Tax Return That Surprised An Accountant

Let’s do something a little different this time.

I want you to see numbers the way a tax CPA does.

Let’s say that you are semi-retired and you bring me your following tax information:

                    W-2                                         24,000

                    Interest income                            600

                    Qualified dividend income      40,000

                    Long-term capital gains          10,000

                    IRA                                         24,000

Looks to me like you have income of $98,600.

How about deductions?

                    Real estate taxes                    10,000

                    Mortgage interest                      5,000

                    Donations                                26,000

I am seeing $41,000, not including your exemptions.

You did some quick calculations and figure that your federal taxes will be about $6,500. You want to do some tax planning anyway, so you set up an appointment. What can you do to reduce your tax? 

What do I see here?

I’ll give you a hint.

Long-term capital gains have a neat tax trick: the capital gains tax rate is 0% as long as your ordinary income tax rate is 15% or lower. This does not mean that you cannot have a tax, mind you. To the extent that you have taxable income in excess of those capital gains, you will have tax.

Let’s walk though this word salad.

Income $98,600 – deductions $41,000 – exemptions $8,100 = $49,500 taxable income.

You have capital gains of $10,000.

Question: will you have to pay tax on the difference – the $39,500?

Answer: qualified dividends also have a neat tax trick: for this purpose, they are taxed similarly to long-term capital gains.

NOTE: Think of qualified dividends as dividends from a U.S. company or a foreign company that trades on an U.S. exchange and you are on the right path.

You have capital gains and qualified dividends totaling $50,000.

Your taxable income is $49,500.

All of your taxable income is qualified dividends and capital gains, and you never left the 15% tax bracket.

What is your tax?

Zero.

How is that for tax planning, huh?

From a tax perspective, you hit a home run.

Let me change two of the numbers so we can better understand this qualified dividend/capital gain/taxable income/15% tax bracket thing.

                    W-2                                         36,000

                    Qualified dividends                 28,000

As you probably can guess, I left your taxable income untouched at $49,500, but I changed its composition.

You now have capital gains and qualified dividends of $38,000. Your taxable income is $49,500, meaning that you have “other” income in there. You are going to have to pay tax on that “other” income, as it does not have that qualified dividend/capital gain trick.

The tax will be $1,153.

You still did great. It is just that no tax beats some tax any day of the week.

It is something to consider when you think about retirement planning. We are used to thinking about 401(k)s, deductible IRAs, Roth IRAs, social security and so on, but let’s not leave out qualified dividends and capital gains. Granted, capital gains are unpredictable and not a good fit for reliable income, but dividend-paying stocks might work for you. When was the last time Proctor & Gamble missed a dividend payment, for example?

OK, I admit: if you leave the 15% tax bracket the above technique fizzles. That however would take approximately $76,000 taxable income for marrieds filing jointly. Congrats if that is you.

BTW I saw scenario one during tax season (I tweaked the numbers somewhat for discussion, of course). The accountant was perplexed and asked me to look at the return with him. The zero tax threw him.

Now he knows the dividend/capital gain thing, and so do you.

Taxing A Nondeductible IRA

Let’s say that you are married. Together you and your spouse earn $200,000.

BTW, congratulations. You have done well. Not Thurston Howell III well, but well enough that Congress considers you wealthy. Then again, one of the last times I paid attention Congress was working on a 10-percent approval rating.

How much of a Roth contribution can you make?

You know you can put away $5,500. If you are age 50 or over you can put away another $1,000. There are two of you – you and your spouse.

So, how much can you contribute?

Would you believe nothing?

Yep, zero. You make too much money.

How’s Lovey, Thurston?

And there is our segue to the nondeductible IRA. The “nondeduct” still exists, but it has been eclipsed (and rightfully so) by the Roth.

The nondeductible preceded the Roth. The idea is that you get no deduction going in, but only a percentage is taxable coming out.

Here is an example. You fund a nondeductible for a decade. You contribute $55,000. Years later, it is worth $550,000 and you start taking withdrawals. How is this taxed?

$55,000 divided by $550,000 is 10 percent. The inverse – 90 percent – is your gain. You pull out $20,000. Your taxable amount is $20,000 times 90% or $18,000.

This thing is a distant cousin to the Roth, where the whole $20,000 would be nontaxable. You would always Roth rather than nondeduct – if you can.

But you make $200 grand. No Roth for you.

