Be Careful With Foreign Tax Information Returns

Today we filed an extension for a client company with a foreign subsidiary. I was recently reading a Chief Counsel’s Advice concerning the same type of tax return that our client will be filing in a few months.

There is an additional form to file when one owns a foreign corporation. That is Form 5471 “Information Return of U.S Persons with Respect to Certain Foreign Corporations.” The common ownership threshold for filing is 10 percent. There is a twist in which an officer or director has a responsibility to file, even if the officer or director owns no shares directly, as long as a US citizen owns at least 10 percent.

Frankly, this is a confusing return. There are four types of “filers,” and each has to fill-out – or not fill-out- certain sections of the return. One may have to provide an income statement for the foreign company, for example, or track its earnings and profits.

The 2010 HIRE Act amended the tax Code (Section 6501(c )(8)) so that the statute of limitations for an income tax return to which an international “information return“ relates does not start until the information return is filed.

What does this mean? Well, Form 5471 is considered an “information return.” This means that it has numbers on it, but there is no line that says “tax due.” There is a similar form (Form 8865) for foreign partnerships and another (Form 3520) for foreign trusts.

So you own (enough of) a foreign corporation to file Form 5471. The accountant doesn’t think about it and files the corporate return without it.  The IRS in CCA 201104041 clarified that the statute of limitations on the corporate return does not begin to run until the Form 5471 is filed.

The client referred to above is new to the firm. One of the reasons that they switched firms? Their former CPA had not been filing Forms 5471.

If you remember, there are also penalties for not filing foreign information returns, including Form 5471. That however is for another blog post.

Olsen v Commissioner

You may recall that there is a”super” penalty that the IRS can assess if one understates his/her tax by too much. This penalty is not trivial: it is 20% and is called the accuracy-related penalty. In many cases the IRS assesses the penalty as a mathematical exercise. You can however request that the penalty be abated by providing a reasonable cause for doing so. A long illness or the death of a close family member, for example, has long been considered as reasonable cause.

We now have a new reasonable cause. I suspect that it will enter the tax lexicon as the “Geithner” defense, for the secretary of the Treasury under President Obama.

Here is what happened.

Kurt Olsen (KO)’s wife received interest income for 2007 from her mother’s estate. This means that she received a Schedule K-1, an unfamiliar form to the Olsens. KO normally prepared the tax returns, and he liked to use TurboTax. Upon receipt of the K-1, he upgraded his version of TurboTax as a precaution in handling this unfamiliar tax form.

TurboTax uses an interview process to obtain information. Using this process, KO entered the name and identification number of the estate. He also took a swing at entering the interest income, but something went wrong. The interest income did not show up on the return. KO was quite responsible and used the verification features in his upgraded software, but he did not discover the error.

The IRS did, though. They sent him a notice requesting an additional $9,297 in tax. The change in tax was large enough to trigger the “super” penalty of $1,859 ($9,297 times 20 percent).

KO knew he owed the tax, but he felt that the penalty was unfair. He felt strongly enough about the penalty that he pursued the issue all the way to the Tax Court. He represented himself under a special forum for small cases.

                Note: The tax term for representing yourself is “pro se.”

Now, the Tax Court has not been forthcoming in considering “tax software” as a reasonable cause. The Court has long expected one to use the software properly. In fact, a famous case (Bunney v Commissioner) has the Court stating that “tax preparation software is only as good as the information one inputs into it.”

The Court however took pains to distinguish KO, commenting that…

·         “We found petitioner to be forthright and credible.”

·         “It is clear that his mistake was isolated as he correctly reported the source of the income.”

·         “He did not repeat any similar error in preparing his tax return.”

·         “Petitioner acted reasonably in upgrading his tax preparation software to a more sophisticated version.”

The Court found reasonable cause to abate the penalty.

The key thing is that the taxpayer had an unusual source of income. He did not know where to look to check that the income had been properly included on his return. He did however meticulously follow the verification features in the software, and he relied – not unreasonably – on the software to report this transaction correctly.

This type of case unfortunately cannot be used as precedent. Tax Court Judge Armen also took care to cite the “unique facts and circumstances of this case.” Nonetheless, as more and more taxpayers use software to prepare their returns, it is expected that we will see more and more instances of the “Olsen” defense. 

Payroll Tax Cut Voted Down

I was reading this morning that the Senate was unable to pass a payroll tax cut bill yesterday. There were two bills and neither passed.

You may recall that the employee share of FICA was reduced from 6.2 to 4.2 percent for 2011. The balance of 1.45 percent for Medicare was untouched. The purpose was to stimulate, or at least not depress, the economy.

The problem is that the 2 percent reduction expires at the end of 2011.

