The Goose And Gander Tax Bill

Here is something that will catch your eye:

It is undisputed that the Debtor failed to file its tax returns for the years 2006 to 2008; and that for such failure, the Debtor incurred penalties totaling $3,662,000."

It is a bankruptcy case from Delaware.

COMMENT: You may wonder how a tax case wound up in bankruptcy court. Bankruptcy law keeps its own beat, and a bankruptcy court can have near-extraordinary powers. For example, the court can determine the amount or legality of any tax, any fine, or any penalty relating to a tax. That is what happened here. The IRS assessed a penalty, the taxpayer protested, the IRS decided it was right (surprise) and submitted the penalty as a claim to the bankruptcy court.

And I find the IRS position so extreme as to constitute bad faith. I further think the IRS should be required to reimburse the professional fees incurred defending against its reckless behavior. You miss a filing deadline by a day or two and one would think the Treasury underpinnings of the nation are in mortal throes. Have the IRS bankrupt you while enforcing some capricious tax argument, however, and you are expected to be a good sport.

I would like to someone (ahem, US Senator Paul) take up the cause. It could be called the Good For The Goose, Good For The Gander - Time For The IRS To Take Responsibility - Act. If the IRS can penalize you for unreasonable positions, then the IRS should also be subject to penalties for unreasonable conduct.  The penalty would be paid to the affected taxpayer.

Our protagonist (Refco Community Pool) formed in 2003 as a partnership. It was an investment group, and their thing was to track the S&P Managed Futures Index. To do this, they needed an investment advisor. They found one in the Cayman Islands (Sphinx Managed Futures Fund). The advisor (Sphinx) in turn used a clearinghouse (Refco, LLC) to execute trades and whatever.

OBSERVATION: Right off the bat, we have two Refco's going - "Pool" and "LLC." Set this aside, as it is not relevant to our story.

Here is what happened:

1. In 2005 Refco LLC filed for bankruptcy. This caused a run, meaning that ...
2. Sphinx yanked out $312 million. However, ...
3. Sphinx had to return $260 million as was deemed a "preference" action.
4. In 2006 Sphinx went into liquidation. As part of the process, the Court appointed two liquidators.  
5. The liquidators soon found very serious accounting issues. They in fact advised that they could not assure the accuracy of tax and accounting information provided investors.
6. Refco Pool wanted its money from Sphinx, but all they received was something called "special situation shares." They were special because no one knew what they were worth until the liquidation was complete, a process which stretched into 2013. 

The IRS noticed that Sphinx was not filing tax returns and issuing K-1s. The Sphinx liquidators explained that it would cost between $5 and $7 million to reconstruct records to even approach a tax return. The two sides came to an agreement, and Sphinx was absolved of filing K-1s from 2005 to 2007.

Let's back up a bit. Who invested in Sphinx? It was Refco Pool. The IRS next went after Refco Pool for not filing its tax return and issuing K-1s.

COMMENT: Here we have a conundrum. Refco Pool has one main asset - special situation shares (whatever that means) in a bankrupt entity with accounting problems severe enough that its liquidators advise against using any numbers. A tax return requires numbers. What to do?

           

Refco Pool argued reasonable cause for abatement of the penalty. You may as well have Refco Pool discover a new planet as get a tax return out of whatever information they could pry from Sphinx.

No, no, no, said the IRS. Refco Pool could have used selected files and summaries and reports and disbursement statements and a receipt from its last visit to Dairy Queen to reconstruct records that Sphinx should have provided but did not because the IRS said it was OK not to and then Refco Pool could have filed its own partnership tax return....

Well ... yes, Refco Pool could. However, the information was unreliable if not completely inaccurate. In fact, the matter went further than that. Even if Refco Pool could do some Harry Potter alchemy, it would not know how to separate the separate tranches, meaning it could not determine its share. And, since we are talking about it, Refco Pool would have no idea what to do with the "special" part of its share - which was certainly less than 100% but not certain to be more than 0%.

The Bankruptcy Court explained:           

As an accrual method taxpayer, the Debtor cannot recognize income until 'all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.'"

One could persuasively argue that Refco Pool could not meet this threshold.

The IRS persisted that Refco Pool could have assembled numbers - however fragile - and filed a tax return had it really wanted to.

