JPMorgan's Nondeductible Madoff Deal

On January 7, 2014, JPMorgan entered into a deferred prosecution agreement with the Justice Department. This is another payment in the ongoing Bernie Madoff saga, and the bank agreed to pay a $1.7 billion settlement as well as $350 million to the Office of the Comptroller of the Currency and $543 million to a court-appointed trustee.

Madoff kept significant balances with JPMorgan.  Banks are the first line of defense against fraud, but JPMorgan never filed suspicious activity reports with regulators, even though there were significant reservations as to when they became suspicious. The bank did not admit any criminal activity in the agreement, but it did allow that it missed red flags from the late 1990s to late 2000s.

What caught my eye was the following text from the following joint release by the Manhattan U.S. Attorney and FBI:
           

… JPMorgan agrees to pay a non-tax deductible penalty of $1.7 billion, in the form of a civil forfeiture, which the Government intends….”

This is unusual language.

The tax code provides a tax deduction for all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

And then the tax Code starts taking back. One take back is Section 162(f):

162(f) FINES AND PENALTIES.— No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.

Let’s drill down a little bit into the Regulations:

This prohibition applies to any fines paid by a taxpayer because the taxpayer has been convicted of a crime (felony or misdemeanor) in a full criminal proceeding in an appropriate court.   The prohibition also extends to civil fines if the fines are intended by Congress as punitive in nature.

So, if fines are paid pursuant to a criminal case, then the taxpayer is hosed. However, if fines are paid pursuant to a civil case, there is one more step: are the fines punitive in nature?

Attorneys differentiate damages between those that are remedial and those that are punitive. A remedial payment is intended to compensate the government or another party – to “make one whole,” if you will. It is intended to restore what was disturbed, upset or lost, and not intended as penalty or lashing against the payer.

Let’s complicate it bit. There is a court case (Talley Industries Inc v Commissioner) that allows damages to be deductible if they are remedial in intent, even if labeled as a fine or penalty.

EXAMPLE: The NFL fines a player for unnecessary roughness. The NFL can call this a fine, but it is not a fine per Section 162(f) and will be deductible to the player involved.

You are seeing how this is fertile hunting ground for tax lawyers. Unless the payment is pursuant to a criminal case, odds are good that it is deductible.

Now remember that this agreement is Madoff related, and that there are hard feelings about JPMorgan’s involvement with Madoff over the years, and you can see why the Justice Department included the “nondeductible” language in the agreement.

Let’s take this a step further. Under Talley, JPMorgan could deduct the $1.7 billion on its tax return. Remember, it is not a fine or penalty under Sec 162(f) just because somebody somewhere called it as such.

Would JPMorgan be likely to do this?

This is a “deferred prosecution” agreement.  If JPMorgan did deduct the settlement, they might not have an issue with the IRS, but they would likely have a very sizeable issue with the Justice Department.

Are You Automatically Liable For Taxes On a Fraudulent IRA Withdrawal?

Sometimes people pursuing a divorce do stupid things.

I am looking this afternoon at Roberts v Commissioner.

The first thing I am thinking is that the wife will be fortunate to not be criminally charged. The second thing I am thinking is that the IRS could not present a more unfriendly face if they cast polar bears adrift on ice floes.

The Roberts in the case is the husband (H).

Roberts and his wife (W) married in 1990. They separated in 2008, permanently separated in 2009 and divorced in 2010.

Roberts and his wife kept joint bank accounts. After they separated, W kept the account at Washington Mutual and he kept his account at Harborstone. He did not have a checkbook for, write checks on or make withdrawals from Washington Mutual. In short, he had no idea about that account, despite the fact that his name was still on it.

In September 2009 one of his IRA custodians received a faxed withdrawal request for $9,000. The fax came from the company for which W worked. Coincidence, surely. The request was signed, but it was not signed the way Roberts normally signed his name.

A second IRA custodian also received two withdrawal requests, the first for $9,000 and the second for $18,980.

