Vacation Or Business Deduction?

Let’s say that we work together. I cannot attend an appointment with a new client first thing in the morning. You volunteer to cover for me.

By the way, welcome to tax practice. Believe me, it is not the glitz and glamour that Hollywood makes it out to be. I know: hard to believe.

You meet the Fishers. They are both attorneys, he as partner in a firm and she as a sole practitioner. They have three children, all under the age of 10. She takes her kids to work periodically for the customary reason: the cost of day care and family members unable to care for the kids at the time.

She had an opportunity to represent a client in the Czech Republic for a few weeks, and she took it. It turned out however that he was unable to watch the kids. Seeing herself in a jam, she took the kids with her but came up with a novel twist:

She would write a travel book about the Czech Republic. It would be written to and for kids and would lessen their tedium while travelling.

She had no previous writing experience, so this was new territory. It occurred to her that other parents might be interested in such books – and this could be a business opportunity for a sharp and motivated person.

She has kept this up now for three years. She has now taken the kids to Disney World as well as to several cities in Europe.

You talk to her about the IRS and its “hobby loss” rules. She is an attorney, not a writer; there is a gigantic personal enjoyment factor present, ….

She cuts you off. Remember: she is an attorney. She has read up on this area of tax law, and she thinks she meets the requirements. For example,

·        She consulted with one of her clients, a published author, who gave her advice on both writing and publishing.

·        That person introduced her to a book distributor, who suggested she hire a graphic designer. She did so.

·        She also consulted with a friend who works at HarperCollins; the friend recommended she hire an agent. She has not done that yet.

·        She completed four prototype books, but has not submitted them for publication. She has instead self-published. Sales however have been minimal.

The Fishers need to file returns for the last three years. Her combined loss from the book-writing activity is approximately $75,000.

They ask whether you can prepare their returns and claim the book-writing loss.

What do you say?

The big issue is whether the activity rises to the level of a tax deduction. You remember some of the factors that the IRS uses to identify a hobby:

·        Not run in a business-like fashion

·        Failure to consult experts

·        Failure to revise business plans when losses pile up

·        Profits dwarfed by the losses

But Ms. Fisher has been meeting people. She has made contacts at a publishing house. She has written prototypes. She has self-published. She seems to be getting some things right.

You don’t see a clear-cut answer. Two people can reasonably disagree. The problem of course is that the IRS has a bit more horsepower than the average person you might disagree with.

You wobble. You tell them that you want to review the literature in this area, as the issue is walking the grey lands. You will call them tomorrow.

We have a chance to talk about the meeting.

I see two things immediately:

(1)   Can we prepare and sign the return under professional standards?

(2)   If so, there is still a significant chance that they would lose the deduction on audit.

Professional standards allow a tax practitioner some leeway when confronted with certain issues. This is fortunate, or professional practice would likely grind to a near halt.  The bar can be higher or lower depending upon the particular issue under discussion. Take a “listed transaction,” for example, and the bar is pretty high. Listed transaction is jargon for tax shelter, and we are nowhere near that with the Fishers. Our bar is much lower.

However, I would say our best chance with the IRS is 50:50, and likely less than that.  We would discuss this with the client and allow them to decide. It is their return, after all. Maybe they will get another accountant’s opinion. Maybe I am wrong.

This is a real case, by the way.

The Fishers are from New York and took this issue to Tax Court.

They lost.

The Court decided that her activity was not so much a business as her investigating going into business. The Court pointed out a few things: she had not hired an agent, had not finalized a book, and had not submitted a proposal to a publishing house. Since business activity had not started, it did not have to consider whether the activity was a hobby.

No business activity = no business deduction.

What do I think?

The Court saw too much personal and not enough business. I suppose that had she been making money the Court may have relented. She had to clear the hurdle of deducting what many people would see as vacations, and that required some serious weight on the other end of the see-saw to sway the Court.

Getting ROBbed

I was skimming a Tax Court decision that leads with:

“… respondent issued a notice of deficiency … of $249,263.62, additions to tax … of $20,228.76 and $22,476.41, respectively and an enhanced accuracy-related penalty … of $63,918.33”

It was Roth IRA decision.

We have spoken before about putting a business in an IRA, and a Roth is just a type of IRA. This tax structure is sometimes referred to as a “ROBS” – roll-over as business start-up. 

