The IRS and Identity Theft

One of the downsides of increased electronic tax filing is increased identity theft. We had one of our e-filings intercepted this year by the IRS for identity mismatch. The IRS did not accept the e-file and instead required a paper return with Form 14039, Identity Theft Affidavit, attached.

I was looking at (OK, I was skimming) a report from the Treasury Inspector General for Tax Administration issued May 3rd. Imagine my surprise to learn that the IRS has no special procedures for our return with Form 14039 attached.

The IRS considers the paper filing to be a duplicate return and does not immediately process it. An employee enters a transaction code into the taxpayer file to memorialize receipt. The return then goes to a separate queue to be worked on, possibly after April 15 when the filing season has ended. The IRS transfers the file to Duplicate function for initial review. If Duplicate considers it an identity theft case, the file is again transferred, quite likely to the Accounts Management function. It is there assigned an assistor, who requests copies of the original tax returns and begins the process, including correspondence, of determining who the legitimate taxpayer is.

This process is slow and the refund can be delayed until late in the year or even the following year. The average case resolution is 414 days.

The assistor very likely works in Accounts Management. The problem is that these employees also answer the toll-free telephone lines during busy season. According to TIGTA, 87% of assistors working identity fraud also answered the phones, and 60% stated that they worked the toll-free line exclusively. TIGTA considers the optimal assistor inventory (that is, caseload) to be 100 to 125 per assistor, but the average assistor had an inventory exceeding 300 cases.

The identity problem is new enough that IRS guidelines are spread out over almost 40 sections in the Internal Revenue Manual. Sometimes the guidelines are inconsistent. The IRS in addition does not have procedures to spot trends which could be useful in detecting or preventing future fraud. One problem, for example, is sending notices to the last address of record, which could just be the person perpetrating the fraud.

Training has also been an issue. TIGTA’s survey showed that almost half of the assistors believed that their training was not sufficient. In one office, 13% of assistors had received no identity theft training.

To be fair, the IRS has agreed with TIGTA’s findings and has begun implementation of many recommendations. For example, there will be specialized units in Accounts Management to work only identity fraud cases.

Then we have Congress. Three representatives this week introduced the “Fighting Fraud Act,” which would double the current penalties for tax preparers who are involved with identity theft. The intent is to give the IRS greater incentive to prosecute this type of theft, presumably because the potential payoff is greater.

Really? This is the best the mandarin class can dream up? Here is an idea: the IRS assigns a PIN to every preparer. Require every professionally-prepared return to require the preparer’s PIN. If a preparer is involved with this type of nonsense, the IRS revokes the PIN and bans the preparer from working before the IRS.

Will this stop the completely unscrupulous? Here is a question in return: in human history, has it ever been possible to stop the completely unscrupulous?

Something New In Gifting of Family Limited Partnerships

Let’s talk this time about gift taxation.

Let’s say that you have a family-owned company.  You desire to pass this on to your kids and grandkids. There are ways to do this, but the method best for you is annual gifts of $13,000, which is the amount of the gift tax annual exclusion. Both you and your spouse can give away $13,000 per beneficiary, so you are transferring $26,000 at a clip. Enough beneficiaries and this can add up.

You ask: what could go wrong?

What if the IRS challenged the value of the gift? Remember, partnership or LLC units generally do not have the same value as a direct and uninterrupted transfer of the asset(s) in the partnership or LLC.

Why is that? Well, if you are a limited member, you have to obtain the general member’s permission to asset. If you are my daughter and I am the general member, rest assured that permission is not happening for a while.  My daughter may “own” $26,000 (2 annual gifts of $13,000) in the LLC, but is it really worth $26,000?  Remember: you need my permission to get to the $26,000. Would you pay her $26,000 today on the hope and prayer that someday I will distribute $26,000 to you? 

