How To Lose A Tax Deduction For Wages Paid

This weeks’ tax puzzler involves a mom and her kids.

We again are talking about attorneys. Both mom and dad are attorneys, and mom is self-employed.

Sometimes she brought her children to the office, where they helped her with the following:

·        answering the telephone

·        mail

·        greeting clients

·        photocopying

·        shredding unneeded documents

·        moving files

Mom believed that having her children work would help them understand the value of money and lay the foundations for a lifelong work ethic.

She had three kids, and for 2006, 2007 and 2008 she deducted wages of $5,500, $10,953 and $12,273, respectively.

There are tax advantages to hiring a minor child. For example, if the child is age 17 or younger, there are no social security (that is, FICA) taxes. In addition, there is no federal unemployment tax for a child under age 21, but that savings pales in comparison to the FICA savings.

Then you have other options, such as having the child fund an IRA. All IRAs require income subject to social security tax. It doesn’t matter if one is an employee (FICA tax) or is self-employed (self-employment taxes), but social security is the price of admission.

Her children were all under the age of ten. Can you imagine what those IRAs would be worth 50 years from now?

The IRS disagreed with her deducting payroll, and they wound up in Tax Court.

Your puzzler question is: why?

(1) You: The Court did not believe that the kids really did anything. Maybe she was just trying to deduct their allowances.

Me: The tax law becomes skeptical when related parties are involved, and you cannot get much more related than a mother and her children.  It was heightened in this case as the children were so young. For the most part, though, the Court believed her when she described what the children did.

(2) You: Mom used the money she “paid” the kids for their support – like paying their school tuition, for example.

Me: The tax law disallows a deduction if the money is disguised support, which tax law expects to be provided a dependent child. In this case, the Court saw the children buying books, games and normal kid items; some money also went to Section 529 plans. The Court did not believe that mom was trying to deduct support expenses.

(3) You: She could not provide paperwork to back-up her deductions. What if she paid the kids in cash, for example?

Me: Good job. One reads that the Court wanted to believe her, but she presented no records. She did not provide bank statements showing the kids depositing their paychecks, presumably because the children did not have bank accounts.

She did not provide copies of the Section 529 plans. That was so easy to do that I found the failure odd.

At least she could show the Court a Form W-2.

Mom had not even issued W-2s.

The Court was exasperated.

It allowed her a deduction of $250 per child, as it believed that the kids worked. It could not do more in the absence of any documentation.

And there is the answer to the puzzler.

Too often it is not mind-numbing tax details that trip-up a taxpayer. Sometimes there is just a lapse of common sense.

Like issuing a W-2 if you want the IRS to believe you paid wages to somebody.

 

Do You Have to Disclose That?

I was recently talking with another CPA. He had an issue with an estate income tax return, and he was wondering if a certain deduction was a dead loser. I looked into the issue as much as I could (that busy season thing), and it was not clear to me that the deduction was a loser, much less a dead loser.

He then asked: does he need to disclose if he takes the deduction?

Let’s take a small look into professional tax practice.

There are many areas and times when a tax advisor is not dealing with clear-cut tax law.

Depending upon the particular issue, I as a practitioner have varying levels of responsibility. For some I can take a position if I have a one-in-five (approximately) chance of winning an IRS challenge; for others it is closer to one-in-three.

There are also issues where one has to disclose to the IRS that one took a given position on a return. The concept of one-in-whatever doesn’t apply to these issues. It doesn’t have to be nefarious, however. It may just be a badly drafted Regulation and a taxpayer with enough dollars on the line.

Then there are “those” transactions.

They used to be called tax shelters, but the new term for them is “listed transactions.” There is even a subset of listed transactions that the IRS frowns upon, but not as frowny as listed transactions. Those are called “reportable transactions.”

This is an area of practice that I try to stay away from. I am willing to play aggressive ball, but the game stays within the chalk lines. Making tax law is for the big players – think Apple’s tax department – not for a small CPA firm in Cincinnati.

Staying up on this area is difficult, too. The IRS periodically revises a list of transactions that it is scrutinizing. The IRS then updates its website, and I – as a practitioner – am expected to repeatedly visit said website patiently awaiting said update. Fail to do so and the IRS automatically shifts blame to the practitioner.

No thanks.

I am looking at a case involving a guy who sells onions. His company is an S corporation, which means that he puts the business numbers on his personal return and pays tax on the conglomeration.