All the monies were deposited to that Washington Mutual account.

This took place over a two-month period. During that stretch, the wife deposited approximately $4,000 from her paycheck. She however spent over $41,000 from the account. The Court asked her about this discrepancy:

“We do not find credible [the wife’s] testimony that she was unaware of the sources of the deposits made to the Washington Mutual account when, in many instances, the deposits dwarfed the account’s balance at the time.”

Roberts let his wife prepare the 2008 tax return. Why not? She had prepared the returns for prior years.

She filed her return as “married filing separately.”

She filed his return as “single.”

She decreased the amount of his W-2 by $3,000. She increased his withholding by $3,000.

And she had his refund deposited to her bank account at Washington Mutual.

Roberts never saw the tax return.

You have figured out what was happening, of course.

Roberts continued oblivious to all this until he receives those pesky Forms 1099-R from the IRA custodians. Surely, they made a mistake. Alternatively he was the victim of a theft, he reasoned.

As the divorce grinds on he learned the truth of the matter. The divorce court considered the withdrawals when separating the property between the spouses.

In 2010 the IRS notified Roberts that they want almost $14,000 in tax and approximately $3,300 in penalties.

To say that the IRS took a strict reading of the tax law is to understate things. They argued: 

(1)  The income was his because he was the owner of the IRA accounts.

(2)  The monies were deposited into Washington Mutual, a jointly owned account.

(3)  The monies were used to pay for “family” expenses.

(4)  He never attempted to return the monies to the IRAs, even after he learned of the withdrawals.

Because of all this, the IRS argued that Roberts had unreported income in 2008.

It is pretty easy to tell that the Tax Court knew that the wife was lying. The Court also was brooking little patience for the IRS’ hyper-technical reading of the law, such as:

Roberts must include in income the amounts withdrawn from his IRAs even though he did not consent nor was he aware the distributions occurred.

Then the IRS trotted out two Tax Court decisions in Bunney and Vorwald.

In Bunney the IRS argued that the recipient of an IRA distribution was automatically the taxable party. 

COMMENT: The Court did not accept that argument in that case. Why would they do so now?  

In Vorwald the Court decided that a mandatory IRA distribution pursuant to a court-ordered garnishment for child support was income to the taxpayer.

            COMMENT: The IRS made more sense with this cite.

The problem with Vorwald is that the taxpayer had a legal obligation, and his IRA account was drained pursuant to that legal obligation. In the instant case Roberts was – essentially – robbed. He did not know that his wife was taking out monies to set up her post-divorce household, with a vacation sprinkled in.

The IRS then brought up their (in my opinion) best argument. In Washington state (where Roberts and his wife resided), an individual must discover and report unauthorized signatures within one year – essentially, a one-year statute of limitations.  Roberts did not do that. Granted, the withdrawals were taken into consideration when dividing marital property, but Roberts did not press for return of the monies.

And the Court did something unexpected: it paused. The IRS had a valid point. However, if there was a one-year statute of limitations, then Roberts had until 2009 to press his case. The Court looked at the tax years the IRS was challenging: year 2008 only. No year 2009.

Oops, said the Court. Sorry IRS. You flubbed.

The Court dismissed any taxes and penalties attributable to the IRA mess. It did allow taxes and penalties attributable to other minor issues on Roberts’ tax return.

We sometimes used to include a moral when reviewing tax cases. What would be the moral for today’s discussion? How about …

If you are divorcing, you may want to separate your finances, including your bank account – and your tax return – from the person you are divorcing.

Just saying.

IRS New Fast Track Settlement Program (Or The Audit From Hell)

We very recently concluded the appeals of a tax audit that had dragged out for years. A CPA friend had begun the audit, and he eventually brought me in as a hired gun to represent on selected issues. He was facing a young examiner who – while bright enough – did not have the accounting background or tax experience to understand the waters he had waded into.

