A Tax Refund When The IRS Fails To Process A Return

I am looking at a case involving a tax refund. The IRS bounced it, and I am having a hard time figuring out what the IRS was thinking.

Let’s talk about it.

James Willetts filed an extension for his 2014 individual tax return. He sent a $8,000 payment and extended the return from April 15 to October 15, 2015.

Standard stuff.

He did not file the return by October 15, 2015.

Oh well.

He finally filed the 2014 return on April 14, 2018.

April 15, 2015 to April 14, 2018 is less than three years, and that is not even including the six-month extension on the 2014 return.

The IRS rejected the return because of potential identity theft.

I presume that the IRS sent a notice, but Willetts did not respond. The Court goes on to observe that it was unclear whether Willetts even knew there was an identity issue before bringing suit.

COMMENT: That struck me as odd, as one of the first things a tax professional would do is obtain a transcript of Willett’s tax account. I then noted that Willetts brought suit as “pro se,” generally interpreted as going to Court without professional representation. Technically, that is incorrect, as one can go to Court with a CPA and still be considered “pro se,” but, in Willetts’ case, I am inclined to believe he was truly pro se.

The issue before the Court was straight-forward: did Willetts file his return in time to get his refund?

Let’s go tax nerd for a moment:

(1)  A taxpayer may recoup a tax overpayment by filing a claim within a statutorily-prescribed period of time.

(2)  That period of time is:

a.    Three years from when the return was filed, if the return was filed within three years of when the return was due; otherwise

b.    … two years from when the tax was paid.

(3)  The three years in (2)(a) extends with a valid tax extension.

Let’s parse this.

(1) Willetts' 2014 tax return was due April 15, 2015.

(2) He had a valid extension until October 15, 2015.

(3) His three-year period for filing a refund claim would run – at a minimum - until April 15, 2018. Since he also had a valid extension, the extension period gets tacked-on. He therefore had until October 15, 2018 to file a refund claim within the three-year lookback period.

You can see where the IRS was coming from. It did not have a tax return in its system until after October 15, 2018.

However, Willetts filed - or at least attempted to file - a return on April 14, 2018. It wasn’t his fault that the IRS held up processing.

The Court made short work of this.

A tax return is deemed filed the day it is received by the IRS, regardless of whether it is accepted, processed, ignored or destroyed by the IRS. The IRS’ own records showed Willetts' return as received on May 2, 2018, well within the period ending October 15, 2018.

The return was filed timely. Willetts was due his refund.

I have a couple of observations:

(1)  I do not understand why the IRS pursued this. The rules here are bright-line. The IRS did not have a chance of winning; in fact, the case strikes me as borderline harassment. 

What concerns me is the mountain of paper returns – especially amended returns – waiting unopened and unprocessed at the IRS as I write this. Are we going to see Willetts-like foot-dragging by the IRS on those returns? Is the IRS going to force me to file with the Tax Court to get my clients their refunds?   

(2)  Let’s play what-if.  

Say that Willetts had filed his return on November 1, 2018, so that all parties would agree that he was outside the three-year lookback period. Once that happened, his refund would be limited to any taxes paid within the previous two years. His 2014 taxes would have been deemed paid on April 15, 2015, meaning that none, zero, zip of his 2014 taxes were paid within two years of November 1, 2018. There would be no refund. This, by the way, is the how-and-why people lose their tax refunds if they do not file their returns within three years.   

Our case this time was Willetts v Commissioner, Tax Court November 22, 2021.

Qualifying For Stock Loss Under Section 1244

 

I am looking at a case having to do with Section 1244 stock.

And I am thinking: it has been a while since I have seen a Section 1244.

Mind you; that is not a bad thing, as Section 1244 requires losses. The most recent corporate exit I have seen was a very sweet rollup of a professional practice for approximately $10 million. No loss = no Section 1244.

Let’s set up the issue.

We are talking about corporations. They can be either C or S corporations, but this is a corporate tax thing. BTW there is a technical issue with Section 1244 and S corporations, but let’s skip it for this discussion.

The corporation has gone out of business.