But you can nondeduct. It is one thing the nondeduct brings to the party – there is no income limit. Make a zillion dollars and you can still put $5,500 into your nondeductible IRA.

If you do, the IRS wants you to attach a form to your return – Form 8606. It alerts them that a nondeductible exists, and it also reminds you of your accumulated contributions decades later when you begin withdrawals. You are going to need that number to calculate your percentage.

I was looking at case where the taxpayer had a nondeductible IRA and it was decades later. He had to calculate the taxable percentage, but he had never completed Form 8606 to do the calculation or to alert the IRS.

He withdrew $27,745. He did not report the $27,745 because it came from his nondeductible IRA.

COMMENT: And we know this is wrong. He was thinking of a Roth, where the whole thing is nontaxable. This is a nondeductible, and only a percentage is nontaxable.

The IRS wanted to tax it all. He had – gasp! – failed to attach…the…proper… form.

Problem was; he did not have the best documentation. No doubt it would been better to file and update that 8606 as he went along.

The Court looked at available documentation, which was sparse.

(1) There was a Citibank summary statement sometime around 1998 showing cost and value.

(2) The taxpayer had Forms 5498 from 2007 through 2013. If you have ever funded an IRA, then you have received one of these. Form 5498 shows your contributions for the previous calendar year. His 5498s showed that he put in no fresh money from 2007 onward.

(3) Taxpayer showed that he was high-income for the years before 2007 when he made his IRA contributions.

The Court gave him the benefit of the doubt. It knew that the IRA account was not a Roth. That left only deductible and nondeductible IRAs. If he was high income and covered by a plan at work, he could not have made a deductible IRA contribution. By process of elimination, the IRA had to be nondeductible.

He was not in the clear though. The Court reminded him that a nondeductible percentage of zero is almost impossible, as the IRA would have to go down in value. He had to calculate his percentage and would have taxable income, but not as much as the IRS wanted.

I suspect I will see this fact pattern as boomers with nondeductible IRAs enter retirement. The Tax Court has given us guidance on how to work around poor recordkeeping.

The case for the home gamers is Shank v Commissioner.

Tattletaling on Sales Taxes

There is a tax case coming before the Supreme Court. It involves Wayfair, the online home goods company, and sales taxes.

The issue can be summarized as follows: if I do not have a building or inventory or employees in your state, can you force me to collect your taxes?

The Wayfair case is an evolution of the Quill case, decided by the Supreme Court in 1992. Quill is an office-supply company, and in 1992 the issue was whether North Dakota could tax Quill just because it sent catalogues to residents of the state.

North Dakota was adamant: Quill was regularly and systematically soliciting its citizenry. It did not care that Quill had no presence in the state. By that reasoning Norway could have also taxed Quill, but let’s not introduce common sense into this argument.

The Supreme Court was unwilling to go that far, recognizing that sales taxation was (and is) the wild west of taxation. Each state has its own rules and - depending upon the state - there can also be counties and cities imposing sales tax.  

What has changed since Quill? The internet, of course.

The new argument is that the internet has revolutionized how business is done.

But sales taxes are still eccentric, often cryptic and frustratingly inconsistent. The internet has not revolutionized that. Perhaps Amazon can wield the accounting staff necessary to comply, but a small business may have a different result.

I have a client that got mugged by the “tattletale” statutes that some states are now implementing.

Let’s look at Washington’s tattletale law.

It applies if you do not otherwise collect Washington sales tax.  

Let’s say that you sell promotional materials for old-time movies. You have a modest warehouse in a nondescript part of town, You sell exclusively over the internet, and you get paid almost exclusively through PayPal.

You have a sale in Washington state. Then two, four, ten…. You get the idea.

Washington is watching you.

Get to $10,000 in Washington sales and you have issues.

Oh, they cannot force you to collect sales taxes, but they can force you to:

(1) Conspicuously post on your website that sales taxes are due and that the purchaser must file a use tax return.

Fail to do so and there is an immediate penalty of $20,000.

Ouch.

Are we done?

Of course not.

Let’s say that you actually sell something.

(2) You must provide a notice with every sale that no sales tax is being collected, that the purchaser should file a use tax, and instructions on how to pay the use tax. The notice must be “prominently” displayed.

You write a standard notice and keep copies.

Are we done?

(3) At year end you must send the purchaser a list of everything they bought, by date. You again must provide the usual gospel on use tax and how to get information on its filing.

This starting to get expensive. Who has time for this nonsense?

