholdings on the option exercise.

OBSERVATION: Another way would be for Steve to sell enough stock to cover his withholdings. The nerd term for this is “cashless.”

It may be that the withholdings are so large they would swamp Steve’s regular paycheck. Maybe Steve writes a check to cover the withholdings.

COMMENT: If I know Steve, he is retiring when the checks clear.

Steve has income. It will show up on his W-2. He will include that option exercise (via his W-2) on his tax return for the year. The government got its vig.

How about the employer?

Steve’s employer has a tax deduction equal to the income included on Steve’s W-2.

The employer also has employer payroll taxes, such as:

·      Employer FICA

·      Federal unemployment

·      State unemployment

Let’s be honest, the employer payroll taxes are a drop in the bucket compared to Steve’s income from exercising the option.

Why would Steve’s employer do this?

There are two reasons. One is obvious; the second perhaps not as much.

One reason is that the employer wants to hold onto Steve. The stock option serves as a handcuff. There is enough there to entice Steve to stay, at least for a few years.

The second is that the employer manufactured a tax deduction almost out of thin air.

Huh?

How many shares did Steve exercise?

50,000.

What was the bargain element in the option exercise?

$110 - $10 = $100. Times 50,000 shares is $5,000,000 to Steve.

How much cash did the employer part with to pay Steve?

Whatever the employer FICA, federal and state unemployment taxes are – undoubtedly a lot less than $5,000,000.

Tax loophole! How Congress allow this? Unfair! Canadian football!

I disagree.

Why?

To my way of thinking, Steve is paying taxes on $5,000,000, so it is only fair that his employer gets to deduct the same $5,000,000. To argue otherwise is to wander into the-sound-of-one-hand-clapping territory.    

But, but … the employer did not actually pay $5,000,000.
   

COMMENT: Sometimes the numbers go exponential. Mark Zuckerberg, for example, had options to purchase 120 million shares for just 6 cents per share when Facebook went public at $38 per share. The “but, but …” crowd would want to see a $4,550,000,000 check.

I admit: so would I. I would frame the check. After I cashed it. It would also be my Christmas card every year.

You are starting to understand why Silicon Valley start-up companies like nonqualified stock options. Their cost right now is nada, but it can be a very nice tax deduction down the road when the company hits it big.

I suspect that Soupman, Inc did something like the above.

They just forgot to send in Steve’s withholdings.

An Attorney, A CPA and Confidentiality

Do you have privacy protection if you tell me something as your CPA?

Your first thought might be yes, as your CPA might be the financial doppelganger to an attorney.

Then again, the answer might be no, as your CPA is not in fact an attorney – unless he/she is one of those rare birds that pairs-up a JD/CPA.

What got me thinking along these lines is the recent case US v Galloway.

Let’s travel to 2006. The IRS notifies Galloway that his 2003 return has been pulled for audit.

Audit starts.

In the middle of the audit Galloway’s CPA fires him. Why? Galloway did not pay his fees.

In 2008 Galloway gets sent to CID (Criminal Investigation Division), the part of the IRS that carries badges and guns.

As a heads-up: you NEVER want to deal with CID. It is one thing to argue with regular IRS, appeal penalties, stretch out a payment plan and so on. All that crowd wants is your money. CID investigates criminal conduct and they have a different goal: to put you in jail.

CID agents went to his business offices in Bakersfield, California. Upon their approach, a man in the office locked the door and called the police.

The CID agents also called the police and informed them there were two plain clothed and armed federal agents waiting for them to arrive.

The man stepped out of the building and provided them with the name of an attorney. The CID agents cleared out before the police arrived.

Nothing. Suspicious. There.

Since that visit went so well, CID next issued a summons for production of documents to the former CPA.

The CPA met with them, explained his relationship with Galloway and answered questions on how he prepared Galloway’s 2003 return. No great surprise: Galloway had forwarded QuickBooks information; the CPA asked a few questions, massaged a few numbers and produced a tax return. Happens in a thousand CPA offices every day.

There was a smidgeon of a problem, though.

Remember that the CPA had started the Galloway audit. As part of the audit, Galloway had provided him more paperwork, including additional and replacement QuickBooks runs. No big deal - usually.

What was unusual was that the new QuickBooks runs did not match-up to the earlier run the CPA used for the tax return.  

Galloway was charged with four counts of attempting to evade tax.

What to do?

Galloway sought to suppress all evidence obtained from his prior CPA. Why? Code Section 7609. The AICPA Code of Professional Conduct. Equitable authority. Applebee’s 2 for $20 menu.

You get it: kitchen sink. Galloway was throwing everything he had.

And this brings us to the Couch case from 1973. It was a Supreme Court case, so it is big-time precedent.

Couch owned a restaurant. At issue was unreported income. Cash. Pocket. Wink. You understand.

The IRS issued a subpoena to Couch’s accountant for books, records, bank statements, cancelled checks, deposit ticket copies, Sunday newspaper coupons and unexpired S&H green stamps.

Couch said: hold up. She had provided all that stuff to her accountant, so subpoenaing her accountant rather than her personally was nonetheless a violation of her Fifth Amendment right against self-incrimination.

I like her argument.

Ultimately – as Captain Picard would say – her argument was futile.

The Court was short and swift: Couch had no “legitimate expectation of privacy” upon providing information to a third-party with the goal of processing, straining and compressing that same information onto a government tax return.

Back to Galloway.

As you can see, he was taking a low-probability swing on a high-and-tight fastball.

He struck out. He could not make enough separation between his situation and Couch to avoid the precedent.

How do tax CPAs handle situations like Galloway in practice?

First of all: interaction with CID is rare. One can have a long career and never see the criminal side of the IRS.  

I have run into CID once or twice over 30+ years, most recently in connection with a fraudulent tax preparer in northern Kentucky. I also recently (enough) represented a client whose file was submitted by Exam to CID, but CID rejected the matter. The client was eye-rollingly negligent, but Exam hyperventilated (I thought then and now) and started seeing intent where only stupidity abounded.  

Anyway, here is what the CPA should recommend:

(1) Have the client hire an attorney

(2) Have the attorney hire the CPA

Under this arrangement, the CPA works for the attorney. He/she is protected under the attorney’s confidentiality privilege and cannot be compelled to testify unless the attorney releases him/her. The attorney will not – of course -  do any such thing.

This set-up is called a “Kovel,” by the way. Not surprisingly, it refers to a case by the same name.

What did Galloway’s accountant do wrong?

To be fair: nothing. Galloway was no longer a client. He was under no obligation to chase Galloway down.

Galloway really should have thought of that before stiffing the CPA for his fee.

Let’s however say Galloway was still a client. 

Folks, at the first hint or whiff of a criminal investigation I am (1) firing you or (2) you are providing me with a Kovel. Those are the only two options.

But it requires the accountant to recognize the danger signs.

Like a combined civil-criminal IRS examination, for example. Those are borderline unfair, as the IRS will pretend there is no criminal side to it. They introduce an unsettling miasma of entrapment, and they require the tax practitioner to realize that he/she is being played.

But that is not what happened with Galloway. CID went to his office, for goodness’ sake.

There was not a lot of subtlety there.

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.