A corporation has stock. When the corporation goes out of business, that stock is worthless. This means that the shareholder has incurred a loss on that stock. If he/she acquired the stock for $5,000, then there is a loss of $5,000 when the corporation closes.

Next: that loss is – unless something else kicks-in – a capital loss.

Capital losses offset capital gains dollar-for-dollar.

Let’s say taxpayer has no capital gains.

Capital losses are then allowed to offset (up to) $3,000 of other income.

It will take this person a couple of years to use up that $5,000 loss.

Section 1244 is a pressure valve, of sorts, in this situation.

A shareholder can claim up to $50,000 of ordinary loss ($100,000 if married filing joint) upon the sale, liquidation or worthlessness of stock if:

 

(1)  The stock is be either common or preferred, voting or nonvoting, but stock acquired via convertible securities will not qualify;

(2)  The stock was initially issued to an individual or partnership;

(3)  The initial capitalization of the corporation did not exceed $1 million;

(4)  The initial capitalization was done with stock and property (other than stock and securities);

(5)  Only persons acquiring stock directly from the corporation will qualify; and

(6)  For the five tax years preceding the loss, the corporation received more than 50% of its aggregate gross receipts from sources other than interest, dividends, rents, royalties, and the sale or exchange of stocks or securities.

The advantage is that the ordinary loss can offset other income and will probably be used right away, as opposed to that $3,000 year-by-year capital loss thing.

Mind you, there can also be part Section 1244/part capital loss.

Say a married couple lost $130,000 on the bankruptcy of their corporation.

Seems to me you have:

                      Section 1244                     100,000

                      Capital loss                         30,000

Let’s look at the Ushio case.

Mr Ushio acquired the stock of PCHG, a South Carolina corporation, for $50,000.

PCHG intended to was looking to get involved with alternative energy. It made agreements with a Nevada company and other efforts, but nothing ever came of it. PCHG folded in 2012.

Ushio claimed a $50,000 Section 1244 loss.

The IRS denied it.

There were a couple of reasons:

(1)  Mr. Ushio still had to prove that $1 million limit.

 

The issue here was the number at the corporate level: was the corporation initially capitalized (for cash and property other than stock and securities) for $1 million or less? If yes, then all the issued stock qualified. If no, the corporation must identify which shares qualified and which shares did not.

        

It is possible that PCHG was not even close to $1 million in capitalization, in which a copy of its initial tax return might be sufficient. Alternatively, PCHG’s attorney or accountant might/should have records to document this requirement.        

 

(2)  PCHG never had gross receipts.

 

This means that PHGC could not meet the 50% of gross receipts requirement, as it had no gross receipts at all.

 

Note that opening a savings or money market account would not have helped. PCHG might then have had gross receipts, but 100% of its gross receipts would have been interest income – the wrong kind of income.

Mr Ushio did not have a Section 1244 loss, as PCHG did not qualify due to the gross-receipts requirement. You cannot do percentages off a denominator of zero.

My first thought when reviewing the case was the long odds of the IRS even looking at the return, much less disallowing a Section 1244 loss on said return. That is not what happened. The IRS was initially looking at other areas of the Ushio return. In fact, Ushio had not even claimed a capital loss – much less a Section 1244 loss – on the original return. The issue came up during the examination, making it easy for the IRS to say “prove it.”

How would a tax advisor deal with this gross-receipts hurdle in practice?

Well, the initial and planned activity of PCHG failed to produce any revenues. It seems to me that an advisor would look to parachute-in another activity that would produce some – any – revenues, in order to meet the Section 1244 requirement. The tax Code wants to see an operating business, and it uses gross receipts as its screen for operations.

Could the IRS challenge such effort as failing to rise to the level of a trade or business or otherwise lacking economic substance? Well, yes, but consider the alternative: a slam-dunk failure to qualify under Section 1244.

Our case this time was Ushio v Commissioner, TC Summary Opinion 2021-27.

Owning Gold And Silver In Your IRA

 

We have previously talked about buying nontraditional assets in an IRA. We have talked about starting a business with IRA monies (these are the “ROBS”) as well as buying real estate.

Just this week someone reached out to me about buying real estate through their Roth. It would be a vacation home. Mind you, they might never vacation there themselves, but you and I would refer to it generically as a vacation home.