His name is Vee.

He got himself into a certain type of employee benefit plan.

A benefit plan provides benefits other than retirement. It could be health, for example, or disability or severance. The tax Code allows a business to prefund (and deduct) these benefits, as long as it follows certain rules. A general concept underlying the rules is risk-taking and cost-sharing – that is, there should be a feel of insurance to the thing.

This is relatively easy to do when you are Toyota or General Mills. Being large certainly makes it easier to work with the law of large numbers.

The rules however are problematic as the business gets smaller. Congress realized this and passed Code Section 419A(f)(6), allowing small employers to join with other small employers – in a minimum group of ten – and obtain tax advantages  otherwise limited to the bigger players.

Then came the promoters peddling these smaller plans. You could offer death and disability benefits to your employees, for example, and shift the risk to an insurance company. A reasonable employer would question the use of life insurance. If the employer needed money to pay benefits, wouldn’t a mutual fund make more sense than an illiquid life insurance policy? Ah, but the life insurance policy allows for inside buildup. You could overfund the policy and have all kinds of cash value. You would just borrow from the cash value – a nontaxable transaction, by the way – to pay the benefits. Isn’t that more efficient than a messy portfolio?

Then there were the games the promoters played to diminish the risk of joining a group with nine others.

Vee got himself into one of these plans.

He funded the thing with life insurance. He later cancelled the plan, keeping the life insurance policy for himself.

The twist on his plan was the use of experience-rated life insurance.

Experience-rated does not pay well with the idea of cost-and-risk sharing. If I am experience rated, then my insurance cost is based on my experience. My insurance company does not look at you or any of the other eight employers in our group. I am not feeling the insurance on this one.

Some of these plans were outrageous. The employer would keep the plan going for a few years, overpay for the insurance, then shut down the plan and pay “value” for the underlying insurance policy. The insurance company would keep the “value” artificially low, so it did not cost the employer much to buy the policy on the way out. Then a year or two later, the cash value would multiply ten, twenty, fifty, who-knows-how-many-fold. This technique was called “springing,” and it was like finding the proverbial pot of gold.

The IRS had previously said that plans similar to Vee’s were listed transactions.

This meant that Vee had to disclose his plan on his tax return.

He did not.

That is an automatic $10,000 penalty. No excuses.

He did it four times, so he was in for $40,000.

He went to Court. His argument was simple: the IRS had not said that his specific plan was one of those abusive plans. The IRS had said “plans similar to,” but what do those words really mean? Do you know what you have forgotten? What is the point of a spice rack? Does anybody really know what time it is?

Yea, the Court felt the same way. The plan was “similar to.” They were having none of it.

He owed $40,000.

He should have disclosed.

Even better, he should have left the whole thing alone.

Taxation of Disability Insurance

I was recently reviewing an individual tax return. There was something on there that distresses me.

This client walked into a tax trap, and that trap has gone off.  Unfortunately, there is nothing that can be done.

Let’s talk about disability insurance.

This client is a personal friend. You and I would agree that he is a high-incomer. He works for a large employer on the Kentucky side. One of the advantages of a large employer is the benefits. One of the benefits his provides is employer-funded long-term disability insurance.

He got hurt and hurt badly. He is now collecting on the disability insurance, and probably will be for a long time.  

Did you know that disability insurance can be taxable?

How?

There is extensive tax law on the taxation of disability insurance, and there are different answers depending upon who is paying the premiums and whether it is a group or individual policy. There is an overarching theme, though:

Disability benefits are taxable to the extent that the premiums were not included in income.

His long-term insurance was 100% employer-paid and 100% excluded from W-2 income. While this was beneficial to him then, it is the worst-case scenario now.

Long-term policies can be expensive. Take someone who is pushing the top tax brackets, and a recommendation to pay tax can mean thousands of extra dollars. Combine that with an all-too-human “it cannot happen to me” response, and it is easy to understand the reluctance.

And that is assuming the tax advisor is even aware of what is happening. Employer-provided disability insurance would not necessarily appear on any documents one would be reviewing. There are good odds that you and your tax advisor will be learning about your disability insurance together.

And so he has to pay tax on disability at the same time that his earning power is reduced.

Is there a compromise?

