The IRS Could Not Collect When Limitations Period Expired

Let’s talk a bit about the tax statute of limitations.

There are two limitations periods, and it is the second one that can lead to odd results.

(1) The first one is referred to as the limitations on assessments. This is the three-year period that we are familiar with. The IRS has three years to audit your return, for example. If they do not, then – in general – the opportunity is lost to them.

There are a number of ways to extend the three-year period. When I was young in the profession, for example, tax practitioners would “hold back” certain tax deductions until the client was closing-in on the three years. With a scant few and breathless days remaining before the period expired, they would file amended tax returns, thereby obtaining a refund for the client and simultaneously kneecapping the IRS’ ability to look at the return.

The rules have been revised allowing the IRS additional time when this happens. I have no problem with this change, as I consider the previous practice to be unacceptable. 

(2) The second one is the collections period, and this one runs ten years.

Say you filed your return on April 15, 2014. You got audited and the IRS assessed $15,000 on December 15, 2015. The IRS has ten years – until December 15, 2025 – to collect.

There are things that can extend (the technical term is “toll”) the collections period. Make an offer in compromise, for example, and the period gets tolled. 

Sometimes tax practice boils down to letting the ten-year period click-off, hoping that the IRS does not initiate action. It happens. A few years ago I had a client who had moved to Florida, remarried and had her new husband involve her in an unnecessary tax situation. It was extremely unfortunate and she was extraordinarily ill-advised. He passed away, leaving her as the remaining target for the IRS to pursue. She had a fairness argument, but that meant as much as a snowball in July to IRS Collections. They have a different mind frame over there.

So I am looking at a case where a taxpayer (Grauer) had an issue with his 1998 tax return. He filed it late (in 2000).  That was his first problem. He owed around $40 grand, which quickly became almost $58 grand when the IRS was done tacking-on interest and penalties. That was his second problem. He could pay that much money about as easily as I can fly.

In 2001 he signed a waiver, extending the ten-year collections period.

What makes this point interesting to a tax nerd is that someone would not (knowingly) sign a waiver without something else going on.  In fact, Congress disallowed this in the late nineties, responding to perceived IRS abuses - especially in Collections.

Sure enough, the IRS said that he signed an installment agreement in 2001 (around the time of that waiver), but that he broke it in 2006

Grauer said that he never signed an installment agreement.

It was now 2013, and off to Tax Court they went.

The Court looked at the account transcript, which showed that the IRS had issued an earlier Notice of Intent to Levy.  This was an immediate technical issue, as the Court would not have jurisdiction past the first Notice. The IRS persuaded the Court that the transcript was wrong. 

COMMENT: Your transactions with the IRS go to your “account.” That account is updated whenever a transaction occurs. The posting will include a date, a code, and sometimes a dollar amount and perhaps a meaningful description.  Some codes are straightforward, some are cryptic. 

The Court next observed that Grauer asserted that he had not signed a payment plan. In legal jargon, this was an “affirmative defense,” and the IRS had to prove otherwise. The IRS argued that its transcript was correct and that Grauer was incorrect.

The Court was a bit flummoxed by this response. The IRS was having it both ways.

The Court told the IRS to “show us the installment agreement.” 

The IRS could not.

The Court went on to describe the IRS account transcript as “indecipherable and unconvincingly explained.”

The Court decided for the taxpayer.

Remember: ten years had passed. The waiver needed to attach to something. In the absence of something, the waiver fizzled and had no effect.

The statute had expired.

Did the taxpayer get away with something?

I don’t know, but think about the alternative. Let’s say that the IRS could post whatever it wanted – to speak bluntly, to make things up – to your account. You then get into tax controversy. You are required to prove that the IRS did not do whatever it claimed it did. Good luck to you in that scenario. I find that result considerably more unacceptable than what happened here.

How To Lose A Tax Deduction For Wages Paid

This weeks’ tax puzzler involves a mom and her kids.

We again are talking about attorneys. Both mom and dad are attorneys, and mom is self-employed.

Sometimes she brought her children to the office, where they helped her with the following:

·        answering the telephone

·        mail

·        greeting clients

·        photocopying

·        shredding unneeded documents

·        moving files

Mom believed that having her children work would help them understand the value of money and lay the foundations for a lifelong work ethic.

She had three kids, and for 2006, 2007 and 2008 she deducted wages of $5,500, $10,953 and $12,273, respectively.

