Stop Shoveling, Mr. Edwards

I am looking at a case where the IRS assessed over $1 million in tax and over $790,000 in penalties against a taxpayer.

Apparently this amount was too low, so the IRS added another $202,000 in tax and $152,000 in penalties.

Good grief. Just because you have a shovel doesn’t mean you should keep digging.

If you wondered how $202,000 in tax triggers $152,000 in penalties, it is because the IRS asserted fraud. The fraud penalty is 75%.

This immediately removes this taxpayer (?) from my range of practice. It is one thing to take an aggressive tax position. It is quite another to cross the street, jump the fence and walk into marching-band halftime fraud show.

Fraud requires the IRS to show intent by the taxpayer. This is a difficult standard and made more so by a tax Code that can be heatedly argued by opposing parties.

That said, I was speaking with another CPA this week representing a business tax audit which has stretched over several years. We have bounced ideas on this audit before, and he was telling me that the IRS intends to assert fraud penalties. That surprised me a bit, as there was (to the extent of my knowledge) no indication that revenues were underreported. Deductions, however, were a different story. This was one of those clients that deducted everything in sight – whether or not it was his and twice if you weren’t keeping count. Bam!! Fraud penalty.

And I tell you what I told my friend: I do not believe the penalty will stick if his client pursues the matter. Mind you, the case may have to go to Court, as there is a price to pay for being reckless. His client may not pay the fraud penalty, but the client will pay a tax professional.

Back to our tax case: Edwards.

This case has been in the system for a long time, as the IRS is assessing the 2000 tax year.

Edwards owned a corporation (Magna Corp) in North Carolina. Magna was involved with health insurance and workers’ compensation.  It received commissions from selling insurance, including:

                Sunshine Co                                     $128,239

                Fidelity Group                                   $276,528

Sunshine Co made the checks payable to Edwards individually. This happens, and generally the business owner endorses the check over and deposits it in the business account. That did not happen here.

Fidelity made its checks payable to Capital Marketing, a company owned by a Magna employee.

COMMENT: OK, that is odd. It goes without saying that the money did not make it back to Magna via normal channels.

There must be more to the story, as Capital Marketing also sent over $1.1 million to a Bear Stearns brokerage account owned by Edwards. The account was not in his name, though. It was in the name of “Carolina Green.” 

COMMENT: Folks, here is a tip from a 30-year tax CPA. You probably want to hold up going all Shakespeare-like naming personal bank and brokerage accounts.  Couple that with opaque, almost untraceable and frequent cash transfers and you are likely to have a revenue agent parked in your life for a while.

Edwards was also building a house, and Capital Marketing transferred over $1.4 million to his builder.

                COMMENT:  Enter opaque and untraceable.

Edwards and his wife filed their 2000 tax return and reported a little over $36,000 in income.

Edwards was indicted for mail fraud, wire fraud, money laundering and a rash of other things. He entered a voluntary guilty plea to many of the charges. The IRS held up until the criminal trial was done. That is the reason that we are reading about a 2000 tax case in 2016.

It has to be an upstream row to defend yourself in Tax Court when you have already been criminally convicted. Suffice to say, it did not go well for Edwards.

He could have tried a little harder not to insult the Court’s intelligence, however. He argued, for example, that the $1.4 million that went to the builder was actually a loan to him.

Sure.

Banks make $1.4 million loans to people making $36,000 all the time.

Paying Tax Twice On The Same Income

Let me set up a scenario for you, and you tell me whether you spot the tax issue.

There is a fellow who is involved with health delivery services. He is paid by an insurance company, and he in turn pays out claims against that reimbursement. Whatever is left over is his profit.

In the first year, he received reimbursements from Cigna. There were issues, and in a second year he had to repay those monies. There was of course litigation. It turned out he was right, and Cigna – in yet a third year – paid him approximately $258,000.

Is the $258,000 taxable to him?