Make time. The penalties begin at $5,000 and can increase exponentially.

(4) You must send a copy of that list to the state of Washington.

Fail to do so and penalties begin at $20,000.

By my math, if you sell $10,001 into Washington and do not become an unpaid agent of the Department of Revenue, you are exposed to $45,000 in penalties.

Washington of course says that it can waive penalties.

Fairy tales used to be for children. 

And the fairy tale is a one-off only. There is no second chance at a waiver.

Mind you, Washington’s state sales tax rate is 6.5%. Go to Seattle and you pick up a city sales tax, making the combined rate 9.6%

What pathological bureaucrat sets the bar at $650 in sales tax?

This is the standard structure of the tattletale laws: resistance is futile.

In ancient times – say the 1980s – there was a concept in state taxation called the Commerce Clause. This refers to the Constitution and its restriction on states to not so burden and fetter their laws so as to interfere with interstate commerce.

Seems to me that the Supreme Court should consider the Commerce Clause implications of a $45,000 penalty on $10,001 in sales when considering the Wayfair decision.

I know.

Fairy tales used to be for children.

When Do You Become A Landlord?

There is a requisite to being an NFL player – current or retired.

You must have played in the NFL.

There is a tax spiff on this point when you decide to landlord.

When does your rental start?

Probably when you place it in service, that is, when you have a tenant and begin receiving rent.

Can it start before then? Say that you are having trouble getting a tenant. Can you can say that you started renting before you have a tenant?

It probably can happen, but you had better line-up your facts in case of challenge.

I am looking at a case where the IRS assessed the following tax:

                 2004             $ 78,292

                     2005             $144,053     

                     2006             $218,228

                     2007             $143,729

                     2008             $252,777

                     2009             $309,060

Numbers like that will attract attention, the kind that can result in a challenge.

There is a doctor who now lives in Florida but used to live in Rhode Island. In 2004 he and his wife bought a mansion in Newport. The house was derelict, having been vacant for four decades.

It was uninhabitable, so the first thing they did was bring in a contractor.

It was a historic property, so there were also some tax credits in there.

Restoration started in 2002.

The work went into 2008.

That is a lot of restoration.

The family moved to Florida in 2005.

I suppose that answers the issue of whether this was ever a principal residence. It could not be if one could not live in it.

In 2006 they met a rental agent who specialized in luxury properties.

They got a temporary certificate of occupancy in 2007 and a final certificate in 2008.

Seems that one could argue that it was available for rent in 2007.

By 2007 the agent was hopeful she could attract a renter. She held up actively marketing it, however, as renovations were unfinished.

Sure enough, one of her clients expressed an interest in 2008.

The debt on this fiasco was ballooning, so the doctor and his wife decided to dump the house. The ante was upped when the bank increased their monthly payment in 2008 from $25 grand to $39 grand a month.

Count me out on ever renting this place.

In July, 2009 they sold the house.

They filed their 2009 tax return and reported a capital loss of a gazillion dollars.

Tax advisors are not overly fond of capital loses, as the only thing they can offset – with one exception – is capital gains. If you have no capital gains, then the loss just sits there – unused and gathering dust.

The doctor and his wife met a tax advisor who said that he could help: just treat the house as business property and the loss would be deductible. The good kind of loss – the kind you can actually lose.

They amended their 2009 return and reported a $8-plus million business loss.

Now they had a 2009 net operating loss. They carried the loss backward and forward. There were tax refunds and jollity aplenty.

However, numbers like that attract IRS attention, especially when you amend a return.

The IRS did not believe they had business property. If it was not business, then the initial reporting as capital loss was correct. The IRS wanted its money back.

Don’t think so, replied the doctor and his wife.

Off to Tax Court they went.

At issue was whether the house ever shifted to rental status, as that is the trigger for it to be business property.

There was one key – and punishing – fact: they never rented the house.

Here is the Court:

While we have no doubt that petitioners devoted a great deal of time, effort and expense to the renovation of Wrentham House Mansion, the record overwhelmingly confirms that Wrentham House Mansion was never held out for rent or rented after the restoration was complete. Quite simply, the rental activity with respect to Wrentham House Mansion never commenced in any meaningful or substantive way.”

Perhaps the doctor and his wife would have held on – at least long enough to rent for a while – if the monthly payment had not skyrocketed. They were pushed into a corner.

Still, no rent = no business = no business loss.

The best they could do was a capital loss.

What is the one exception to a capital loss I alluded to earlier?