There are tax advantages to hiring a minor child. For example, if the child is age 17 or younger, there are no social security (that is, FICA) taxes. In addition, there is no federal unemployment tax for a child under age 21, but that savings pales in comparison to the FICA savings.

Then you have other options, such as having the child fund an IRA. All IRAs require income subject to social security tax. It doesn’t matter if one is an employee (FICA tax) or is self-employed (self-employment taxes), but social security is the price of admission.

Her children were all under the age of ten. Can you imagine what those IRAs would be worth 50 years from now?

The IRS disagreed with her deducting payroll, and they wound up in Tax Court.

Your puzzler question is: why?

(1) You: The Court did not believe that the kids really did anything. Maybe she was just trying to deduct their allowances.

Me: The tax law becomes skeptical when related parties are involved, and you cannot get much more related than a mother and her children.  It was heightened in this case as the children were so young. For the most part, though, the Court believed her when she described what the children did.

(2) You: Mom used the money she “paid” the kids for their support – like paying their school tuition, for example.

Me: The tax law disallows a deduction if the money is disguised support, which tax law expects to be provided a dependent child. In this case, the Court saw the children buying books, games and normal kid items; some money also went to Section 529 plans. The Court did not believe that mom was trying to deduct support expenses.

(3) You: She could not provide paperwork to back-up her deductions. What if she paid the kids in cash, for example?

Me: Good job. One reads that the Court wanted to believe her, but she presented no records. She did not provide bank statements showing the kids depositing their paychecks, presumably because the children did not have bank accounts.

She did not provide copies of the Section 529 plans. That was so easy to do that I found the failure odd.

At least she could show the Court a Form W-2.

Mom had not even issued W-2s.

The Court was exasperated.

It allowed her a deduction of $250 per child, as it believed that the kids worked. It could not do more in the absence of any documentation.

And there is the answer to the puzzler.

Too often it is not mind-numbing tax details that trip-up a taxpayer. Sometimes there is just a lapse of common sense.

Like issuing a W-2 if you want the IRS to believe you paid wages to somebody.

 

Do You Have to Disclose That?

I was recently talking with another CPA. He had an issue with an estate income tax return, and he was wondering if a certain deduction was a dead loser. I looked into the issue as much as I could (that busy season thing), and it was not clear to me that the deduction was a loser, much less a dead loser.

He then asked: does he need to disclose if he takes the deduction?

Let’s take a small look into professional tax practice.

There are many areas and times when a tax advisor is not dealing with clear-cut tax law.

Depending upon the particular issue, I as a practitioner have varying levels of responsibility. For some I can take a position if I have a one-in-five (approximately) chance of winning an IRS challenge; for others it is closer to one-in-three.

There are also issues where one has to disclose to the IRS that one took a given position on a return. The concept of one-in-whatever doesn’t apply to these issues. It doesn’t have to be nefarious, however. It may just be a badly drafted Regulation and a taxpayer with enough dollars on the line.

Then there are “those” transactions.

They used to be called tax shelters, but the new term for them is “listed transactions.” There is even a subset of listed transactions that the IRS frowns upon, but not as frowny as listed transactions. Those are called “reportable transactions.”

This is an area of practice that I try to stay away from. I am willing to play aggressive ball, but the game stays within the chalk lines. Making tax law is for the big players – think Apple’s tax department – not for a small CPA firm in Cincinnati.

Staying up on this area is difficult, too. The IRS periodically revises a list of transactions that it is scrutinizing. The IRS then updates its website, and I – as a practitioner – am expected to repeatedly visit said website patiently awaiting said update. Fail to do so and the IRS automatically shifts blame to the practitioner.

No thanks.

I am looking at a case involving a guy who sells onions. His company is an S corporation, which means that he puts the business numbers on his personal return and pays tax on the conglomeration.

His name is Vee.

He got himself into a certain type of employee benefit plan.

A benefit plan provides benefits other than retirement. It could be health, for example, or disability or severance. The tax Code allows a business to prefund (and deduct) these benefits, as long as it follows certain rules. A general concept underlying the rules is risk-taking and cost-sharing – that is, there should be a feel of insurance to the thing.

This is relatively easy to do when you are Toyota or General Mills. Being large certainly makes it easier to work with the law of large numbers.