I am not a fan, and I have no hesitation saying so.

Put an asset in an IRA that is susceptible to personal use, and you are courting danger.  Talk to me about a commercial strip mall, and I might be OK with it. Talk to me about a vacation home, and I will (almost) always advise against it. There are a million-and-one alternate investments you can consider. It is not worth it.

I am looking at a case about another category of investments that can go south inside an IRA.

Gold and silver coins and bullion.

Let’s set this up:

(1)  IRAs are not allowed to own collectibles.

(2)  Precious metals are normally considered to be collectibles.

(3)  Therefore we do not expect to see precious metals in an IRA, except that …

(4)  Someone must have had a great lobbyist, as there is an exception for 

a.    Selected coins with a 99.5% fineness level

b.    Selected bullion with a 99.9% fineness level

You may have heard the radio commercials for American Gold Eagle and American Silver Eagle coins as a way “to hedge inflation” within your IRA, for example.

Mind you, I have no problem if you wish to own gold, silver, platinum or palladium. You can even own them in your IRA, but you have to respect the separation of powers that the tax Code expects in an IRA.

(1) The IRA is a trust. When you open an IRA, you are actually creating a self-funded trust. This means that it has a trustee. It will also have a custodian and a beneficiary.

a.    You open an IRA with Fidelity. Fidelity is the trustee.

b.    Someone has to hold the assets, probably stocks and mutual funds. This would be the custodian.

c.    Someone has to prepare the paperwork, including IRS filings such as a Form 5498 for funding the IRA.  This can be either the trustee or custodian. In our example, Fidelity is so huge they are probably both the trustee and custodian, making the two roles seamless and invisible to the average person.

d.    You are the beneficiary.

                                                        i.     Well, until you die. Then someone else is the beneficiary.

There is one more thing the tax Code wants: the beneficiary may not take actual and unfettered possession of IRA assets. More accurately, the beneficiary can take possession, but taking possession has a name: “distribution.” A distribution - barring a Roth or a 60-day rollover – is taxable.

Possession is not an issue for the vast majority of us. If you want your IRA monies, you have to contact Fidelity, Vanguard, T. Rowe Price or whoever. You do not have possession until they distribute the money to you.

How does it work with coins?

Let’s look at the NcNulty case.

Andrew and Donna McNulty decided to establish self-directed IRAs. The IRAs, in turn, created single-member LLC’s. These entities, while existing for legal purposes, were disregarded for tax purposes. The purpose of the LLCs was to buy gold and silver coins.

Over the course of two years, they transferred almost $750 grand to the IRAs.

The IRAs bought coins.

The coins were shipped to the McNulty’s residence.

Where they were stored in a safe.

With other coins not belonging to an IRA.

But do not fear, the IRA coins were marked as belonging to an IRA.

Good grief.

Where was the CPA during this?

Petitioners did not seek or receive advice from the CPA about tax reporting with respect to their self-directed IRAs or the physical possession of AE coins purchased using funds from their IRAs …. Nor did they disclose to their CPA that they had physical possession of the AE coins at their residence."

The Court decided that mailing the coins to their house was tantamount to a distribution. A beneficiary cannot – repeat, cannot – have unfettered access to IRA assets. There was tax. There were penalties. There was interest. It was a worst-case scenario.

Why did the McNulty’s think they could get away with taking physical possession of the coins?

There were a couple of reasons. One was that merely labelling them as IRA assets was sufficient even if the coins were thrown in a safe with other coins and other stuff that did not belong to the IRA.

Let’s admit, that reason is lame.

The second reason is not as lame – at least on its face.

Remember that IRAs are not allowed to own collectibles. The tax Code includes an exception to the definition of collectibles to allow an IRA to own coins and bullion.

There are people out there who took that exception and tried to graft it to the requirement to have independent custody of IRA assets. Their reasoning was:

The same exception to collectibles status applies to custody, meaning that you are permitted to keep coins at your house, maybe next to your sock drawer for safekeeping.

No, you are not. These people are trying to sell you something. They are not your friends. Review this with an experienced tax advisor before you drop three quarters of a million dollars on a pitch.

