Portney’s Complaint or I’m Late, I’m Late For A Very Important Date

Do you extend your individual income tax return? More specifically, do you rely upon your tax advisor to extend the return for you?

There was a warning shot concerning extensions last year in Tesoriero v Commissioner. As a practicing tax CPA, it gave me pause.

Anthony and Eleanor Tesoriero had used the same CPA form (Portney & Company) for over a quarter of a century. The firm prepared approximately 1,000 individual tax returns annually (that is a lot). Of those, approximately 400 to 450 went on extension.

The firm had procedures. They would prepare the extensions and give them to the secretary, who would address and seal the envelope, take it downstairs and drop it in the mailbox. The firm did not use registered or certified mail. They did use a postage meter but did not keep a record or mail log.

Jack Portney extended the Tesoriero return in April 2005. He did not spend a whole lot of time estimating the numbers. Rather he took the estimated tax payments and showed that amount as both tax due and tax paid-in. He did not even include the withholding taxes from Mr. or Mrs. Tesoriero’s W-2s.

On August 15 the Tesoriero's filed their individual income tax return.

The must have had a good year, as their liability was around $280,000. Jack had extended the tax return showing a liability and tax paid-in of around $69,000.

The IRS sent a penalty notice that the return had not been extended. This made the return late-filed, and the late-file penalty is 5% per month.

            OBSERVATION: 5% of a big number is likely to be a big number.

The Tesoriero’s were not amused. They contested the penalty, explaining that the CPA had extended the return and therefore it was not late-filed. With that explanation, would the IRS be kind enough to abate the penalty?

The IRS did not and the matter went to the Tax Court.

In comes Jack Portney to explain his tax extension procedures. He was certain that the extension was mailed. It may not have been received, but it was mailed.

There is a presumption in the tax Code that a timely mailed return is timely received by the IRS. The issue with that presumption is when the return gets lost. One then needs a fallback position, and that fallback is to use certified or registered mail or an authorized delivery service. There have been court decisions that allow for other extrinsic evidence, such as an accountant’s mail log. Not all courts agree on the use of extrinsic evidence, however.

The Tesoriero’s were unfortunately in the Second Circuit, and the Second Circuit had previously decided that it would not accept extrinsic evidence to prove timely mailing. The Second Circuit includes New York, and there you simply have to use certified or registered mail or an authorized delivery company.

Here is the Court:

... such testimony is irrelevant in a case appealable in the Second Circuit. Mr. Portney did not mail the Form 4868 via certified or registered mail, nor did he use presumption of delivery. Because we cannot establish that respondent ever received the Form 4868, we cannot find that petitioner timely filed a valid extension request. Because the purported Form 4868 was not valid, petitioner did not timely file his 2004 tax return."

The Tesoriero’s came back and argued that they had relied upon a professional, and that surely this oversight could not be their fault. After all, how could they know the mail procedures that their CPA was using?

Here is the Court again:

Thus, petitioner can no more rely on Mr. Portney to file the extension than to file the return. Furthermore, the Court of Appeals for the Second Circuit has held that reliance upon an adviser to file an extension request does not constitute reasonable cause. Thus, petitioner's reliance upon Mr. Portney does not constitute reasonable cause."

The Court decided that the Tesoriero’s were subject to the late filing penalty.

My Take: Good grief! I practice in the Sixth Circuit, not the Second, but that does not mean that we do not have clients around the country – or the world - for that matter. Is a tax advisor to review every client for their specific Circuit and adjust his/her extension procedures accordingly?

Some things that Jack Portney did are standard: the postage meter, the secretary, the extensions in the mailbox. Others not so much: not keeping a mail log, for example. But a mail log would not have saved Tesoriero, as that would be considered extrinsic evidence.

Electronic filing may soon take this issue off the table. E-filing gives practitioners feedback on IRS acceptance, so any non-acceptance would be immediately flagged and corrected. This case gives an advisor (like me) impetus to insist upon e-filing all extensions.

I do feel bad for the Tesoriero's. I presume they claimed against their accountant’s malpractice or E&O insurance. Still, how can they be held responsible for tax arcana like this?

Change in Office-In-Home Rules (Starting Next Year)

The IRS surprised me yesterday.

Do you ever work from home? Let me phrase it differently: do you have an office-in-home, as the IRS defines the term?

I have an office at home and I work from home occasionally (I try to keep my workload at the office). I do not however have an office-in-home for tax purposes. Why? My office would have to meet one of three criteria to rise to a tax deduction:

 

(1)   My office–in-home is the principal place of my trade or business

·        I will not meet this test as I have an office in Cincinnati.

(2)   A place where I meet with clients, patients or customers in the normal course of my business

·        Granted, I do a lot of my work on a computer or over a cell phone, but I primarily meet with clients at my office in Cincinnati.

(3)   I work from home for the convenience of my employer

·        The IRS has interpreted this test to mean that the employer does not provide the employee with an office, so the employee – needing a place to work – has one in his/her home. If the employer does provide an office, one will have an almost insurmountable challenge in meeting this test. There may be some latitude in a hoteling situation, but you get the idea. I will likely fail this test.

Let’s say that you meet one of the three tests. Perhaps you freelance as a second job. That freelancing may qualify you for the office-in-home deduction. We meet for preparation of your taxes. We discuss expenses related to your office-in-home: the interest, taxes, utilities, insurance, security and etc. We calculate the depreciation. We then have to prorate between the personal use of your home and the business use. All the while, I am remembering that just putting this deduction on your return increases your odds of audit selection.

So the IRS came out yesterday and provided a simplified rule for an office-in-home. They will spot you $5 per square foot – up to 300 square feet - for your office. No depreciation. No proration of expenses. There is a downside: you will not be able to carryover excess office-in-home deductions under this method. There is an upside: you can elect annually which method you want to use. Obviously if you have more than 300 square feet, or your expenses run more than $5 per square foot, you will probably elect to use actual expenses.