Let’s say that IRS comes in says that the LLC units are not worth $26,000. Instead the units are worth $40,000.  What just happened? What happened is that I have to amend my gift tax return. I am now using my lifetime exemption so as not write a check to the IRS. Had I already used-up my lifetime exemption, I would be writing a check. I would not be happy.

What if I changed the terms of the gift? Instead of saying that my wife and I transferred X number of units, we say we transferred units (or fractions thereof) worth $13,000 to our daughter. If the IRS adjusts the gift value upward, then – as far as I am concerned - I “actually” gifted fewer units. Remember, I gifted $13,000 in value, NOT a set number of units. Brilliant!

Except that the IRS thought it too brilliant. This tax technique is called a “defined value clause,” and the IRS has pursued these cases on multiple grounds, including being against public policy.

One of the first cases was Proctor. There the donors gifted remainder interests using the following clause:

“In the event it should be determined … that any part of the transfer in trust hereunder is subject to gift tax, it is agreed by all parties hereto that in that event the excess property hereby transferred which is decreed by such court to be subject to gift tax, shall automatically be deemed not to be included in the conveyance in trust hereunder and shall remain the sole property of the taxpayer.”        

The Fourth Circuit of Appeals nixed the Proctor clause as being after-the-fact. It was a condition subsequent. The IRS continued its win streak with Ward and with Harwood.

Those cases are easy to understand: you cannot undo what has already been done. Let’s make it more challenging.

What if you are not trying to undo anything?  What if you have two beneficiaries: your family and any excess going to charity? Think about this for a moment. If the IRS revalues the gift, the revaluation would be “excess” and go to the charity. There is no gift tax on transfers to charity. There would be little motivation for the IRS to pursue you. The IRS still did not like this and litigated the matter in Christiansen, McCord and Petter. This time, they were not as successful.

What if you like the result in McCord but it is not your intent to include a charitable beneficiary? Congratulations. You are Dean and Joanne Wandry. The Wandry’s gifted partnership units worth $1,099,000 on January 1, 2004. The actual number of units was not fixed, pending a later valuation. The valuation was completed July 26, 2005. The IRS examined the gift tax returns and issued the tax assessment in February, 2009.

The IRS argued that

·         The descriptions on the gift tax returns sounded like a transfer of units and not dollars

·         The entry the accountant made to the books sounded like a transfer of units and not dollars

·         The attorney’s documents sounded like a transfer of units and not dollars

·         It was against public policy to transfer dollars and not units, and

·         In any event the taxpayers smelled funny.

The Wandry’s took the matter to Tax Court. They won their case this past March, and they are now famous as being the first taxpayers to win against the IRS using a formula clause that doesn’t have a charitable element. Granted, this is not the same as winning the Peyton Manning sweepstakes, but it is something.

My take: I expect to see Wandry clauses as standard boilerplate in FLP transfer documents from this point on.

A Letter To The IRS

This is an actual letter sent to the IRS approximately 15 years ago Remember to laugh at least once daily. Enjoy!

Sirs:

I am responding to your letter denying the deduction for two of the three dependents I claimed on my 1994 Federal Tax return. Thank you!

I have questioned whether or not these are my children for years. They are evil and expensive. It's only fair that, since they are minors and no longer my responsibility, the government should know something about them and what to expect over the next year. Please do not try to reassign them to me next year and reinstate the deduction. They are yours!

The oldest, Kristen, is now 17. She is brilliant. Ask her! I suggest you put her to work in your office where she can answer people's questions about their returns. While she has no formal training, it has not seemed to hamper her mastery of any subject you can name. Taxes should be a breeze. Next year she is going to college. I think it's wonderful that you will now be responsible for that little expense. While you mull that over, keep in mind that she has a truck. It doesn't run at the moment, so you have the choice of appropriating some Department of Defense funds to fix the vehicle, or getting up early to drive her to school. Kristen also has a boyfriend. Oh joy! While she possesses all of the wisdom of the universe, her alleged mother and I have felt it best to occasionally remind her of the virtues of abstinence, or in the face of overwhelming passion, safe sex. This is always uncomfortable, and I am quite relieved you will be handling this in the future. May I suggest that you reinstate Dr. Jocelyn Elders who had a rather good handle on the problem.