You can deduct $3,000 a year against non-capital-gain property.

Which is no solace when you have an $8-plus million capital loss.

The case is Keefe v Commissioner for the homegamers.

Researching For Deductions

I was skimming a Tax Court case that almost made me laugh out loud.

It initially caught my attention because it involved a deduction for research costs.

The tax surrounding research costs come in two flavors:

·      What is deductible as research?

·      And – perhaps more importantly – can you get a tax credit for it?

Let’s talk this time about the first question, which may not be what you anticipate. Here is an example:

You build a garage to store your business equipment. The garage’s claim to fame is that it is built from natural fibers rather than bricks and lumber. It is the Kon-Tiki of garages. Can you deduct the cost of the garage as you build it?

At the end of the day, you will have a building. Granted, it may be unusual, but it is still a building. Can you deduct a building as you go along? Or do you have to accumulate (and defer) the cost until the building is ready for use? And then what - do you deduct the accumulated cost at that time or do you deduct the cost over a period of years?

You will be deducting the cost over a period of years, otherwise known as depreciation. You self-constructed a long-lived asset, and the tax Code (barring the unusual) will not let you deduct it immediately.

Let’s swing back to research costs.

What if the research costs result in a patent?

You have legal rights for a period of years to intellectual property, and the patent may be worth a fortune.

So we rephrase the question: can you immediately deduct the research costs resulting in that patent?

But CTG, you say, the two are not the same. Chances are that salaries make-up most of the research costs. It doesn’t seem right to capitalize and depreciate salaries. Sticks and bricks have staying power; they last for years. It makes more sense to depreciate those rather than salaries.

Hmmm. What about the wages of the tradesmen-and-women that constructed the building? Do we get to carve those out from the sticks-and-bricks and deduct them immediately?

Of course not.

You now get the issue with research costs.

To answer it the tax Code gives us Section 174:

        (a)  Treatment as expenses.

(1)  In general.

A taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as a deduction.

As long as the costs meet the definition of “research or experimental expenditures,” you have the option of deducting them immediately.

Problem solved.

Our case this time is Bradley and Hayes-Hunter v Commissioner.

Mr. Bradley was a litigation consultant. He reviewed evidence, provided expert testimony and conducted legal research. He was self-employed, and on his 2014 individual income tax return he deducted $25,000 as “Research.”

The IRS was curious what “research and experimental expenditures” a litigation coach could possibly have. It is well-trod ground that Section 174 addresses research in an “experimental” or “laboratory” sense. While one does not have to be in a Pfizer lab wearing a white coat, one likewise cannot be in a library shepardizing law cases.

What did he deduct?

I will give you a clue: his billing rate was $250 per hour.

He deducted $25,000.

And $25,000 divided by $250 is 100 hours.

Not only was he nowhere near a Section 174 research cost, he was also deducting his own time.

How I wish.

Who knows how much tax research I do over an average year. If I could only deduct my time, I would never pay income taxes again.

It won’t work for me, and it did not work for Mr. Bradley.

A CPA Draws A Fraud Penalty

I see that a CPA drew a fraud penalty.

There is something you don’t see every day.

The CPA is Curtis Ankerberg. He practices in Oregon, which means that I could not have met him. I however am certain that I have met his acolytes.

He graduated in 1994 and did the CPA firm route until 2005, when he went out on his own.

Good for him.

The IRS pulled his personal 2012, 2013 and 2014 returns.

Should be easy for a practicing CPA.

During those years he prepared 50 to over 70 individual returns for clients. It doesn’t sound like a lot, but those are just individual returns. It does not include business returns or any accounting he may also have done.

He maintained an office-in-home, which meant that the IRS examiner came to his house. The audit started off on a bad foot. The auditor added up his 1099s for one year and found that the sum exceeded what Ankerberg had reported as income. Needless to say, the auditor immediately recorded a write-up.

Comment: Folks, if you want to chum the waters for an IRA auditor, this is a good way to do so. I am – if anything – surprised that the IRS computers did not catch this before the auditor even showed up.

Emboldened, the auditor now presented a list of documents he wanted to review.

Our CPA said sure, but he never followed up. He was creative with his excuses, though:

·      He had cataract surgery coming up.

·      He was awaiting the outcome of a complaint he filed with the Treasury Inspector General for Tax Administration.

·      He lost his records.

·      The auditor was messing around with one of the years, as the CPA had already agreed he had underreported income.