There is a doctrine in the tax Code that every tax year stands on its own. One has to resolve all the numbers that go into income for that year, even if some debate about an "exact" number exists. More commonly this is an issue for an accrual-basis taxpayer, meaning that one pays tax on amounts receivable even before receiving cash. Fortunately one is also able to deduct amounts payable (with exceptions) before writing the check. This is generally accepted accounting and is the way that almost all larger businesses report their income.

There is an alternative way. One can report income when cash is received and deduct expenses when bills are paid. This is the cash basis of accounting, and it too is generally accepted accounting.

For the most part, cash basis is the domain of smaller businesses. Depending upon the type of business, however, it may not matter if one is large or small. For example, an inventory-intensive business is required to use accrual accounting.

Our taxpayer is Udeobong, and he uses the cash basis of accounting.

When Cigna paid him the first time, he would have reported income in year one - the year he received the check.

When he repaid Cigna in year two, he had two options:

(1) He could deduct the payment in that second year, as he was repaying amounts previously taxed to him; or

(2) He could file his taxes for the second year using Section 1341, known in tax-speak as the “claim of right.”

The Code recognizes that just deducting the repayment in a second year could be unfair.  Let me give you an example. Let’s say that you received a very large bonus in 2014, large enough for you to retire. You invest the money and live comfortably, but 2014 was your bellwether year and is never to be repeated. Something happens – say that there is clawback - and you have to return some of the bonus in 2016. Sure, you could deduct the repayment, but that repayment could overwhelm your income in 2016. It is possible that you would lose any tax advantage once your income goes negative. If one looks at the two years together (2014 and 2016), you would have paid tax on income you did not get to keep.

That is where Section 1341 comes in. The Code allows you to do a special calculation:

·        You start off with the tax you actually paid in 2014

·        You then do a pro forma calculation, subtracting the repaid amount from your income in 2014. This gives you a revised tax amount.

·        You subtract the revised tax amount from the actual tax you paid in 2014.

·        The IRS allows you to claim that difference as tax paid in 2016.

The Code is trying to be fair, and for the most part it works.

There is one more piece you need to know. Udeobong did not either deduct the repayment or use the claim-of-right in year two. He did ... nothing.

Is the $258,000 in year three taxable to him?

Unfortunately, it is.

But why?

Because the Code gives him two options: deduct the payment in year two or use the claim of right alternative.

COMMENT: You may be wondering if he could amend his year-one return. This is the technical problem with every tax year standing on its own. Unless there were exceptional circumstances, the Code takes the position   that he received and had control over the income in year one, even if something occurs later requiring him to repay some or all of that income. Since he had control in year one, he had income in year one. Should he repay in a later year, then the repayment is reported in the later year.

The Code does not give him a third option of excluding the $258,000 in year three.

So he has to pay tax again.

It is a harsh result. One can understand the reasoning without the conclusion feeling fair or just ... or right.  I am also frustrated with Udeobong. There is no mention that he used a tax advisor. He had no idea of what he walked into.

He tried to save professional fees, perhaps because he saw his tax return as a simple matter of cash in and cash out. I understand, and I do not – in general – disagree. Still, one has to be cognizant when something unusual happens, like swapping real estate, exercising stock options or repaying Cigna a lot of money. The combination of "unusual" and "a lot" probably means it is a good time to see a tax expert.  

Pouring Concrete In Phoenix

I read the tax literature differently than I did early in my career. There is certainly more of “been there, read that,” but there is also more consideration of why the IRS decided to pursue an issue.

I am convinced that sometimes the IRS just walks in face-first, as there is no upside for them. Our recent blog about the college student and her education credit was an example. Other times I can see them backfilling an area of tax law, perhaps signaling future scrutiny. I believe that is what the IRS is doing with IRAs-owning-businesses (ROBS).

A third category is when the IRS goes after an issue even though the field has been tilled for many years. They are signaling that they are still paying attention.