The politicians now want to extend the program. The Senate Democrats proposed a plan to reduce the 6.2 percent withholding to 3.1 percent. In an unanticipated move, the Democrats proposed this be paid for by a tax increase on the wealthy.

The Republicans proposed extending the tax cut at 2 percent and paying for it by freezing federal salaries and streamlining the federal workforce by 10 percent. This was predictably described as extreme.

The President demanded action and announced his next vacation.

The House is taking up the issue next.

Get Ready for Stock Cost-Basis Reporting

There will be changes in how your stockbroker reports your stock trades for 2011.

Your broker now has to report the “cost” of your stock trades. This is a new rule for 2011. It came in as part of the 2008 Emergency Stabilization Act, also known as the bank bailout bill. You can anticipate that the purpose of this rule is to raise taxes.

There are three steps to the phase-in of this bill:

(1)    For 2011 (that is, the 2012 tax season), brokers are to report cost on all equity trades, if the equity was bought on or after January 1, 2011.

(2)    For 2012 (the 2013 tax season) brokers will report cost for mutual funds, dividend reinvestment plans and many exchange –traded funds bought on or after January 1, 2012.

(3)    For 2013 (the 2014 tax season), the rule will be extended to bonds and options.

There is a tax trap in here, so let’s go over it. The trap releases if you bought the security at different times and prices. Brokers refer to this as “accumulation.” Each time you buy the stock is called a “lot.”Let’s use the following accumulation as an example:

Let’s say you bought Sirius XM Radio at the following prices:

                January, 2010                     500 shares           $0.70

                May, 2011                           400 shares           $2.31

                August, 2011                      300 shares           $1.71                   

You sell 300 shares today at $1.77 per share. What is your cost for the 300 shares?

The IRS has provided four options:

(1)    First-in, first, out (FIFO).

a.       Under this rule, your cost would be 300 times $0.70 = $210.

(2)    Last-in, first out (LIFO)

a.       Under this rule, your cost would be 300 times $1.71 = $513.

(3)    Highest cost

a.       Under this rule, your cost would be 300 times $2.31 = $693

(4)    Specific identification

a.       You get to pick which shares you sold. All things being the same, you would probably select the May, 2011 lot and use $693 as cost.

Under our example, your answer could vary from a gain of $321 to a loss of $162.  It is quite a swing.

Where is the trap?

You have to tell the broker which method you are using, and you have to tell them before the settlement date of the trade. This is very different from the way it has been, which previously allowed the accountant to decide which method to use when preparing your return. We many times contacted a broker for lot dates, shares and cost when a client had accumulated a position in a stock. We had the luxury (if it could be called that) of doing so when preparing the return. This now has to be done within three business days of the trade date.

There is also another trap. If you do not select a method, the IRS will select it for you. The IRS will decree that you selected the first-in, first-out method. That is a fine method, but if you look back at our example, you will see that it is also the method that reports the least cost, and therefore the most gain, to the IRS. Remember what I said about raising revenue for the government?

 And the final trap? By the time you get to me, there is nothing I – as your tax CPA – can do.

Related Party and Tax Deductions

If you are a partnership, LLC or S corporation and report on the accrual basis, this may apply to you.

You may be aware that there are restrictions on deductions between related accrual-basis and cash-basis entities or individuals. These are the “related party” rules of IRC Section 267 and are well-known to tax accountants. By the way, these rules drive on a one-way street: the effect is to delay the deduction, not to delay the income.

                EXAMPLE ONE:

Sanctuary, Inc is a C Corporation and accrual-basis taxpayer. It owes $34,000 at year-end to Sam (a Schedule C) for the provision of goods or services. Sam is a 51% shareholder.  Sam is on the cash-basis, as most individuals are. Sanctuary, Inc cannot deduct the $34,000 until Sam includes it in income, because more-than-50% ownership triggers the related party rule.

                EXAMPLE TWO:

Sam (a Schedule C) owes Sanctuary, Inc $27,000 at year-end for the provision of goods or services.  Sam (a Schedule C) cannot deduct this until it makes payment. Sam (a Schedule C) is, after all, on the cash-basis. Sanctuary, Inc is quite unruffled by all this. As an accrual-basis entity, it will report the $27,000 in income without waiting for Sam’s (a Schedule C) deduction.

The trap here is the more-than-50 percent rule. The 50% requirement goes away if the transaction is between an S corporation, partnership/LLC and a shareholder or partner/member.

Change Sanctuary to a partnership, LLC or S corporation and the threshold drops to any ownership. As an example, an accrual to a 2-percent S- corporation shareholder would be disallowed under the related party rules.

Why? Here is how I make sense of it. As a pass-through investor, both sets of numbers will wind up on one income tax return. The IRS is therefore stricter than it would be if the numbers wound up on two tax returns, such as between a C corporation and an individual.