So, can an IRA own gold?

Of course, but somebody is going to store it for you somewhere. You will not have it in your possession. This means that you will have to pay for its storage, but that is an unavoidable cost if you want to own physical gold in your IRA. Perhaps you can visit one or twice a year and do a Scrooge McDuck in the vault storing the gold. I will leave that to you and your custodian.

Or you could just own a gold or silver ETF and skip physical ownership.

Our case this time was McNulty v Commissioner, 157 TC 10 11.18.21.

Not Filing A Return and Owing Tax

 

The question comes up periodically, even among accountants: 

Is there a penalty for filing a late return if the taxpayer has a refund?

In general, the answer is no. Mind you, this is not an excuse to skip filing. If anything, you have money due to you. Do not file for three years and you are losing that refund.

Let’s switch a variable:

Is there a penalty for filing a late return if the taxpayer owes taxes?

Uhhhh, yes.

As a rule of thumb, assume an automatic 25% penalty, and it can be more.

So what happens if someone cannot file by the extended due date?

I have a one of these clients. I called him recently to send me his 2020 information.

His comment?

         I thought you took care of it.”

Now, I have been at this a long time, but I cannot create someone’s return out of thin air. Contrast that with estimating a selected number or two on a tax return. That happens with some regularity, although - depending on the size and tax sensitivity of the numbers – I might flag the estimates to the IRS’ attention. It depends.

Let look at the Morris case.

James and Lori Morris were business owners in Illinois. In 2013 James expanded the business, creating a new company to house the same. They had a long-standing relationship with their CPA.

The IRS came in and looked at the 2013 return. It appears that there were issues with the start-up and expansion costs of the new business, but the case does not give us much detail on the matter.

The Morris’ held up filing a return for 2014. They also held up filing 2015 and 2016, supposedly from concern of repeating the issue the IRS was addressing on the 2013 return.

Seems heavy-handed to me.

Well, as long as they were fully paid-in:

They did not make any estimated tax payments during the year at issue and did not have tax withheld from their paychecks during 2015. Petitioner-husband had a minimal amount of tax withheld from his wages during 2016. Petitioner-wife had withholding credits of $10 and $11 during 2015 and 2016, respectively.”

Got it: next to nothing paid-in.

Maybe the businesses were losing money:

For 2015 and 2016 petitioners, respectively, had ordinary income from their S corporations of over $2.2 million and $3 million.”

What was going on here? I am seeing income over $5 million for two years with little more than $21 of tax paid-in.

The Morris’ argued that their long-standing CPA advised that filing a return while an audit for earlier years was happening could subject them to perjury charges.

COMMENT: Huh? There are areas all over the Code where a taxpayer and the IRS might disagree. If it comes to pass, one appeals within the IRS or files with a court. The system does not lock-down because the IRS disagrees with you.

Frankly, I am curious what was on that return that the issue of “perjury” even saw the light of day.

Oh, well. Let’s have the CPA testify. Hopefully the Morris’ will have reasonable cause for penalty abatement because of their reliance on a tax professional.

Mr Knobloch (that is, the CPA) did not testify at trial, and there is no evidence in the record except for petitioner-husband’s testimony of Mr. Knobloch’s alleged advice.”

The Court was not believing this for a moment. 

We need not accept a taxpayer’s testimony that is self-serving and uncorroborated by other evidence, and we do not do so here.”

I find myself wondering why the CPA did not testify, although I have suspicions.

I also do not understand why – even if there were substantive issues of tax law – the Morris’ did not pay-in more for 2015 and 2016.  Did they think they had losses? OK, they would be out the money for a time but they would get it back as a refund when they file the returns.

They instead racked-up big penalties.

Our case this time was Morris v Commissioner, T.C. Memo 2021-120.

Income, Clearly Realized

 

What is income?

Believe it or not, there is a line of cases over decades developing the tax concept of income.

Some instances are clear-cut: if you receive wages or salary, for example, then you have income.

Some instances may not be so clear-cut.

For example, let’s say that you receive a stock dividend. The company has a good year, and you receive – as an example – 1 additional share for every 5 shares you own.  