• NOTE: The simplified election starts with tax year 2013. We cannot use this election when preparing your 2012 individual tax return, unfortunately.

By the way, let me clarify what the IRS means by office-in-home. Any direct expenses you have – say a camera or film for a photographer or payroll for an employee – are not considered office-in-home expenses. An alternate phrasing is that these expenses would be avoidable if you did not engage in the business activity. The office-in-home expenses are indirect and unavoidable. That is, you would still have the mortgage, taxes, and insurance whether you freelanced or not.

Haagen-Dazs and the King of Insurance

Let’s talk about a tax issue that has been evolving since the 1990s: can corporate goodwill not belong to the corporation itself?

With that tease, you can guess how festive tax CPA conferences can be.

The issue makes more sense if we discuss the associated tax problem. Let’s say that you have a company, and you have organized the company as a C corporation. A C corporation pays its own tax, as contrasted with an S corporation whose income is included on the owner’s personal tax return.  The S corporation owner is taxed on both his/her personal income as well as the business income. That business income can push him/her through the tax rates pretty quickly.

The problem occurs when a C corporation sells its business. If it sells assets (by far the preferred method for the non-Fortune 500), the corporation pays taxes on the sale, distributes what cash is left and then the shareholders get to pay taxes again on their exchange of shares. There used be a way to avoid this result (the General Utilities doctrine), but that option was eliminated back in 1986. This is one aspect of the double taxation associated with C corporations, and is also one of the reasons that many tax practitioners have moved their business clients to S corporations and LLCs.

OBSERVATION: By the way, we may see tax advisors moving their business clients back to C corporations, given the existing and expected Obama individual tax rates.

Let’s aggravate the double taxation by pointing out that a successful business probably has “goodwill,” which is something that a prospective buyer would be willing to pay for.

There was a famous case back in the 1990s called Martin Ice Cream. A father (Arnold Strassberg) and his son owned all the stock of Martin Ice Cream. Arnold had worked the industry for years and developed very strong business relationships. The owner of Haagen-Dazs approached Arnold, as they had been unable to penetrate the supermarkets. Voila – Martin Ice Cream began distributing Haagen-Dazs.

Several years go by. Haagen-Dazs wants to acquire Arnold’s relationships with the supermarkets, but they did not want to acquire Martin Ice Cream itself. A little tax planning and Martin Ice Cream created a subsidiary owning all the supermarket relationships. The subsidiary was spun-off to Arnold. The subsidiary sold all its assets to Haagen-Dazs for $1,500,000.

They now have the IRS’ attention. The IRS wants tax on the sale/liquidation of the subsidiary (a C corporation) as well as taxes from Arnold. Arnold says “I don’t think so,” and the issue goes to Tax Court. The Court determined that Martin Ice Cream never owned the relationships that Haagen-Dazs wanted, so it could not sell them. The relationships belonged to Arnold, who could and did sell them personally. That conclusion sidestepped the double taxation issue of a C corporation selling assets and liquidating. Tax advisors were frolicking in the streets.

We now have a 2012 case along these lines: H & M Inc v Commissioner. H & M was an insurance agency in North Dakota and was owned by Harold Schmeets. Harold was the big dog among insurance agents in that area. Here is the Court:

Despite the competitive market, Schmeets stood out among insurance agents in the area. He had experience in all insurance lines and all facets of running an insurance agency, including accounting, management, and employee training. He also had experience in a specialized area of insurance called bonding, and his agency was the only agency in the area, aside from the bank’s, that did this kind of work. There was convincing testimony that in that area around Harvey no one knew insurance better than Schmeets, and even some of his competitors called him the “King of Insurance.”

Wow! How would you like to be known as the “king of insurance”?

Harold’s deal was different from Martin Ice Cream. He sold the insurance agency for $20,000 but entered into an employment contract and non-compete for $600,000. The IRS argued that some of the compensation from the employment agreement and non-compete was actually disguised payment for the goodwill, triggering the double tax. The IRS wanted a check.

There were some technical problems with the transaction as structured, but in the end the Court determined that H & M did not own the goodwill. It could not sell what it did not own, and the IRS lost the case.

A key fact in both Martin Ice Cream and H & M is that the shareholder and key employee did not have a non-compete with their company. From a business perspective, this meant that neither owner was restricted from going down the street and opening another company competing with Martin Ice Cream or H & M. Granted, neither would do so (of course), but he could.  That could means all the difference in the tax world.

How do advisors handle this in practice? We had a dentist as a client. He owned a two-location practice with another dentist, but he was the majority shareholder and by far the key man. Upon investigation, we discovered that the attorney had drafted – and our client had signed – a non-compete with his dental practice. The situation was complicated because there was another shareholder, but we recommended that the non-compete be terminated. A significant portion of the practice’s value was patient loyalty, and the value of this asset (think goodwill) would be materially impaired if our client opened a competing dental practice down the street.

COMMENT: If this is you, please review whether you have a non-compete in place. Many times attorneys draft such documents on a near-routine basis. That doesn’t mean that it makes sense for your situation, however.

2013 W-2 Reporting For Larger Employers

I was reminded that there is new W-2 reporting for larger employers this year.

If you will be issuing more than 250 Forms W-2 this month, please remember that you have to include and report the cost of employer-sponsored health insurance provided to the employee during 2012.

Smaller employers are exempt from this requirement for the 2012 W-2s.

The IRS wants taxpayers to know that this reporting is just “informational.” The amount paid is not taxable to the employee for 2012.

COMMENT: Call me a cynic, but why do I believe that the key word in the above sentence is “2012?”