I will give you an example. My friend’s firm did the routine bookkeeping for this client. The routine pretty much consisted of tracking bank accounts and notes payable, with no monthly adjustments to Accounts Receivable or Accounts Payable. Those two accounts put the books on an “accrual basis,” so my friend was essentially maintaining the books on a “cash basis.”

At the end of a period (say year-end), he adjusted the books with the following entries:

            Accounts Receivable                              XXXX

                    Revenues                                                 XXXX

            Some Expense Account                         XXXX

                    Accounts Payable                                    XXXX

When I was a young accountant, I saw this bookkeeping more times than I can count.

The examiner came across one of those interim ledgers without revised Accounts Receivable and Accounts Payable, and he charged the client with maintaining two sets of books.

It was one of the few times I seriously considered running an examiner to ground. And yes, I did discuss the matter with the group manager. A charge like that borders on alleging fraud. The client hated (and hates) the IRS, but at no time was there fraud.

The examiner’s inability to comprehend routine bookkeeping alerted me that the audit was going to be rough. It was. Eventually I took over the audit, and my friend was glad to hand it off. To be fair, he is a general practitioner while I have specialized in tax for years. I guess I am more accustomed to beating my head against a wall.

It was a pain. We had complex tax issues, like methods of accounting and tax credits, and the examiner had already stumbled over prosaic stuff.

We tried to force issues away from the examiner and to the group manager. We appeared to have agreement from the manager, only to see issues reappear like some accounting knock-off of The Living Dead.

So now I am looking at the expanded IRS Fast Track Settlement Program. Fast Track has been around for years, but it has been limited to larger companies. The IRS has now expanded the program to smaller businesses and self-employed taxpayers. The program is an alternative to standard dispute resolution arising from an IRS audit.

There are requirements, of course. The issues must be fully developed, which is a fancy way of saying that both sides have presented their reasoning, with supporting authority and footnotes and all that. The taxpayer, the examiner or the group manager can initiate the request, which will go to IRS Appeals.

NOTE: What makes it “fast track” is the change in administrative procedure. Normally I have to wait for the examiner (that is, Examination) to write-up his/her adjustments and submit it in the form of a 30-day letter. I then appeal the 30-day letter. This program instead hauls one or more issues out of Examination and immediately puts it with Appeals. In effect, Examinations and Appeals are working simultaneously and before any of those 30-day or 90-day letters go out. 

If Appeals accepts the request, its goal is to resolve the matter within 60 days.

            COMMENT: Big improvement over the audit from hell.

To be able to respond so quickly, Appeals will not accept certain cases, such as correspondence audits or where Appeals believes the taxpayer has not worked fairly with the IRS.

If you change your mind, you can withdraw from Fast Track.

And, if Appeals decides against you, you still have the traditional Appeals rights you would have had anyway.

How did the audit from hell turn out? Examination wanted over $310 thousand. We went to Appeals. We just settled the case for around $5 thousand. Not bad, except for the tax fees the client had to pay for an audit that ran off the rails. 

How Early Can You File Your 2013 Tax Return?

How soon can you file your 2013 tax returns?

• If we are talking about your individual income tax return, you have to wait the entire month of January. The IRS will not open its electronic filing system until Friday, January 31.
• If we are talking about a business return (Form 1120, 1120S, 1065), you can file more than two weeks earlier – on Monday, January 13.

IRS Income Statistics For 2011 Are Out

IRS statistics are out.

• The top 1% of all filers paid approximately 35.1% of all federal income taxes. It takes adjusted gross income (AGI) of at least $388,905 to make the top 1%
• The top 5% paid 56.5%, with AGI of $167,728
• The top 10% paid 68.3%, with AGI of $120,136

The bottom 50%? They paid 2.9% of all federal income taxes. 

One should include the obligatory caveat that above statistics refer to federal income taxes and do not include social security taxes. It is questionable whether that adjustment would make any significant difference, though.