ANALYSIS: The judicial standard however is not whether Refco Pool exhausted all possible alternatives. The standard is whether Refco Pool exercised the level of care that a reasonably prudent person would under the same circumstances. 

The Court pointed out the tax risk that Refco Pool would have assumed by filing a tax return:

By knowingly filing inaccurate returns, the Debtor had a reasonable cause for concern given the specter of accuracy-related penalties it might incur ...."

The IRS could have penalized Refco Pool if the numbers proved to be substantially inaccurate.

Wait, there is more.

Refco Pool had approximately 1,600 partners to whom it was obligated to issue K-1s. Had those K-1s gone south, the partners too could have gone after Refco Pool.

The Court was unconvinced whether Refco Pool could even sign a tax return:           

Based on this knowledge, a reasonable person would likely be concerned with signing the jurat clause at the bottom of Form 1065..." 

COMMENT: The jurat clause is the one at the bottom of the tax form that reads "... to the best of my knowledge and belief, it is true, correct, and complete."

The Court concluded: 

Based on the evidence presented, the Debtor proved that it carefully considered its filing obligations and undertook appropriate steps in an effort to avoid the failure. Accordingly, the Court holds that the debtor acted in a responsible manner both before and after the failure to file occurred."

The Bankruptcy Court disallowed the IRS penalties.

I grant you, this is an extreme case, but perhaps it takes the extreme case to spotlight outrageous government behavior.

Tax penalties can generally be abated for "reasonable" cause. The problem is that the IRS has redefined "reasonable" in a completely unreasonable way. Why? Many suspect that it wants to keep the penalties to supplement its Congressional funding. Is that really what we want: for the IRS to self-fund by automatically assessing penalties and then imperiously decreeing that any request for abatement of said penalties is not "reasonable"?

I propose a compromise if we cannot get the Goose & Gander bill passed: all IRS penalties are to be returned to Treasury. They are then to be re-budgeted as Congress determines, with no assurance that the monies would return to the IRS.  Perhaps that would cool the IRS jets a bit.

When Does A Business "Start"?

There is a category of deductions that the tax Code refers to as “start up” or “pre-opening” expenses.

For the most part, you do not want to go there.

An active trade or business is allowed to deduct its normal and operating expenses (as defined and limited by the Code, of course). There is a trap in that description, and the trap is the word “active.”

What does it mean be active?

It means the business is up and running.

How can a business not be up and running?

Let's say that you are opening a Five Guys Burgers and Fries restaurant. You have all kinds of expenses - in addition to building the place - before you open the doors. You have to turn on the lights, hire and train employees, establish suppliers and receive inventory, and so forth.

All this before you sell your first hamburger.

The problem is that you cannot deduct these expenses, because you have not yet started business. You have to be in business before you can deduct your expenses. There is a Kafkaesque absurdity to the whole thing.

The Code however does step-in and provide the following safety valve in Section 195:

(a)Capitalization of expenditures

Except as otherwise provided in this section, no deduction shall be allowed for start-up expenditures.

(b)Election to deduct 

(1)Allowance of deduction If a taxpayer elects the application of this subsection with respect to any start-up expenditure
(A)the taxpayer shall be allowed a deduction for the taxable year in which the active trade or business begins in an amount equal to the lesser of

(i) the amount of start-up expenditures with respect to the active trade or business, or

(ii) $5,000, reduced (but not below zero) by the amount by which such start-up expenditures exceed $50,000, and

(B) the remainder of such start-up expenditures shall be allowed as a deduction ratably over the 180-month period beginning with the month in which the active trade or business begins.

I do not consider it much of a safety valve, as the best you can get is $5,000. Let the expenses go over $55,000 and you lose even that. You deduct the balance over 180 months.

That is 15 years. Think about it: you can start a kid in first grade and almost put him/her through college before you get to fully deduct your Five Guys start-up and pre-opening expenses.

And that is the problem: the period is so long that it effectively is a penalty. It is one thing when Walmart opens a super store, as they are towing the resources (and cash flow) of a Fortune 500. It is a different issue when a budding entrepreneur heads out there with a hope and a prayer.

Let’s look at the Tizard case.