I am looking at a reasonable compensation case.  I believe it is type (3), although it sure looks a lot like type (1).

To set up the issue, a company deducts someone’s compensation – a sizeable bonus, for example. In almost all cases, that someone is going to be an owner of the company or a relation thereto. 

There are two primary reasons the IRS goes after reasonable compensation:

(1)  If the taxpayer is a C corporation (meaning it pays its own tax), the deduction means that the compensation is being taxed only once (deducted by the corporation; taxed once to the recipient). The IRS wants to tax it twice. In a C environment, the IRS will argue that you are paying too much compensation. It wants to move that bonus to dividends paid, as there is no tax deduction for paying dividends.

(2) If the taxpayer is an S corporation (and its one level of tax), the IRS will argue that you are paying too little compensation. There is no income tax here for the IRS to chase. What it is chasing instead is social security tax. And penalties. Some of the worst penalties in the tax Code revolve around payroll.

There is a world of literature on how to determine “reasonable.” The common judicial tests have you run a gauntlet of five factors:

(1) The employee’s role in the company

(2) Comparison to compensation paid others for similar services

(3) Character and condition of the company

(4) Potential conflict of interest

(5) Internal consistency of compensation

Let’s look at the Johnson case as an example.

Mom and dad started a concrete company way back when. They had two sons, each of which came into the business. They specialized in Arizona residential development. As time went on, the brothers wound up owning 49% of the stock; mom owned the remainder. The family was there at the right time to ride the Phoenix housing boom, and the company prospered.

A downside to the boom was periodic concrete shortages. The company did not produce its own concrete, and the brothers came to believe it to be a business necessity. They presented an investment opportunity in a concrete supplier to mom. Mom wanted nothing to do with it; she argued that the company was a contractor, not a supplier. This was how companies overextend and eventually fail, she reasoned.

The brothers went ahead and did it on their own. They invested personally, and mom stayed out. They even guaranteed some of the supplier’s bank debt.

Who would have thought that concrete had so many problems? For example, did you know that concrete becomes unusable after 

(1) 90 minutes or

(2) If it reaches 90 degrees.

I am not sure what to do with that second issue when you are in Phoenix. 

The brothers figured out how to do it. They developed a reputation for specialized work. They worked 10 or 12 hours a day, managed divisions of 100 employees each, were hands-on in the field and often ran job equipment themselves. Sometimes they even designed equipment for a given job, having their fabrication foreman put it together.

Not surprisingly, the developers and contractors loved them.

That concrete supplier decision paid off. They always had concrete when others would not. They could even charge themselves a “friendly” price now and then.

We get to tax years June 30, 2003 and 2004 and they paid themselves a nice bonus. The brothers pulled over $4 million in 2003 and over $7 million in 2004.

COMMENT: I really missed the boat back in college.

The brothers were well-advised. They maintained a cumulative bonus pool utilizing a long-time profit-sharing formula, and they had the company pay annual dividends.

The IRS disallowed a lot of the bonus. You know why: they were a C corporation and the government was smelling money.

The Court went through the five tests:

(1) The brothers ran the show and were instrumental in the business success. Give this one to the taxpayer.

(2) The IRS argued that compensation was above the average for the industry. Taxpayer responded that they were more profitable than the industry average. Each side had a point. Having nothing more to go on, however, the Court considered this one a push.

(3) Company sales and profitability were on a multi-year uptrend. This one went to the taxpayer.

(4) The IRS appears to have wagered all on this test. It brought in an expert who testified that an “independent investor” would not have paid so much compensation and bonus, because the result was to drop the company’s profitability below average.

Oh, oh. This was a good argument.

The idea is that someone – say Warren Buffett – wants to buy the company but not work there. That investor’s return would be limited to dividends and any increase in the stock price. Enough profitability has to be left in the company to make Warren happy.

This usually becomes a statistical fight between opposing experts.

It did here.