The rules however are problematic as the business gets smaller. Congress realized this and passed Code Section 419A(f)(6), allowing small employers to join with other small employers – in a minimum group of ten – and obtain tax advantages  otherwise limited to the bigger players.

Then came the promoters peddling these smaller plans. You could offer death and disability benefits to your employees, for example, and shift the risk to an insurance company. A reasonable employer would question the use of life insurance. If the employer needed money to pay benefits, wouldn’t a mutual fund make more sense than an illiquid life insurance policy? Ah, but the life insurance policy allows for inside buildup. You could overfund the policy and have all kinds of cash value. You would just borrow from the cash value – a nontaxable transaction, by the way – to pay the benefits. Isn’t that more efficient than a messy portfolio?

Then there were the games the promoters played to diminish the risk of joining a group with nine others.

Vee got himself into one of these plans.

He funded the thing with life insurance. He later cancelled the plan, keeping the life insurance policy for himself.

The twist on his plan was the use of experience-rated life insurance.

Experience-rated does not pay well with the idea of cost-and-risk sharing. If I am experience rated, then my insurance cost is based on my experience. My insurance company does not look at you or any of the other eight employers in our group. I am not feeling the insurance on this one.

Some of these plans were outrageous. The employer would keep the plan going for a few years, overpay for the insurance, then shut down the plan and pay “value” for the underlying insurance policy. The insurance company would keep the “value” artificially low, so it did not cost the employer much to buy the policy on the way out. Then a year or two later, the cash value would multiply ten, twenty, fifty, who-knows-how-many-fold. This technique was called “springing,” and it was like finding the proverbial pot of gold.

The IRS had previously said that plans similar to Vee’s were listed transactions.

This meant that Vee had to disclose his plan on his tax return.

He did not.

That is an automatic $10,000 penalty. No excuses.

He did it four times, so he was in for $40,000.

He went to Court. His argument was simple: the IRS had not said that his specific plan was one of those abusive plans. The IRS had said “plans similar to,” but what do those words really mean? Do you know what you have forgotten? What is the point of a spice rack? Does anybody really know what time it is?

Yea, the Court felt the same way. The plan was “similar to.” They were having none of it.

He owed $40,000.

He should have disclosed.

Even better, he should have left the whole thing alone.

Taxation of Disability Insurance

I was recently reviewing an individual tax return. There was something on there that distresses me.

This client walked into a tax trap, and that trap has gone off.  Unfortunately, there is nothing that can be done.

Let’s talk about disability insurance.

This client is a personal friend. You and I would agree that he is a high-incomer. He works for a large employer on the Kentucky side. One of the advantages of a large employer is the benefits. One of the benefits his provides is employer-funded long-term disability insurance.

He got hurt and hurt badly. He is now collecting on the disability insurance, and probably will be for a long time.  

Did you know that disability insurance can be taxable?

How?

There is extensive tax law on the taxation of disability insurance, and there are different answers depending upon who is paying the premiums and whether it is a group or individual policy. There is an overarching theme, though:

Disability benefits are taxable to the extent that the premiums were not included in income.

His long-term insurance was 100% employer-paid and 100% excluded from W-2 income. While this was beneficial to him then, it is the worst-case scenario now.

Long-term policies can be expensive. Take someone who is pushing the top tax brackets, and a recommendation to pay tax can mean thousands of extra dollars. Combine that with an all-too-human “it cannot happen to me” response, and it is easy to understand the reluctance.

And that is assuming the tax advisor is even aware of what is happening. Employer-provided disability insurance would not necessarily appear on any documents one would be reviewing. There are good odds that you and your tax advisor will be learning about your disability insurance together.

And so he has to pay tax on disability at the same time that his earning power is reduced.

Is there a compromise?

I think so, but – again – it has to be done upfront. I have no problem with short-term disability being taxable, whether because the premiums are employer-paid or because you run the premiums through your cafeteria plan. This is the insurance you buy from Aflac, for example, and it pays you for six months or a year if you get hit by the proverbial bus. Yes, it would stink to have to pay taxes, but it would only be for a short period of time. The expectation of this insurance is that you will heal and get back to work.

But long-term disability is different enough to warrant a different answer. You almost surely want to make sure this is paid with after-tax monies. If you are unfortunate enough to collect on this type of insurance, you do not need to compound the misfortune by having taxes as part of your household budget.