Julie Tizard graduated from Baylor and entered the Air Force as a 2^nd lieutenant. While serving at Wright-Patterson in Dayton, Ohio, the USAF announced that women would be allowed to apply for pilot positions. Julie was all over that, becoming a pilot and rising through the ranks as instructor pilot, flight commander and wing flying safety officer.

In 1990 she started working as a full-time commercial pilot with United Airlines, where she flew 737s, 757s, 767s and the Airbus 320.

The FAA requires commercial pilots to retire at age 65.

Knowing that, she looked for things to do after she turned 65. She decided to start an aviation business in Arizona. She selected an airplane model (the Slingsby T-67C “Firefly”), a single engine propeller model that is fuel-efficient, has excellent visibility, is responsive and is “acrobatic.” Acrobatic apparently has a different meaning to pilots than to ordinary people – think of intentionally rolling or stalling the plane. You have as much chance of getting me on that plane as the Browns have of winning the Super Bowl this year.

She purchased the plane for $54,200. It turned out that the guy selling the plane was a real estate developer with a development in Phoenix. He expressed interest in her services. She was off to a promising start.

She posted a picture of herself with the plane on Facebook. She received 50 “likes.”

The same day she got the plane home, she took out an acquaintance whom she considered a potential client. Being promotional, Julie did not charge her.

Julie set-up an LLC (Tizard) for the business.

She worked up a business plan. She would start by offering aerial land surveys, flight charters and aviation photography, as well as professional aviation and safety consulting. The Firefly was well-designed for this use, and to the best of Julie’s knowledge she was the only person in central Arizona offering this menu of services.

She crunched the numbers and figured that she would break-even at 2.5 aviation hours per month. At 15 hours she was earning a meaningful profit.

Sounds like Julie knew what she was doing.

Time came to prepare her 2010 tax return. She had no income from the airplane and over $13 thousand of expenses.

The IRS bounced her return. They said she had not yet started business.

There are several factors that one considers in determining whether business activities have started:

         (1) Sales

         This is the best evidence, but she did not have any.

         (2) Advertising and marketing

She posted on Facebook and had approached both the seller of the plane as well as an acquaintance as potential customers.

         (3) Business Plan

She had given the matter some thought. She researched potential competition and had analyzed costs to the extent she knew how many flight hours per month were required to break-even.

Seems to me that she had one solid (factor (3)) and one so-so (factor (2)).

Problem is that factor (1) is the elephant in the room. Nothing gets the IRS to back off more than a real person handing over real money.

The Court seemed to like Julie:

The Court found the petitioner's testimony to be credible and forthright."

But the Court was not impressed with Julie's marketing:

However, other than the picture and short statement (that makes no mention of her aviation business) that she posted on her personal Facebook page ..., petitioner did nothing in 2010 to formally advertise to the general public ... or describe the various services that Tizard would offer to its clients."

That left a lot of pressure on factor (3). It was too much pressure, unfortunately:

Petitioner's ... efforts ... do not impress the Court as evidence that Tizard was actually functioning and performing the activities for which it was organized."

The Court decided she had not started business in 2010.  She had to run her expenses through the Section 195 filter. The best she could deduct was $5,000, and the balance would be allowed over the next 15 years.

Is there something she could have done differently?

She could have tried harder to line-up that first paying customer. To be fair, she acquired the plane late in the year, which allowed her little time to react.

Absent revenues, marketing became a critical factor. The Court wanted more than a hopeful conversation or Facebook photo of her next to her new plane. 

I am thinking she should have set-up a business website - including history, services, photos - for the airplane business. Perhaps that, with her business plan, would have been enough.

The Hosbrook Road Terrible Tax Tale

Let's talk about S corporations.

There are two types of corporations: C corporations and S corporations. Think Amazon or Apple and we are talking about "C" corporations: they file their own returns and pay their own taxes. Think of family-owned Schmidt Studebaker Carriage & Livery and we are talking about "S" corporations: only so many shareholders, do not normally pay tax, the numbers flow-through to the owners who pay the tax on their personal returns.

S corporations are almost the default tax structure for entrepreneurial and family-owned businesses, although in recent years LLCs have been giving them a run for their money. They are popular because the owner pays tax only once (normally), as contrasted to a C corporation with its two levels of tax.

But there are rules to observe.