Patrick is 14. I've had my suspicions about this one. His eyes are a little closer together than those of normal people. He may be a tax examiner himself one day, if he is not incarcerated first. In February, I was awakened at three in the morning by a police officer who was bringing Pat home. He and his friends were TP'ing houses. In the future, would you like him delivered to the local IRS office, or to Ogden, UT? Kids at 14 will do almost anything on a dare. His hair is purple. Permanent dye, temporary dye, what's the big deal? Learn to deal with it. You'll have plenty of time, as he is sitting out a few days of school after instigating a food fight in the cafeteria. I'll take care of filing your phone number with the vice-principal. Oh yes, he and all of his friends have raging hormones. This is the house of testosterone and it will be much more peaceful when he lives in your home. DO NOT leave him or his friends unsupervised with girls, explosives, inflammables, inflatables, vehicles, or telephones. (They find telephones a source of unimaginable amusement. Be sure to lock out the 900 and 976 numbers!)

Heather is an alien. She slid through a time warp and appeared as if by magic one year. I'm sure this one is yours. She is 10 going on 21. She came from a bad trip in the sixties. She wears tie-dyed clothes, beads, sandals, and hair that looks like Tiny Tim's. Fortunately you will be raising my taxes to help offset the pinch of her remedial reading courses. "Hooked On Phonics" is expensive, so the schools dropped it. But here's the good news!

You can buy it yourself for half the amount of the deduction that you are denying me! It's quite obvious that we were terrible parents (ask the other two). She cannot speak English. Most people under twenty understand the curious patois she fashioned out of valley girls/boys in the hood/reggae/yuppie/political double speak. The school sends her to a speech pathologist who has her roll her "r's". It added a refreshing Mexican/Irish touch to her voice. She wears hats backwards, baggy pants, and wants one of her ears pierced four more times. There is a fascination with tattoos that worries me, but I am sure that you can handle it. Bring a truck when you come to get her, she sort of "nests" in her room and I think that it would be easier to move the entire thing than find out what it is really made of.

You denied two of the three exemptions, so it is only fair that you get to pick which two you will take. I prefer that you take the youngest two, I will still go bankrupt with Kristen's college, but then I am free! If you take the two oldest, then I still have time for counseling before Heather becomes a teenager. If you take the two girls, then I won't feel so bad about putting Patrick in a military academy. Please let me know of your decision as soon as possible, as I have already increased the withholding on my W-4 to cover the $395 in additional tax and made a down payment on an airplane.

Yours truly,

Bob

By the way, the IRS allowed the dependency exemptions.



The IRS, Layla, Ludwig Drums and Demutualization

Well, this is not the easiest tax reading I have ever done. I just finished Cadrecha v U.S. The case is like reading a calendar.    

You ever wonder about the difference between a tax attorney and a tax CPA? There are differences in practice. The CPA of course is much more involved with numbers and the attorney is more so with contracts and documents. A big difference is that the attorney can take a case to court. Robert and Cynthia Cadrecha (Cadrecha) could have used an attorney, because the IRS beat on them like a set of Ludwig drums.

This case has to do with a life insurance company demutualization. Demutualization means the life insurance company issues stock. The IRS took the position that any stock received would have a basis of zero; a subsequent sale would therefore be all gain. Sounds like a position the IRS would take. There was a taxpayer who took the IRS to court on this matter (Fischer v U.S.) and won. Cadrecha occurred during this period of time.

Here goes:

4/15/04           Cadrecha files 2003 tax return showing no basis in the stock.

3/20/07           He learns of the Fischer case. Cadrecha mails amended return showing basis in the stock.

3/22/07           IRS receives amended return.