And the Court thought that the brothers’ expert did a better job than the government’s expert.

COMMENT: One can tell that the Court liked the brothers. It was not overly concerned that one or two years’ profitability was mildly compromised, especially when the company had been successful for a long time. The Court decided there was enough profitability over enough years that an independent investor would seriously consider the company. 

Give this one to the taxpayer.

(5) The company had a cumulative bonus program going back years and years. The formula did not change.

This one went to the taxpayers.

By my count the IRS won zero of the tests.

Why then did the IRS even pursue this?

They pursued it because for years they have been emphasizing test (4) – conflict of interest and its “independent investor.” They have had significant wins with it, too, although some wins came from taxpayers reaching too far. I have seen taxpayers draining all profit from the company, for example, or changing the bonus formula whimsically. There was one case where the taxpayer took so much money out of the company that he could not even cash the bonus check. That is silly stuff and low-hanging fruit for the IRS.

This time the IRS ran into someone who was on top of their game.

If Your Job Requires It, Can You Deduct It?

I was recently talking with a friend about job opportunities available to him.

Some locations – like New York and L.A. – he dismissed immediately.

Then he mentioned that another location would require him to “suit and tie” every day.

I could not help but laugh. We both worked together in a mandatory “tie” environment, and I have worked in a mandatory “coat and tie” one. I suspect the latter is because the firm was downtown, and the firm wanted to project a certain image as its employees walked about. 

Still, suiting up gets expensive.

Sure would be nice if you could get a tax deduction out of it.

It’s almost impossible.

There is a famous case that laid down three requirements for clothing to be deductible:

(1) The clothing is of a type specifically required as a condition of employment;

(2) It is not adaptable to ordinary day-to-day wear; and

(3)  It is not used for day-to-day wear.

All in all, that seems to cover almost all clothing, unless you wear uniforms or are an astronaut.

But let me give you a few odd situations, and you tell me if there is hope of a tax deduction:

(1) You are a painter and are requested by the union to wear the traditional white-on-white painter’s outfit.

(2) You are a television news anchor and have to dress the part.

(3)  You are a Swedish rock band and wear clothing that looks like it has been dragged and ripped by wild dingoes.

(4) You are a musician and dress like a gypsy (or Welsh witch) for your performances.

There is a fellow who works for Ralph Lauren Corp. The company requires him to wear Ralph Lauren apparel while representing the company. As a consequence he has quite the extensive collection (and investment), and he tried to deduct some of it as a miscellaneous deduction on his Schedule A.

The Tax Court just said no dice. The clothing could be used day-to-day and therefore did not rise to the level of a deduction. The cost and restrictions imposed upon him by his employer were not tax relevant.

In truth, I wonder why he even pursued this matter. There is a case from before I came out of school where an Yves Saint Laurent employee tried the same deduction and failed.

Back to our examples:

(1) No deduction. The clothing could still be worn, although one is unlikely to do so. There may be an argument if the union required you to dress that way. The tax trigger would be more the requirement and less the clothing.

(2) Almost impossible. There is a case involving a news anchor with a wardrobe she considered too conservative for everyday use. She segregated it and wore it only at work. Not only did the Tax Court disallow the deduction, they also assessed penalties.

(3) This was the band ABBA, and they got the deduction. If you google their photographs, it is clear you would not wear that clothing outside of a performance or on Halloween.

(4) This was Stevie Nicks of Fleetwood Mac. She deducted over $40 grand on her 1991 tax return for costumes and hair styling. The IRS disallowed these and selected other deductions on her return. While the matter was docketed for Tax Court, it was returned to IRS Appeals. It was there resolved, and unfortunately tax practitioners (other than Stevie’s tax advisor) do not know how it turned out.

Then for the extreme tax athletes there is the woman who was able to deduct her body makeup, and I freely admit I am not sure what that is. She did not deduct clothing, as she wore none. She was an actress for the Broadway performances of Oh! Calcutta!