For example, you have to keep track of your basis in your stock - that is, the amount of after-tax money you have invested in the stock. Your basis goes up as you put the business income on your personal return, but it also goes down as you take distributions (the S equivalent of dividends) from the company. You are allowed to take distributions tax-free as long as your basis does not go negative. Why? Because you paid tax on the business income, meaning you can take it out without a second tax.

Accountants keep permanent schedules to track this stuff.  Or rather, they should. I have been involved in more than one reconstruction project over the years. You have to present these schedules upon IRS audit.

I did not previously have a worse-case story to tell. Now I do. The best part is that the story takes place in Cincinnati.

Gregory Power is a commercial real estate broker with offices first on Montgomery Road and then on Hosbrook Road. He started his company (Power Realty Advisors, Inc.) in 1993. Somewhen in there he used Quicken for his accounting, and he would forward selected reports to his accountant for preparation of the returns.

COMMENT: Quicken is basically a check-register program. It tracks deposits and withdrawals, but it is not a general ledger - that is, the norm for a set of business books. It will not track your inventory or depreciable assets or uncollected invoices, for example.

There was chop in the preparation. For example, the numbers were separated between those Mr. Power reported as a proprietor (Schedule C) and those reported on the S return. Why? Who knows, but it created an accounting problem that would come back to haunt.

He lost money over several years, including the following selected years:

            1995              (191,044)

            1996              ( 70,325)

            2002              ( 99,813)

Nice thing about the S corporation as that he got to put these losses on his personal return. To the extent his return went negative, he had a net operating loss (NOL) which he could carry-over to another year. Mind you, he got to put those losses on his personal return to the extent he did not run out of basis - yet another reason to maintain permanent schedules.

He took distributions. In fact, he took distributions rather than taking a salary, which is a tax no-no. The IRS did not come after him on this issue because it had another angle of attack.

He had the corporation pay some of his personal and living expenses, which is another no-no. Accountants will reclassify these to distributions and tell you to stop.

Some of his S corporation returns did not show distributions. This is not possible, of course, as he was taking distributions rather than salary. That tells me that the accountant did not have numbers. It also tells me the accountant could not maintain the schedules - at least not accurately - that we talked about.

Sure enough, his big payday years came. There was tax to pay ... except for those NOLs that he was carrying-forward from his bad years. He told the IRS that he had over $500,000 of NOLs, which he could now put to good use.

Problem: He did not have those schedules.

Solution: He or his accountant went back and reconstructed those schedules.

Problem: The IRS said they were bogus.

Solution: You go to Tax Court.

COMMENT: It would have been cheaper to keep schedules all along.

Mr. Power ran into a very severe issue with the Court: it does not have to accept your tax returns as proof of the numbers.  The Court can request the underlying books and records: the journals, ledger and what-not that constitutes the accounting for a business.

The Court did so request.

He trotted out those Quicken reports and handwritten summaries.

The Court noted that Mr. Power was somehow splitting numbers between his proprietorship and the corporation, although it did not understand how he was doing so. This made it difficult for the Court to review a carryforward schedule when the Court could not first figure-out where the numbers for a given year were coming from.

Strike one.

The Court wanted to know what to do with those tax returns that did not show distributions, which it knew was wrong as he was taking distributions rather than a salary.

Strike two.

And there was the matter of personal expenses being paid through the company. It appears that in some years the corporation deducted these expenses, and in other years it did not. The Court wasn't even sure what the amounts were. It did not help when Mr. Power commingled business and personal funds when buying his house in Indian Hill.

Strike three.

His business accounting was so bad that the Court bounced the NOL carryforward. The whole thing.

He owed tax. He owed penalties.

And no one knows if he really had an NOL that he could use to sop-up his profitable years because he had neglected his accounting to an extreme degree. He could not prove his own numbers. 

But Mr. Power has attained tax fame.

What Does It Take To Get Reasonable Cause Around Here?

My partner has a difficult IRS penalty issue.

He expects a client to be penalized for more than one year. This complicates how we handle the first year.

The IRS has reorganized its penalty review function to a system called the Reasonable Cause Assistant (RCA). There however is a problem: the system does not work well. The Treasury Inspector General for Tax Administration (TIGTA) reported that RCA was inaccurate 89% of the time in 2012.