Odds are the only one who is going to get robbed is you. I had earlier looked into and decided that I did not like the ROBS structure. There are too many ways that it can detonate. I do not practice high-wire tax.  

I have also noticed the IRS pursuing this area more aggressively. There often is complacency when a “new” tax idea takes, as the IRS may not respond immediately. That lag is not an imprimatur by the IRS, although self-interested parties may present it as such. I have been in practice long enough to have heard that sales pitch more than once.

Let’s discuss Polowniak v Commissioner.

Polowniak had over 35 years of marketing experience with Fortune 500 companies, including Proctor & Gamble, Johnson & Johnson and Kimberly Services. In 1997 he formed his own company – Solution Strategies, Inc. (Strategies). He was the sole shareholder and its only consultant.

In 2001 he received a nice contract - $680,000 – from Delphi Automotive Systems – which had him travel extensively to Europe, Asia and South America. 

Now the turn. His financial advisor recommended an attorney who pitched the idea of “privately owned Roth IRA corporations,” also known as PIRACs. These things are not rocket science. In most cases an individual already has an existing company, likely profitable or soon to be. Said individual sets up a Roth IRA. Said Roth purchases the stock of a new corporation (NewCo), which amazingly does exactly the same thing that the existing corporation did, and likely with the same customers, vendors, employee, office space and so on.

The idea of course is that NewCo is going to be very profitable, which allows the opportunity to stuff a lot of money into the Roth in a very short period of time.

So Polowniak sets up a NewCo, which he names Bevco Investments, Inc. (Bevco). There is a little flutter in the story as Bevco selects a January year-end, meaning that a sharp tax advisor may have the opportunity to move things back-and-forth between a calendar-year taxpayer and an entity that doesn’t file its tax return until a year later.

This is fairly routine tax work.

Polowniak owned 98 percent and his administrative assistant owned 2 percent.  His wife later purchased 6% of Bevco.

Strategies and Bevco entered into an agreement whereby it would receive 75% of Strategies revenues for 2002.

By the way, Delphi was never informed of Bevco. Neither was the administrative assistant.

The years passed. Polowniak let the subcontract with Bevco lapse.

And he started depositing all the Strategies revenue from Delphi into Bevco. There was no more pretense of 75 percent.

Bevco was finally dissolved in 2006.

And then came the IRS.

It went after Solutions, which did not report the $680,000 from Delhi. You remember, the same amount it was to share 75% with Bevco.

Sheesh.

It also came after Polowniak personally. The IRS wanted penalties for excess funding into a Roth.

Huh?

There are limits for funding a Roth. For example, the 2015 limit for someone age-50-and-over (ahem) is $6,500. If you go over, then there is a 6% penalty. Mind you, the 6% doesn’t sound like much, but it becomes pernicious, as it compounds on itself every year. Tax practitioners refer to this as “cascading,” and the math can be surprising.

How did he overfund?

Simple. He took existing money from Solutions and put it into Bevco. It is the equivalent of you depositing money at Key Bank rather than Fifth Third.

Polowniak’s job right now was to convince the Court that was a substantive reason for the Solutions –Bevco structure. If Bevco was just an alter ego, he was going to lose and lose big.

He trotted put Hellweg, a tax case featuring Roth IRAs and Domestic International Sales Corporations (DISCs). Whereas the taxpayer won that case, there was some arcane tax reasoning behind it, likely exacerbated by those DISCs.

The Court did not think Hellweg was on point. It thought that Repetto was much more applicable, pointing out:

·        All the services performed by Bevco had previously been performed by Polowniak through Strategies

·        Polowniak performed all the services under the contract with Delphi

·        Since he was the only person performing services, the transfer of payments between Strategies and Bevco had no substantive effect on the Delphi contract

·        Delphi did not know of the contract with Bevco; in fact, neither did the administrative assistant

·        The business dealing between Strategies and Bevco were not business-normative. For example, Bevco never kept time or accounting records of its services, nor did it ever invoice Strategies.

The Court decided against Polowniak. It did not respect the PIRAC, and as far as it was concerned all the Delphi money put into Bevco was an overfunding.

And that is how you blow through a third of a million dollars.

Is there something Polowniak could have done?