Do you have income?

Let’s talk this out. Let’s say that the company is worth $25 million before the stock dividend and has 1 million shares outstanding. After the stock dividend it will have 1.2 million shares outstanding. What are those extra 200,000 shares worth?

This is an actual case – Eisner v Macomber - that the Supreme Court decided in 1920. Congress had changed the tax law to tax this stock dividend, and someone (Myrtle Macomber) brought suit arguing that the law was unconstitutional.

Her argument:

·      The company was worth $25 million before the dividend

·      The company was worth $25 million after the dividend

·      She may have more shares, but her shares represent the same proportional ownership of the company.

·      She did not have any more money than she had before.

She had a point.

The Bureau of Internal Revenue (that is, the IRS) came at it from a different angle:

There was income – the income generated by the company.  The company was “distributing” said income by means of a stock dividend.

The Court reasoned that one could have income from labor or from capital. The first did not apply, and it could find nothing to support the second had happened to Mrs Macomber.

The Court decided that she did not have income.

Let’s continue.

The Glenshaw Glass Company sued the Hartford-Empire Company for damages stemming from fraud and for treble damages for business injury.

The two companies settled, and Hartford was paid approximately $325 thousand in punitive damages.

Glenshaw had no intention of paying tax on that $325 grand. That money was not paid because of labor or because of capital. It was paid because of injury to its business - returning Glenshaw to where it should have been if not for the tortious behavior.

Not labor, not capital. Glenshaw was draped all over that earlier Eisner v Macomber decision.

But the IRS had a point – in fact, 325 thousand points.

Here is the Court:

Here we have instances of undeniable accessions to wealth, clearly realized, and over which taxpayers have complete dominion. The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income.”

The Court levered away from its earlier labor/capital impasse and clarified income to be:

·      An increase in wealth

·      Clearly realized, and

·      Over which one has (temporary or permanent) discretion or control

In time Glenshaw has come to mean that everything is taxable unless Congress says that it is not taxable. While not mathematically precise, it is precise enough for day-to-day use.

I have a question, though.

At a conceptual level, what are the limits on the “clearly realized” requirement?

I get it when someone receive a paycheck.

I also get it when someone sells a mutual fund.

But what if your IRA has gone up in value, but you haven’t taken a distribution?

Or the house in which you raised your family has appreciated in value?

Do you have an increase in wealth?

Do you have discretion or control over said increase in wealth?

Do you have “income” that Congress can tax under Glenshaw?

A Winter Barge and Depreciation

 

The question comes up with some frequency: when is an asset placed-in-service for tax purposes?

Generally one is talking about depreciation. Buy an expensive asset near the end of the year, allow for delivery (and perhaps installation) time and one becomes quite interested with the metaphysics of depreciation.

Let me give you a couple of situations:

·      You finish constructing an office building near the end of the year. It is ready-to-go, but your first tenant doesn’t move in until early the following year. When do you start depreciation?

·      You are a pilot and buy a plane through your business. It is delivered in the last few days of December. There is no business travel (as it is near year-end and between holidays), but you take the plane up for its shakedown flight. When do you start depreciation?

The numbers can become impressive when you consider that we presently have 100% bonus depreciation, meaning that a qualifying asset’s cost can be depreciated/deducted in full when it is placed in service.

And what do you do in COVID 2020/2021, if you buy an asset but government orders and mandates restrict or close the business?

There is a classic tax case that goes back to the 1960s. It distinguished between an asset being ready and available for use and actually being placed into use. Why the nitpicking? Because life happens. In general, a place-in-service date occurs when the asset is ready and available for use.  

Well, that rule-of-thumb would help with COVID 2020/2021 issues.

On to our case.

A company in New York bought a barge from a builder in Louisiana.

The barge made it to Rome, New York.

It was outfitted and ready to go by the end of 1957.

Winter came. The canal froze. The barge was stuck in a frozen New York canal until spring of 1958.

When was the barge placed-in-service?

You know the IRS was on the side of 1958. They had persuasive arguments in their favor, and that – plus the sheer cost of a barge – meant the matter was going to be litigated.