Step away from RCA and you still have the following:

 * It used to be that penalties were assessed as a means to encourage voluntary compliance. Many tax pros feel that is no longer the case, and penalties are being used as a means to raise revenue.  An example is the penalty assessed for late filing of a partnership return: $195 per month per partner. Take a 10-person partnership, file a week late and face a $1,950 penalty. There is little consideration for the size of the partnership, its total assets or revenues - or the fact that partnerships do not pay federal taxes.            

* Penalties are assessed even when taxpayers are trying to do the right thing. For example, enter into a reportable transaction, disclose it on your tax return but forget to file a copy with a second office and you will be assessed a penalty. Fail to disclose the transaction at all and you will be subject to the same penalty.

 * The IRS is automatically asserting penalties. For example, for fiscal year 2015, the IRS assessed over 40 million penalties on individuals and businesses. To put that in context, there were approximately 243 million returns filed for the period.

* Many penalties can be waived if the taxpayer can show "reasonable cause," but many tax professionals believe the IRS has so narrowed the definition as to be almost unreachable, unless you are willing to die. To aggravate the matter, the IRS has also instructed its personnel to substitute "first time abatement" (FTA) for reasonable cause as a matter of policy. While the IRS argues that FTA is easier to review and administer than reasonable cause, there exists a high degree of skepticism. Why would a taxpayer automatically burn a "get out of penalty-jail free" card if the taxpayer otherwise has reasonable cause? Wouldn't a taxpayer want to keep that card available just in case?

My partner - by the way - has that last situation: burning his FTA chip without a reasonable-cause backup for the second year. Ironically, he may have reasonable cause for the first year, but that sequence does not follow IRS policy. I anticipate going to Appeals to obtain reasonable cause and preserve the FTA for the second year.

Let's talk about the Carolyn Rogers (Rogers v Commissioner) case.

Carolyn lived in New York. In 2006 she had a small business (Talk of the Town Singles) which she operated from her cooperative. In 2006 there was a fire which rendered the place uninhabitable.

She moved. In 2007 there was another fire, one she appears to have caused herself. The local newspaper called her out, and she was thereafter harassed by people in her neighborhood.

She moved to the YWCA until 2010. She did not have a pleasant time there, and in 2009 she fell off a subway platform and fractured her skull on the rails. She was in the hospital for days, and she continued to suffer from dizzy spells thereafter.

Prior to this period, she had a record of filing timely returns. She also made significant efforts to correctly prepare her tax returns, consulting books and references and more than once contacting the IRS. She did not use a paid preparer.

The IRS penalized her for not filing a 2009 return.

She explained that the insurance company settled the second fire in 2009, and she lost a bundle. According to her research, the casualty loss would wipe out her income, and she was therefore below the filing threshold. She did not need to file.

The IRS then trotted technical guidance on a casualty loss. While the layperson might think that the loss would be deferred until the insurance is settled, the tax Code uses a different test:

* If an insurance claim is not paid in the year of casualty AND there is a reasonable prospect of recovery, then the loss is deferred until one can determine the amount of recovery.

* If there is no hope for insurance - or the prospect of recovery is unreasonable - then the loss is deductible in the year of the casualty.

 The IRS said that she came under the second rule. She knew that insurance would not cover the full loss from the 2007 fire. The loss was therefore deductible in 2007.

COMMENT: There is enough "what if" to this rule that even a tax professional could blow it.

The IRS wanted penalties for not filing that 2009 return.  

The Tax Court reviewed her filing history and her chaotic life. It noted:

Petitioner's error (regarding the proper year of deduction of the portion of a casualty loss for which there is no reasonable prospect of recovery from insurance) is considerably different from the errors made by a taxpayer whose failure to file, late filing, or late payment is chronic. Erroneously deducting a loss in a year later than the correct year is not usually considered to be a blatant tax avoidance technique ..."

Ouch. The Court did not appreciate the IRS wasting its time.

Taking into account all of the facts and circumstances, we conclude that petitioner exercised ordinary business care and prudence under the difficult circumstances in which she was living at the time leading up to the due date of her 2009 return...."

The Court found reasonable cause. She owed the tax, but she did not owe the penalties.