5/10/07           IRS writes letter asking for more information. Cadrecha provides it.

6/26/07           IRS sends letter that it is researching.

8/6/08             Fischer wins case against IRS.

8/13/07           IRS sends letter it fell asleep and will now really start researching.

8/31/07           IRS sends letter saying “fuhgetaboutit” and disallows the amended return.

The IRS, with all its efficiency, tells Cadrecha that they filed the amended return after three years had expired. This is of course incorrect. What happened is that the IRS got the 3/20/07 filing confused with the additional information provided on 5/10/07. Generally speaking, the additional information will be attributed back to the earlier filing.

OBSERVATION: This is why we recommend using certified mail.

NOTE: Something VERY important happens here. The disallowance is on Letter 105C, which includes the following language concerning an appeals or suit:

“The law permits you to do this within 2 years from the date of this letter. If you decide to appeal our decision first, the 2-year period still begins from the date of this letter.”

I believe that Cadrecha, and Cadrecha’s accountant, got mislead by the reason given on Form 105C. Granted, the amended return was filed within 3 years, but the claim was DISALLOWED.  This has significance separate and apart from any reason given and will come back to haunt Cadrecha.

8/31/07           Cadrecha sends a letter to the IRS disagreeing with the “dates” issue.

10/1/08           Cadrecha sends a letter to the IRS asking whether anyone is still alive.

11/3/08           Cadrecha files Form 843 in order to perfect the earlier (3/20/07) claim. (An amended return is a claim).

11/5/08           IRS responds to Cadrecha’s letter of 11/3/08, saying someone is still alive.

12/30/8           IRS – in a blur of motion – responds to the claim filed 11/5/08, saying it will need more time to research and to put the children through middle school.

1/15/09           The IRS writes again, stating that it is forwarding the claim filed 11/3/08 to Austin by the slowest means possible.

6/25/09           Cadrecha’s accountant contacts the Taxpayer Advocate.

12/11/09         Cadrecha’s accountant actually speaks to an IRS employee. She (the employee) explains that the IRS is delaying because it intends to appeal Fischer. She also says that the children are doing well and have started high school.

4/19/10           Cadrecha, in a moment of insanity, writes the IRS.

8/22/10           Cadrecha writes the Taxpayer Advocate imploring it to “PLEASE help.” Johnny Depp is rumored to be in consideration for the movie lead.

4/26/11           Cadrecha receives a letter from the IRS stating that their claim was “being held in suspense” while the IRS was litigating a similar demutualization case in Arizona. The IRS also remarked how the children had grown and were soon to start college.

Anyway, Cadrecha winds up in court. What did the IRS argue? That Cadrecha’s complaint was not filed timely! Can you believe the gall?

The court decided against Cadrecha. The case was not filed timely. Look back above and reread my comment on the 8/31/07 entry. Cadrecha had 2 years to file. Not 2 years and a day or 3 years less a week. He was late.

Is it equitable? Most likely not, but it was the bright-line law.

Is there a moral? Yes. When this issue got played out like Clapton’s “Layla,” Cadrecha needed an attorney. I know, I know. One does not have unlimited money to throw around, and one has to consider whether the amount of tax at issue is worth the additional cost. But Cadrecha needed something that a CPA could not provide: a court filing before the two years ran out.

Hazard of Being a Volunteer Nonprofit Director

Can you be on the hook for unpaid payroll taxes if you are a volunteer director for a nonprofit? What if you do not have authority to write checks?

Let’s take a look at the recent (March 8, 2012) U.S. District Court decision Bunch v Commissioner.

Perceptions, Inc. was a Tennessee nonprofit formed in 2004, Perceptions provided supportive living service for developmentally disabled clients. The incorporators and initial directors were replaced by Roy Don Bunch (Bunch) and two others. Documents filed with Tennessee listed Bunch as the chairman of the board. He was also the registered agent.