He could of course have respected business norms and treated both as separate companies with their own accounting systems, phone numbers, contracts and so forth. It would have helped had Strategies not been depositing and withdrawing monies from Bevco’s bank account.

Still, I do not think that would have been enough.

There are two major problems that I see:

(1) There was an existing contract in place with Delphi. This is not the same as starting Bevco and pounding the streets for work. There is a very strong assignment of income feel, and I suspect just about any Court would have been disquieted by it.

(2) There were not enough players on the field. If I own a company with 75 employees, I may be able to take a slice of its various activities and place it inside a PIRAC or ROBS or whatever, without the thing being seen as my alter ego. Polowniak however was a one-man show. This made it much easier for the IRS to argue substance over form, which the IRS successfully argued here.

 

My advice? Leave these things alone. There are a hundred ways that these IRA-owned companies can blow up, and the IRS has sounded the trumpet that it is pursuing them.

Pay Payroll Taxes Or Go Out Of Business?

We have talked before about the “big boy” penalty. It is one of the harshest penalties in the tax Code.

This is a payroll related penalty. It is not because you were late with a payment or failed to send in a return on time. No sir, it kicks in when you do not send the government any money at all.

And I am reading about two guys who decided to play big boy. One of them surprised me.

The company itself was based in Rhode Island and provided wireless internet in public spaces. Think Facebook at the airport, for example.

Business tanked. Cash was tight. Vendors did not get paid, including the IRS.

The company needed help. They hired Richard Schiffmann as president in October, 2004. In October, 2005 he brought in Stephen Cummings (who had worked there previously as a consultant) to be chief financial officer.

Cummings quickly found out they had problems with back taxes.

The Board granted check-signing authority to the pair: Schiffmann up to $100,000 and Cummings up to $75,000.

The two tried; they really did. But there was nothing there. The Board fired the two in June, 2006.

You know that the IRS eventually knocked on the door. They were angry and they wanted scalps. They went after Schiffmann and Cummings for the big boy penalty.

In the literature, this is known as the trust fund recovery or responsible person penalty. It addresses the income and FICA taxes withheld from employees. Mind you, the IRS wants the employer FICA also, but it is emphasizing the employee withholding. The IRS takes the position that this was never the employer’s money, whose function was solely to transfer the money as agent for the employees to the IRS.

The penalty is 100%.

It is intended to be Defcon 1.

The IRS went after Schiffmann for $394,334 and against Cummings for $254,280.

Think about this. You got hired. You were there for nine months. I doubt you got paid anywhere near $254,280. This is the lousiest job ever.

The two fought back, although there were some procedural misses we will not discuss but which leave me scratching my head. The two for example raised the following arguments:

(1) Schiffmann argued that he did not learn of the liability until late 2005. The most he could be liable for is two or three quarters, which would not add-up to $394 thousand.

He had a point. The penalty technically goes quarter-by-quarter.

But only in a classroom or in a textbook. In the real world, the IRS will argue that – if you could write a check – then you could have written checks for both current and past payroll taxes. Those past taxes become your problem.

And Schiffmann could write checks up to $100,000. Cummings could write up to $75,000.

Gentlemen, let me introduce problem. Problem, let me introduce gentlemen.

(2) They argued that all monies were encumbered and spoken for. They remitted what they could.

This is the “I had to pay … or the business would have folded” argument.

The IRS will respect encumbrances, but there better be a legal obligation. A pinky swear is not enough. 

The IRS will not respect a responsible person prioritizing them down, when the IRS had as much right to what money may exist as anyone else.

Schiffmann and Cummings could not meet that test.

(3) The Board would not let them pay certain bills.

More specifically, the Board would not let them pay taxes.

Now we have something. The IRS looked into this. It decided that there were two directors who raised a fuss, but it also decided that those two could be outvoted by the remaining directors.

And the directors never formally voted on a resolution, so the IRS could presuppose that the two would have been outvoted.

Then the IRS made an interesting observation: EVEN IF the Board has prohibited the two from paying the taxes, the most that would have happened is that the Board would have joined them in also being subject to the penalty. It would not have gotten Schiffmann and Cummings off the hook.

The two were held responsible.

Cummings was the one who surprised me.

He used to be an IRS field auditor.