The IRS should have found reasonable cause too. It is troubling that it didn't.

Deducting Everything - The Tanzi Doctrine

I admit: I got a chuckle from reading the case.

The taxpayers (Tanzi's) are married, and for the year in question they were employed by Seminole State College, which is Sanford, Florida. I remember a conversation with a Sanford CPA a year or two ago lamenting that there no longer was separation between Orlando and Sanford. I was in Orlando this year, and he is right - there isn't.

Our taxpayer was an adjunct instructor teaching communications, and his wife worked at the campus library. Although an adjunct, he held a PhD in communications, so we can presume he was hoping for a permanent full-time position.

On their 2011 return they deducted the following as employee expenses:

            (1) 100% of their telephone, internet and television

            (2) depreciation

            (3) books, CDs and DVDs

            (4) computer expenses

The IRS bounced the employee expenses and sent them a notice for approximately $3,000.

Employee expenses are a subset of "miscellaneous deductions." One has to itemize to get to miscellaneous deductions, and even then these miscellaneous deductions are not what they used to be. The common itemized deductions are mortgage interest, real estate taxes and contributions. Living in Florida, our taxpayers did not have to concern themselves with another common itemized deduction - state income taxes. Chances are the first three got them into itemized deduction range, and their miscellaneous deductions then became usable. It is rare that miscellaneous deductions by themselves will be enough to get you to itemize.

Miscellaneous deductions are not tax-efficient, though. The Code requires that you reduce your miscellaneous deductions by 2% of your adjusted gross income, so that portion is immediately forfeited.

EXAMPLE: You and your spouse make a combined $150,000. You would have to immediately reduce your miscellaneous deductions by $3,000 (i.e., $150,000 times 2%). If your miscellaneous deductions totaled $3,500, only $500 would be deductible. And yes, it is intentional. It is a way for Congress to pry a few more tax dollars from everyone who incurs employee expenses.

COMMENT: My daughter is working before returning to graduate school. She is required to use her car for work. Although reimbursed something for mileage, it is not the full rate permitted by the IRS. Her employer explained to her that she could deduct the difference come tax time. As her dad and tax advisor, I explained that this was not true. She would not have enough to itemize, and her unreimbursed mileage would be deductible only if she itemized.

By the way, you forfeit all miscellaneous deductions if you are subject to the AMT (alternative minimum tax). As I said, they are not efficient.

The Tanzi's were deducting employee business expenses. The IRS was questioning how 100% of their telephone and internet - just to start - became business. There is a long-standing doctrine that an employee is "in the business" of being an employee, but one still has to show some nexus between the expenses and being an employee. I receive a W-2, for example, but I cannot deduct my Starbucks tab solely for the reason that I am an employee. I would have a business nexus if I met a client there, but not because I was picking up coffee for my commute to the office.

The IRS wanted to know what that nexus was.

The Tanzi's argued that they must constantly expand their "general knowledge" to be effective at their jobs. Mr Tanzi explained that individuals holding terminal degrees - such as himself, coincidently - especially bear a lifelong burden of "developing knowledge, exploring [and] essentially self-educating."   Mr. Tanzi insisted that all expenses paid in pursuing his general knowledge should be deductible as unreimbursed business expenses.

COMMENT: If Mr Tanzi won this argument, I would immediately try to expand the Tanzi doctrine to include tax CPAs with Masters degrees who also maintain a tax blog. Our burdened ranks must constantly expand our general knowledge to be effective at our jobs. I for example sometimes work with and write about international tax matters. Seems to me that a trip overseas to visit my wife's family should be deductible, as it expands my knowledge of being overseas, or some reasoning along those lines.

The tax Code recognizes that some expenses are simply personal in nature. There is even a Code section that says this out loud:

  Section 262 - Personal, living, and family expenses

      (a) General rule

Except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses.

Here is the Court:

While we find credible the Tanzi's testimony that they spent significant time and resources educating themselves, we do not believe the expenses are ordinary and necessary for the trades of being a professor or a campus librarian but rather are personal, living or family expenses nondeductible under section 262(a)."

No surprise for the Tanzi's, but I am a bit disappointed. Looks like I won't be able to deduct my life expenses as ordinary and necessary to the business of being a tax CPA and blogger. Those tax refunds would have been sweet.