I think so, but – again – it has to be done upfront. I have no problem with short-term disability being taxable, whether because the premiums are employer-paid or because you run the premiums through your cafeteria plan. This is the insurance you buy from Aflac, for example, and it pays you for six months or a year if you get hit by the proverbial bus. Yes, it would stink to have to pay taxes, but it would only be for a short period of time. The expectation of this insurance is that you will heal and get back to work.

But long-term disability is different enough to warrant a different answer. You almost surely want to make sure this is paid with after-tax monies. If you are unfortunate enough to collect on this type of insurance, you do not need to compound the misfortune by having taxes as part of your household budget.

Vacation Or Business Deduction?

Let’s say that we work together. I cannot attend an appointment with a new client first thing in the morning. You volunteer to cover for me.

By the way, welcome to tax practice. Believe me, it is not the glitz and glamour that Hollywood makes it out to be. I know: hard to believe.

You meet the Fishers. They are both attorneys, he as partner in a firm and she as a sole practitioner. They have three children, all under the age of 10. She takes her kids to work periodically for the customary reason: the cost of day care and family members unable to care for the kids at the time.

She had an opportunity to represent a client in the Czech Republic for a few weeks, and she took it. It turned out however that he was unable to watch the kids. Seeing herself in a jam, she took the kids with her but came up with a novel twist:

She would write a travel book about the Czech Republic. It would be written to and for kids and would lessen their tedium while travelling.

She had no previous writing experience, so this was new territory. It occurred to her that other parents might be interested in such books – and this could be a business opportunity for a sharp and motivated person.

She has kept this up now for three years. She has now taken the kids to Disney World as well as to several cities in Europe.

You talk to her about the IRS and its “hobby loss” rules. She is an attorney, not a writer; there is a gigantic personal enjoyment factor present, ….

She cuts you off. Remember: she is an attorney. She has read up on this area of tax law, and she thinks she meets the requirements. For example,

·        She consulted with one of her clients, a published author, who gave her advice on both writing and publishing.

·        That person introduced her to a book distributor, who suggested she hire a graphic designer. She did so.

·        She also consulted with a friend who works at HarperCollins; the friend recommended she hire an agent. She has not done that yet.

·        She completed four prototype books, but has not submitted them for publication. She has instead self-published. Sales however have been minimal.

The Fishers need to file returns for the last three years. Her combined loss from the book-writing activity is approximately $75,000.

They ask whether you can prepare their returns and claim the book-writing loss.

What do you say?

The big issue is whether the activity rises to the level of a tax deduction. You remember some of the factors that the IRS uses to identify a hobby:

·        Not run in a business-like fashion

·        Failure to consult experts

·        Failure to revise business plans when losses pile up

·        Profits dwarfed by the losses

But Ms. Fisher has been meeting people. She has made contacts at a publishing house. She has written prototypes. She has self-published. She seems to be getting some things right.

You don’t see a clear-cut answer. Two people can reasonably disagree. The problem of course is that the IRS has a bit more horsepower than the average person you might disagree with.

You wobble. You tell them that you want to review the literature in this area, as the issue is walking the grey lands. You will call them tomorrow.

We have a chance to talk about the meeting.

I see two things immediately:

(1)   Can we prepare and sign the return under professional standards?

(2)   If so, there is still a significant chance that they would lose the deduction on audit.

Professional standards allow a tax practitioner some leeway when confronted with certain issues. This is fortunate, or professional practice would likely grind to a near halt.  The bar can be higher or lower depending upon the particular issue under discussion. Take a “listed transaction,” for example, and the bar is pretty high. Listed transaction is jargon for tax shelter, and we are nowhere near that with the Fishers. Our bar is much lower.

However, I would say our best chance with the IRS is 50:50, and likely less than that.  We would discuss this with the client and allow them to decide. It is their return, after all. Maybe they will get another accountant’s opinion. Maybe I am wrong.

This is a real case, by the way.

The Fishers are from New York and took this issue to Tax Court.

They lost.

The Court decided that her activity was not so much a business as her investigating going into business. The Court pointed out a few things: she had not hired an agent, had not finalized a book, and had not submitted a proposal to a publishing house. Since business activity had not started, it did not have to consider whether the activity was a hobby.

No business activity = no business deduction.

What do I think?

The Court saw too much personal and not enough business. I suppose that had she been making money the Court may have relented. She had to clear the hurdle of deducting what many people would see as vacations, and that required some serious weight on the other end of the see-saw to sway the Court.