Here is the Court:

… the barge was ready for charter or for use in the taxpayer’s own distribution business by December 1, 1957, but could not be used until May, 1958, because it was frozen into the water of an upstate canal. This was certainly not a condition which the taxpayer desired to bring about.”

And here is the staying power of the case:

… depreciation may be taken when depreciable property is available for use ‘should the occasion arise,’ even if the property is not in fact in use.”

Common tax issue + dramatic facts = memorable tax law.

Our case this time was Sears Oil Co., Inc v Commissioner, 359 F.2^nd 191 (2d Cir 1966).

Happy Halloween

 

ProShares Bitcoin ETF and Futures Taxation

 

This week something happened that made me think of a friend who passed away last year.

I remember him laboring me on the benefits of CBD oil and the need to invest in Bitcoin.

When he and I last left it (before COVID last year), Bitcoin was around $10 grand. It is over $60 grand presently.

Missed the boat and the harbor on that one.

This past week ProShares came out with a Bitcoin ETF (BITO). I read that it tripped the billion-dollar mark after two or three days of trading.

With that level of market acceptance, I suspect we will see a number of these in the near future.

This ETF does not hold Bitcoin itself (whatever that means). It instead will hold futures in Bitcoin.

Let’s talk about the taxation of futures.

First, what are futures and what purpose do they serve?

Let’s say that you are The Hershey Company and you want to lock-in prices for next year’s cacao and sugar. These commodities are a significant part of your costs of production, and you want to have some control over the price you will pay. You are a buyer of futures commodity contracts – in cacao and sugar – locking in volume, price and date of delivery.

Whereas you do not own the cacao and sugar yet, if their price goes up, you would have made a profit on the contract. The reverse is true, of course, if the price goes down. Granted, the price swing on the futures contract will likely be different than the swing in spot price for the commodity, as there is the element of time in the contract.  

That said, there is always someone looking to make a profit. Problem: if commodity traders had to actually receive or deliver the commodity, few people would do it. Solution: separate the contract from actual product delivery.  The contract can then be bought and sold until the delivery date; the buyers and sellers just settle-up any price swings between them upon sale.

It would be also nice to have a market that coordinates these trades. There are several, including the Chicago Mercantile Exchange. The Exchange allows the contracts to be standardized, which in turn allows traders to buy and sell them without any intent to ever receive or deliver the underlying commodity.

The ETF we are discussing (BITO) will not own any Bitcoin itself. It will instead buy and sell futures contracts in Bitcoin.

Bitcoin futures are considered “Section 1256 contracts” in tax law.

Section 1256 brings its own idiosyncrasies:

* There is a mark-to-market rule.

The term “mark” to an accountant means that something is reset to its market price. In the context of BITO, it means that – if you own it at year-end – it will be considered to have been sold. Mind you, it was not actually sold, but there will be a “let’s pretend” calculation of gain or loss as if it had been sold. Why would you care? You would care if the price went up and you had a taxable gain. You will soon be writing a very real check to the IRS for that “let’s pretend” mark.

* The 60/40 rule

This rule is nonintuitive. Whether you have capital gains or losses, those gains and losses are deemed to 60% long-term and 40% short term. The tax Code (with exceptions we will ignore for this discussion) does not care how long you actually owned the contracts. Whether one day or two years, the gain or loss will be deemed 60/40.

Mind you, this is not necessarily a bad result as long-term capital gains have favorable tax rates.

* Special carryback rule

If you have an overall Section 1256 loss for the year, you can carryback that loss to the preceding three years. There is a restriction, though: the carryback can only offset Section 1256 gains in those prior years.

This is a narrow rule, by the way. I do not remember ever seeing this carryback, and I have been in tax practice for over 35 years.

I do not know but I anticipate that BITO will be sending out Schedules K-1 rather than 1099s to its investors, as these ETFs tend to be structured as limited partnerships. That does not overly concern me, but some accountants are wary as the K-1s can be trickier to handle and sometimes present undesired state tax considerations.

Similar to my response to Bitcoin investing in early 2020, I will likely pass on this opportunity. There are unusual considerations in futures trading – google “contango” and “backwardation” for example – that you may want to look into when considering the investment.