·      He had not attached necessary forms to his tax returns because to attach them was a “red flag.”

·      He had bank statements but he could not turn them over because he could not see well.

Alrighty then.

That last one cost him and big.

If the IRS wants your bank statements, they will get your bank statements. You can play it nice and provide copies yourself, or you can stick it to the man and have the IRS subpoena them from the bank. The latter may give you a momentary rush of I-am-a-bad-dude, but you have hacked off an auditor.

What is the first reason that comes to mind if one refuses to provide bank statements?

Exactly.

The IRS agent poured over those bank statements like they were winning lottery tickets. Our CPA had again underreported income. In each year.

Can you feel the penalty coming? Oh, it is going to be a biggun.

What more can a disgruntled agent do?

The agent disallowed the following expenses:

·      Insurance

·      Taxes and licenses

·      Office expenses

·      Repairs and maintenance

·      Utilities

·      Interest

·      Vehicle expenses

·      Office in home

·      And others

This is not fatal. Just provide the documents.

Which Ankerberg did not do.

Our CPA is before the Tax Court explaining how he got into this mess. I imagine the conversation as follows:

“Your honor,” he said, “I had serious medical issues, and those issues constitute reasonable cause. I had cataract surgery, and before then I was really a mess. This auditor caught me at a bad time.”

“Really?” asked the Court. “We are curious then how you prepared all those tax returns for all those clients.”

“Braille,” replied our CPA.

“You continued to drive a car,” continued the Court.

“Self-driving,” explained our CPA. “It is a Google car.”

“Interesting,” noted the Court. “How about that 2014 return, the one after your cataract surgery?”

“Phantom blindness,” offered the CPA generously.

“Let us see. Too little income. Too many deductions. A tax professional who knew the tax ropes. Someone who never provided bank statements or other documentation requested by the auditor. What does this sound like? Let us think… let us think...”

“Aha! We remember now: they sound like badges of fraud.”

Bam!

BTW the fraud penalty is 75%.

Just provide the bank statements, Barney.

Fewer Like-Kind Exchanges in 2018

The new tax bill changed like-kind exchanges.

This is Section 1031, which was and is a tax provision that allows one to defer taxes on a property sale - if one follows the rules.

I suspect that almost every practicing tax accountant has met with a client who said the following:

·      I sold property last year,

·      I hear that there is a tax break if I buy another piece of property

Well, yes there MIGHT be a tax break, but you have to follow the rules from the beginning, not just months later when you meet with your accountant.

The normal sequence is to sell the property first. It doesn’t have to be that way – you can start with the buy – but that is unusual. The tax nerds refer to that as a “reverse.”

There are ropes:

(1)  You want the money held by a third party, such as an attorney or title company;

(2)  You have to identify the replacement property within 45 days (there is some latitude in identifying replacement properties); and

(3)  You have to complete the whole transaction – sell and buy – within 180 days.

(4) Anticipate that you will be buying-up: buy more than what you sold.

(5)  Debt is tricky. To be safe, increase your debt, at least a little bit.  

(6)  You never want to receive cash from the deal. Cash is income – period.

If you wait to until you meet with your accountant, then you have probably blown requirement (1).

The most common like-kind that I see – I kid you not – is vehicle trade-ins. They happen every day, to the point that we do not even pay them attention. In the tax world, however, trade-ins are like-kind exchanges.

The next most common are real estate exchanges. I have probably seen at least one a year for the last couple of decades. Those usually go through a title company or attorney, and I have the pleasure of looking over a binder of paperwork that would weigh down a Clydesdale.

There are others. One can like-kind exchange personal property, for example. The rules are stricter than the rules for real estate, and for the most part I have not seen a lot of those.

The new tax bill made a big change to like-kind exchanges.

How?

Because personal property no longer qualifies for like-kind treatment.

So much for trade-ins.

But there is another kind that I thought of recently.

Think sports.

Yep, back in 1966 the IRS considered player contracts – if done correctly – to be property qualifying for like-kind.

I am unsure how professional sports will work-around this change. It is not an area I practice, although I would have loved to.

Why did Congress mess with this?

It wasn’t about player contracts. It rather had to do with art and collectibles. It had become de rigueur to like-kind exchange in the art world, as buyers had come to view art as just another tradable commodity. Think stocks, but with the option of delaying taxes until the end of time. This reached the attention of the Obama administration, which began the push to eliminate them.

It took another White House, but it finally got done.