IRS Buyout Packages

I saw today in Government Executive that the IRS is extending buyout packages to as many as 5,400 IRS employees. The buyouts are capped at $25,000 per person, and eligible employees have until November 22 to decide.

Why are they doing this?

Both the House and Senate have proposed cutting the IRS fiscal 2012 budget by up to $500 million.

Do Tax Preparers Get Penalized On Their Own Returns?

Do tax preparers ever get penalized by the IRS on their own returns?

We are going to look at one today: Joyce Anne Linzy (JAL). She is party to a Tax Court Memorandum Decision issued on November 7, 2011.

JAL is a tax preparer with more than 15 years’ experience. During 2007 she operated an income tax return preparation business. She owned an apartment building in which she both lived and worked: the business was on the first floor and she lived on the second floor. She also rented out second-floor space that she did not use as a residence.

There were a number of proposed IRS adjustments for the Court to consider:

1.    JAL omitted $2,500 of gambling income.

This is actually the least of her problems.

2.    JAL claimed almost $35,000 of contract labor.

There is no problem with claiming this deduction, but the IRS expects one to maintain documentation to substantiate the deduction upon examination. Here is the Court’s language on this matter:

“Petitioner presented canceled checks, bank account statements, receipts and invoices purporting to substantiate various items claimed as business expenses deductions. These records are not well organized, and have not been submitted to the Court in a fashion that allows for easy association with the portions of the deductions that remain in dispute. Nonetheless, we make what sense we can with what we have to work with…”

The Court is trying to work with JAL. They are referring to the Cohan rule: if the Court knows that a taxpayer incurred an expense, it can (with some statutory exceptions) allow estimates of the actual expenses. JAL must be quite the tax adept, though, as the Court goes on…

“None of the numerous receipts petitioner offered in support of her claimed contract labor expense were for contract labor.”

“The checks are photocopied such that the dates are missing or incomplete, and the full amount cannot be determined…”

Oh, oh.

“These records are incomplete, and there is not enough information to permit a reasonable estimate. Accordingly, respondent’s complete disallowance of petitioner’s … deduction for contract labor is sustained.”

3.    Mortgage interest

JAL used one-third of the building for her tax return business. She deducted one-half of the mortgage interest as a business expenses.

Seems like simple math.

4.    Depreciation

During 2007 she purchased several depreciable items. She did not depreciate the cost of these items but instead claimed the costs as contract labor expenses.

Some of these items could not be immediately expensed under Section 179 because they related to building improvements. These items included siding and tuck pointing. Buildings of course have a long depreciation life, so the swing between immediately expensing and depreciating over many years is magnified.

There was no fallback position here for JAL.

5.    Charitable contributions

You may be aware that you are required to get a timely statement from the charity describing the contribution and that you received nothing of monetary value in return, or to estimate the amount if there was monetary value. You are supposed to have this in hand before you file your return.

JAL seems to have forgotten this.

She deducted a $2,500 donation to Schneider School.

Here is the Court:

               

“Although petitioner received a receipt from the Chicago Public Schools, it does not qualify as a contemporaneous written acknowledgement because it does not state whether she received any goods or services in return for her contribution.”

She deducted a $7,500 donation to Faith Deliverance.

Again, here is the Court:

               

“The letter does not state whether petitioner received goods or services in exchange for contribution and was not received by the earlier of her return’s filing date or its due date…. Thus there is no contemporaneous written acknowledgement from the donee that would permit petitioner to deduct the contributions.”

6.    The substantial understatement penalty

This is a “super penalty” if you misstate your taxable income by too much. The IRS defines “too much” as more than 10% of the final tax but at least $5,000.

JAL had no problem leaping over this hurdle.

The IRS can waive this penalty if one has “reasonable cause.” There are a number of factors that constitute reasonable cause, but a common one is reliance on a tax professional. In fact, I drafted a letter this week requesting abatement of this very penalty, and the reason I gave was their reliance on a tax professional. What happens, however, when you are a tax professional and it is your OWN tax return?

Here is the Court:

“Petitioner’s records were insufficient to substantiate several of her claimed deductions, and she failed to keep adequate books and records. Furthermore, petitioner, a tax return preparer with more than 15 years experience, improperly deducted….Petitioner offered no evidence that she acted with reasonable cause and in good faith. Accordingly, we hold that petitioner is liable … due to negligence or disregard of rules or regulations.”

The penalty alone was over $3,100.

What can I say about JAL?

A lesson here is that the Tax Court is going to hold a professional preparer to a higher standard. Now, JAL was not an attorney, CPA or enrolled agent, but when she stepped into “professional preparer” shoes the Court was going to be less lenient. It is not unreasonable, as others pay you for knowing more about the tax system than the average person. It seems to me that JAL did not rise to the occasion.