Owing Partnership Tax As A Partner

 

We have wrapped-up (almost) another filing season here at Galactic Command. I include “almost” as we have nonprofit 990s due next month, but for the most part the heavy lifting is done.

Tax seasons 2020 and 2021 have been a real peach.

I am looking at a tax case that mirrors a conversation I was having with one of our CPAs two or three days ago. He was preparing a return for someone with significant partnership investments. The two I looked at are commonly described as “trader” partnerships.

The tax reporting for trader partnerships can be confusing, especially for younger practitioners. A normal investment partnership buys and sells stocks and securities, collects interest and dividends and has capital gains or losses along the way. The tax reporting shows interest and dividends and capital gains and losses – in short, it makes sense.

The trader partnership adds one more thing: it actively buys and sells stocks and securities as a business activity, so to speak. Think of it as a day trader as opposed to a long-term investor. The tax issue is that one has interest, dividends and capital gains and losses from the trader side as well as the nontrader side. The trader partnership separates the two, with the result that trading dividends (as an example) might be reported somewhere different on the Schedule K-1 from nontrading dividends. If you don’t know the theory, it doesn’t make sense.

The two partnerships pumped out meaningful taxable income.

What they did not do was pump out equivalent cash distributions. In fact, I would say that the partnerships distributed approximately enough cash to pay the taxes thereon, assuming that the partner was near the highest tax bracket.

The client had issues with the draft tax return.

Why?

There was no way he could have that much income as he did not receive that much cash.

And therein is a lesson in partnership taxation.

Let’s take a look at the Dodd case.

Dodd was the office manager at a D.C. law firm. The firm specialized in real estate and construction law.

She in turn became a 33.5% member in a partnership (Cadillac) transacting in – wait on it – the purchase, leasing and sale of real property. The other 66.5% partner was an attorney-partner in the law firm.

Routine so far.

Cadillac did well in 2013. Her share of gains from property sales was over a $1 million. Her cash distributions were approximately $200 grand.

Got it: 20 cents on the dollar.

When she prepared her individual return, she included that $1 million-plus gain as well as partnership losses. She owed around $170 grand with the return.

She did not send a check for the amount due.

The case has been bogged-down in tax procedure for several years. The IRS wanted its tax, and Dodd in turn requested Collections (CDP) hearings. We have had three rounds of back-and-forth, with the result that we are still talking about the case in 2021.

Her argument?

Simple. She had never received the $1 million. The money instead went to the bank to pay down a line of credit.

This is going to turn out badly for Dodd.

At 30 thousand feet, partnership taxation is relatively intuitive. A partnership does not pay taxes itself. Rather it files a tax return, and the partners in the partnership are allocated their share of the income and are themselves responsible for paying taxes on that share.

The complexity in partnership taxation comes primarily from how one allocates the income, as tax attorneys and CPAs have had decades to bend the rules.

Notice that I did not say anything about cash distributions.

Mind you, it is bad business to pump-out taxable income without distributing cash to cover the tax, but it is unlikely that a partnership will distribute cash exactly equal to its income. Why? Here are a couple of reasons that come immediately to mind:

·      Depreciation

The partnership buys something and depreciates it. It is likely that the depreciation (which follows tax rules) will not equal the cash payments for whatever was bought.

·      Debt

Any cash used to repay the bank is cash not available to distribute to the partners.

There is, by the way, a technique to discourage creditors of a partner from taking a partner’s partnership interest. Why would a creditor do this? To get to those distributions, of course.

There is a legal issue here, however. Let’s say that you, me and Lucy decided to form a partnership. Lucy has financial difficulties, and one of her creditors takes over her partnership interest. You and I did not form a partnership with Lucy’s creditor; we formed a partnership with Lucy. That creditor cannot just come in and force you and me to be partners with him/her. The best the creditor can do is get a “charging order,” which means the creditor receives only the right to Lucy’s distributions. The creditor cannot otherwise vote, demand the sale of assets or force the termination of the partnership.

What do you and I do in response to the new guy?

The creditor will have to report Lucy’s share of the partnership income, of course.