Bunch was benevolent with Perceptions. He allowed it to use one of his properties rent-free. He also made start-up loans and – later – bridge loans when Perceptions did not have sufficient money to pay its bills. His generosity was not insignificant. Between February, 2005 and August, 2007, Bunch made loans of approximately $648,000.

When Perceptions had money, it would repay him. Between 2006 and 2007 Bunch was repaid approximately $558,000.

Bunch never received a paycheck. He never hired or fired employees. He never asked to see the books. He never asked if taxes were being paid. He did speak up in December, 2006 when he learned that Perceptions was thinking about employee raises. His question was reasonable: we are almost bankrupt. Why are we talking about raises? No raises were given, but Bunch’s hopes for a Congressional career were jettisoned.

In December, 2006 Bunch learned that quarter 3, 2006 employment taxes were unpaid. He loaned money to Perceptions to pay these taxes.

In June, 2007 he finally gave up and took over financial responsibility, including writing checks. He was hoping to make Perceptions a viable business. Payroll was met, providers were paid and Bunch was repaid on his loans. Perceptions however did not pay its current or back employment taxes.

The IRS finally shows up wanting to know what is going on. In March, 2008 the IRS decides that Bunch is a “responsible person” for the second and fourth quarters of 2006 and all of 2007.  You do not want to be a “responsible person,” as this means the IRS is coming after you. The IRS wanted almost $194,000 from Bunch.

Bunch was an inquisitive sort. His attorney asked the IRS for their basis in concluding that Bunch was a “responsible person.”  The IRS sent the attorney copies of an interview questionnaire but no reasoning or other basis for their determination.

Bunch filed an appeal on April 25, 2008.

Summer comes. Fall comes. Winter comes. In January, 2009 Bunch received a letter from IRS Appeals. They want affidavits and documents, which he provides. What he did not receive, however, is the basis on which the IRS concluded he was a responsible person.

Spring comes. Summer comes. In September the IRS tells him to pay the penalties. They again fail to tell him why.

In October, 2009 Bunch filed a Request for Abatement. He attaches and documents everything.

The IRS tells him his claim would open for review on January 10, 2010. Two weeks later – January 25 – Bunch receives the IRS’ denial of his claim. Bunch can almost hear the tires squealing as the IRSmobile speeds away. The IRS still failed to tell him why he was responsible.

On February 9, 2010, Bunch sends the IRS almost $194,000. He then files a court motion. He wants his money back. And to find out why he is responsible.

In court Bunch admits that he was a responsible person as of June 22, 2007, when he took over financial responsibility for Perceptions. He disagreed that he was a responsible person before that date. He had a point. One of the key indicators is whether the person in question had discretion over cash disbursements, including signature authority. A bookkeeper who pays what he/she is instructed to pay would not be a responsible person, whereas his/her boss could be.

The court disagreed with Bunch. It did not matter that he did not hire or fire, have ownership, get paid or write checks. The court reasoned that he had authority as a director and significant financial authority because he lent a lot of money to Perceptions. In fact he could have forced Perceptions out of business by simply not loaning them money. The court did not care that he did not know or did not exercise authority. The court reasoned that he could have, and “could have” was sufficient.

Bunch was a responsible person for all periods. The IRS could keep his $194,000.

Yipes!

My take: sadly, I have to agree with the court. There is a long-standing tax doctrine that one cannot intentionally stick his/her head in the sand and claim ignorance. Bunch was involved enough to lend Perceptions money on an almost-monthly basis. As a director, he had the right to ask why, where the money was going, what bills were being paid and – importantly – what bills were not being paid. He already had one fright with unpaid employment taxes, and it was not unreasonable for a director to oversee that such taxes not be overlooked in the future.

The difficult part here is separating his duty as a director from his obvious generosity with the charity. As director he had authority to inquire, berate and insist. Events came to his attention which reasonably required him, as director, to get involved. It was not reasonable for a director to turn a blind eye. He was a tremendous benefactor, but not a very good director. Had he just been a benefactor, I doubt the court would have arrived at the same decision.