CTG University: Part One

Let's discuss a famous tax case, and then I will ask you how you would decide a second case based on the decision in the first.

We are going back to 1944, and Lewis received a $22 thousand bonus.  He reported it on his 1944 tax return. It turns out that the bonus had been calculated incorrectly, and he returned $11,000 in 1946. Lewis argued that the $11,000 was mistake, and as a mistake it should not have been taxed to him in 1944. He should be able to amend his 1944 return and get his taxes back. This had an extra meaning since his tax rate in 1946 was lower (remember: post-war), so if he could not amend 1944 he would never get all his taxes back.

The IRS took a very different stand. It pointed out that the tax Code measures income annually. While arbitrary, it is a necessary convention otherwise one could not calculate income or the tax thereon, as there would (almost) always be one or more transactions not resolving by the end of the year. Think for example of writing a check to the church on December 31 but the check not clearing until the following year. The Code therefore taxes income on a "period" concept and not a "transactional" concept. With that backdrop, Lewis would have a deduction in 1946, when he returned the excess bonus.

The case went to the Supreme Court, which found that the full bonus was taxable in 1944. The Court reasoned that Lewis had a "claim of right," a phrase which has now entered the tax literature. It means that income is taxable when received, if there are no restrictions on its disposition. This is true even if later one has to return the income. The reasoning is that there are no limits on one's ability to spend the money, and there is also no immediate belief that it has to be repaid. Lewis had a deduction in 1946.

Looks like the claim of right is a subset of "every tax year stands on its own."

Let's roll into the 1950s. There was a company by the name of Skelly Oil. During the years 1952 through 1957 it overcharged customers approximately $500 thousand. In 1958 it refunded the $500 thousand.

You can pretty much see the Lewis and claim-of-right issue.

But there was one more fact.

Skelly Oil had deducted depletion of 27.5%. Depletion is a concept similar to depreciation, but it does not have to be tied to cost. Say you bought a machine for $100,000. You would depreciate the machine by immediately expensing, allocating expense over time or whatever, but you would have to stop at $100,000. You cannot depreciate more than what you spent. Depletion is a similar concept, but without that limitation. One would deplete (not depreciate) an oil field, for example. One would continue depleting even if one had fully recovered the cost of the field. It is a nice tax gimmick.

Skelly Oil had claimed 27.5% depletion against its $500,000 thousand or so, meaning that it had paid tax on a net of $366,000.

Skelly Oil deducted the $505,000 thousand.

Skelly Oil had a leg up after the Burnet v. Sanford & Brooks and Lewis decisions, as every tax year was to stand on its own. It refunded $505,000, meaning it had a deduction of $505,000. Seemed a slam dunk.

The IRS said no way. The $505,000 had a trailer attached - that 27.5% depletion - and wherever it went that 27.5% went. The most Skelly Oil could deduct was the $366,000.

But the IRS had a problem: the tax Code was based on period reporting and not transactional reporting. The 27.5% trailer analogy was stunning on the big screen and all, but it was not tax law. There was no ball hitch on the $505,000 dragging depletion in its wake.

Here is the Supreme Court: 

[T]he Code should not be interpreted to allow respondent 'the practical equivalent of double deduction,' *** absent a clear declaration of intent by Congress."

The dissent argued (in my words):           

So what? Every year stands on its own. Since when is the Code concerned with the proper measurement of income?

Odd thing, though: the dissent was right. The Lewis decision does indicate that Skelly Oil had a $505,000 deduction, even though it might not have seemed fair. The Court reached instead for another concept - the Arrowsmith concept. 

[T]he annual accounting concept does not require us to close our eyes to what happened in prior years."

There is your ball hitch. The concept of "net items" would drag the 27.5% depletion into 1958. "Net items" would include revenues and deductions so closely related as to be inseparable. Like oil revenues and its related depletion deduction.

The Court gave us the following famous quote: 

In other situations when the taxes on a receipt do not equal the tax benefits of a repayment, either the taxpayer or the Government may, depending on circumstances, be the beneficiary. Here, the taxpayer always wins and the Government always loses."

And over time the Skelly Oil case has come to be interpreted as disallowing a tax treatment where "the taxpayer always wins and the Government always loses." The reverse, however, is and has always been acceptable to the Government.