We in turn make no distributions to Lucy - or to the new guy. The partnership distributes to you and me, but that creditor is on his/her own. Sorry. Not. Go away.

As you can guess, creditors are not big fans of going after debtor partnership interests.

Back to Dodd.

What did the Court say?

No matter the reason for nondistribution, each partner must pay taxes on his distributive share.”

To restate:

Each partner is taxed on the its distributive share of partnership income without regard to whether the income is actually distributed.”

Dodd had no hope with this argument.

Maybe she would have better luck with her Collections appeal, but that is not the topic of our discussion this time.

We have been discussing Dodd v Commissioner, T.C. Memo 2021-118.

Uber Driver Failed To Report Income

I am reading a case concerning an Uber driver who ran afoul of Form 1099 requirements.

The amounts at issue were impressive.

           Tax                          $193,784

           Penalties                  $ 85,354

Robert Nurumbi drove for Uber in 2015. He ran the business through a single-member LLC and used two bank accounts. Business was doing well. He bought multiple cars which he rented out to family and friends who drove for Uber through him. The twist to the tale is that all Uber payments were paid to the LLC’s bank account - meaning Nurumbi’s bank account, as he was the LLC - and he in turn would pay his family and friends.

Sounds like he established a small business, with employees and all.

Except that he treated his drivers as independent contractors, not employees. I get it: Uber is gig economy.

Every week Uber would pay Nurumbi. He would transfer the family-and-friends portion to a second bank account. He would sometimes pay them by electronic transfer; at other times he paid in cash. He did not keep documentation on these payments, and he further muddied the waters by also paying nondriver expenses from the second bank account.

He filed his 2015 personal tax return showing wages of approximately $19 grand.

Uber meanwhile issued him two 1099s totaling approximately $543 thousand.

The IRS saw a case of unreported income.

It is not clear to me how Nurumbi prepared his tax return, as a self-employed does not receive a W-2 from himself. He should have filed a Schedule C with his return, as Schedule C reports self-employed business activity. I would have expected his C to report gross receipts of approximately $543 grand, with a bunch of expenses reducing the net to approximately $19 thousand. The IRS would have matched Uber’s 1099 to the gross receipts on the Schedule C and spared us the drama.

However, Nurumbi did not prepare his taxes this way.

Dumb, I am thinking, but not necessarily fatal. Nurumbi would submit a Schedule C (or a facsimile thereof) and argue his point.

But the damage had been done. Nurumbi had spotted the IRS gross income of $543 grand. He next had to show expenses bringing his net income down to $19 thousand. This gave the IRS the chance to say: prove it.

Which is why we keep records: invoices, bank statements, cancelled checks, QuickBooks files and so forth.  

Nurumbi had a problem. He kept next to no records. He had not issued 1099s. His records in many cases were inadequate to even calculate a 1099.

Nurumbi played a wild card.

There is a court-created exception to the customary documentation requirements. It is called the Cohan rule, and it refers to the person and case that prompted the exception decades ago. The rule has two key requirements:

(1)  One must prove that the expenditure occurred, and

(2)  One must prove that the expenditure relates to and was incurred in one’s trade or business.

Even then, the exception will probably not yield the same result as keeping records. The Court may spot you something, but that something is likely to be much less than what you actually incurred.

Nurumbi’s records were so feckless that it would have been unsurprising if the Court allowed nothing.

Except …

Remember that he sometimes paid his drivers electronically from the second bank account.

The Court spotted him a deduction of approximately $157 grand for those payments.

What about the cash payments to his drivers?

No dice.

Let’s summarize the damage.

The IRS increased his 2015 income from $18 to $543 thousand.

The Court allowed a deduction of approximately $157 thousand.

There was another significant deduction that we did not discuss: the fee paid to Uber itself. That was approximately $163 thousand.

That still leaves a bump to income of almost $205 grand.

I believe that Nurumbi paid the money to his family and friends.

But there was no tax deduction.

To be fair, he is the one who decided to keep the payments under-the-table. While not stated, I suspect this … flexibility … was a key factor in the Court’s decision.

Our case this time was Nurumbi v Commissioner, TC Memo 2021-79.