On April 6 Bunch filed a motion seeking to alter or amend the court’s decision. We’ll see how it turns out, but I doubt he will be pleased.

Ohio Offers Two Tax Amnesties

As part of the 2012/2013 budget bill, Ohio has authorized a general amnesty for selected state taxes, including personal income, school district, sales and commercial activity taxes.

This is an attractive amnesty program, although it does have one significant drawback. Under the program Ohio will abate all penalties and one-half the interest. Taxes eligible for the amnesty must have been due and payable as of May 1, 2011. This means that a 2010 individual income tax will be eligible (as it was due April 15, 2011), but a May 2011 sales tax return would not (as it was due June 23, 2011). In addition, you cannot have been previously contacted by Ohio.

Ohio expects full payment when you file these tax returns. Remember – this is a revenue raiser for the state.

The significant drawback? The general amnesty window is very brief: from May 1 to June 15, 2012.

There is a separate use tax amnesty that runs from October 1, 2011 to May 1, 2013.

Note: Use tax applies to purchases of taxable products or taxable services where the seller did not collect the Ohio sales tax. The use tax applies both to individuals and businesses. The use tax is the cousin to the Ohio sales tax. It serves to prohibit one from avoiding Ohio sales tax by purchasing items from another state (free of sales tax) and then bringing them into Ohio.

If one pays all use tax due on or after January 1, 2009, Ohio will waive or abate use tax owed for prior periods. There is also a non-interest payment program available for businesses not previously registered for use tax, although this option requires an officer to personally guarantee the tax debt. On the plus side, Ohio will allow the business up to seven years to pay the back taxes. Once again, you cannot have been previously contacted by Ohio.

The IRS May Allow Videoconferencing

I am just finished reading Nina Olson’s most recent blog post. Nina Olson is the National Taxpayer Advocate with the IRS. The Advocate’s office is independent from the IRS, although it works with the IRS to resolve tax problems. I have worked with the Advocate’s office before, and in general I have been pleased. Recent contacts have concerned me, though. It sounds to me that they are being overworked, at least here in Cincinnati. I suspect they are feeling IRS budget restrictions.

Ms Olson commented on taxpayer frustrations with “corr exams.” These are correspondence exams and frequently address areas using computer matching. You may get a “corr” notice concerning missing dividends or interest income, for example, or possibly the sale of stock. The corr notices are notorious and can frequently take multiple contacts to resolve. Why? Well, a key reason is that no single examiner is assigned to work on your case. Rather, it floats in a pool, and when you send a letter it gets randomly assigned to an examiner. Say that the letter resolves many, but not all, the issues. The IRS sends out another notice. You respond, but it will not go to the same person who earlier worked on your file. There is no continuity in the corr exam process.

Ms Olson is proposing the use of videoconferencing in conjunction with corr exams. Upon receiving a notice, a taxpayer would have the option of making an appointment for an online meeting. The taxpayer gets a PIN and logs on from his home or office computer. If the taxpayer does not have a computer, he/she could alternatively go to the local IRS office or perhaps to a specially designated room at another government building. With a high-resolution camera, the examiner could even read a document that the taxpayer brought to the videoconference. The examiner would retain the case, and all future correspondence would contain his/her name, phone number and e-mail address.

Here is how Ms Olson phrased it:

As anyone who has looked at both the literacy levels of the United States population and the poor quality of IRS exam notices can attest, there is not a whole lot of communicating going on in IRS correspondence exams.”

A virtual face-to-face meeting would allow for diversity in taxpayers’ ability to read, write and express themselves verbally. The taxpayer would be able to explain himself and the examiner could better explain any necessary documentation without the back-and-forth of a correspondence exam.

What does this tax CPA think? Great idea! I am becoming quite the fan of Nina Olson.