But you can see something about the evolution of tax law: you don't really know the law until the Court decides the law. Both Lewis and Skelly Oil could have gone either way.

Now think of the tax law, rulings and Regulations being published every year. Do we really know what this law means, or are we just waiting our turn, like Lewis and Skelly Oil?

Can You Have Cancellation Of Debt Income If You Are Still Paying On The Debt?

Harold is a native Hawaiian. He has worked in the telecommunications industry for more than 40 years. In 1996 he founded Summit Communications, Inc (Summit), which he served in the capacity of president, chief executive officer and director.

Al has a background similar to Harold's, but his company was called Sandwich Isles Communications, Inc (SIC). In 1997 he desperately needed a telecommunications executive. Al met Harold and wanted Harold to come work for him.

Harold was already involved with Summit, which was having business issues. Harold felt a commitment to the company and his employees.

But Al was not going to let go easily.

In 1998 Al sweetened the offer by including a $450,000 loan. He knew that Harold would immediately loan the monies to Summit. In fact, that is why Al offered the deal. He wanted to loan to be to Harold so that he and SIC did not have to deal with Summit's board of directors.

SIC also wanted to contract with Summit for operations and technical support.

Harold signed on with SIC, and Al let him stay on as Summit's director and chief executive officer.

They signed a note, stipulating that Harold had to repay the loan if he ever left SIC's employment.

The relationship went well, and by the end of 1999 Summit was booming, although - granted - SIC represented 60% of its revenues. It was growing so much that it need Harold back. Al, basically being a good guy, agreed that Harold should return.

No one remembered that Harold had to repay the loan.

SIC then received a large loan from the U.S. Department of Agriculture, which it used to upgrade its operations and technical staff. As it did, SIC's reliance on Summit decreased. By 2002 Summit filed a bankruptcy petition. By 2005 Harold had gone back to work for Al.

In 2010 the IRS audited SIC.

In 2011 Al met with Harold and reminded him that the loan was still due. Harold arranged for payroll deductions - first for $300 per month, then $600 and finally a $1,000 a month - to repay the loan.

The IRS sent a notice to Harold. The IRS said that SIC had discharged his loan, and he had cancellation of indebtedness income.

Think about this for a moment. The IRS wanted taxes from Harold because he had been let off the hook for a $450,000 loan. The problem is that Harold was still paying on the loan. Both cannot be true at the same time, so what was the IRS' reasoning?

It primarily had to do with how many years SIC had to pursue collection before the statute of limitations ran out. Remember: Harold did not start paying the loan until 2011. According to the IRS, there was no enforceable loan at that time, as SIC had gone too long without any evident collection activity. That was the triggering event for income to Harold: when the debt was no longer enforceable.

The IRS had a good point.

The IRS also argued that Harold starting repaying on the loan because it had noticed the defaulted loan on audit and Harold did not want to pay taxes on it.

Harold and Al appeared before the Court and testified that they both considered the loan outstanding, and the Court found them both to be "honest, forthright, and credible."

The Court could not help but notice that Harold and Al were on separate sides with respect to the loan.

 ... respondent argues that any repayment activity taken after the commencement of the examination should be discounted. We disagree. The testimony suggests instead that [Harold] sought to repay the SIC loan because he understood that it was his obligation to repay it. Additionally, a reasonable person in this case would not agree to pay an unenforceable debt to save a fraction of that debt on taxes. Repayment, in other words, is against [Harold's] economic interests."

The Court agreed that cancellation of income requires a triggering event, but it disagreed that the expiration of the statute automatically rose to that level.

... the expiration of the period of limitations generally does not cancel an underlying debt obligation but simply provides an affirmative defense for the debtor in an action by the creditor."

The Court decided that Harold owed the debt. He did not have income.

Why did the IRS pursue this? It certainly did not put a smiley face on their public persona.

I suspect the IRS considered themselves backed into a corner. If the loan really was uncollectible AND the IRS did not pursue, then the regular three-year statute on tax assessments would close on Harold's tax year. At that point, the IRS could not reach Harold again if it wanted to. If however the IRS went to Court - even if it lost - it would mean that the loan was either still in place or discharged in a later year. In either case, the IRS could reach Harold.