How Often Can The IRS Audit You For The Same Thing?

How often can the IRS audit you for the same thing?

I would have to ask two more questions before answering:

(1) Is the IRS auditing the same year?

(2) Is the IRS auditing the same issue?

Here is the relevant Code section:

            IRC Section 7605(b):

No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.

Focus in on the lawyered wording:

            “unnecessary examination or investigations”

            “an additional inspection is necessary”

If I were the IRS, I would argue that all examinations and inspections are “necessary” and be done with the matter.

Fortunately, it does not work that way.

Let say that you are self-employed and deducted a bad debt – a sizeable one – in 2014. The IRS takes a look at it and raises some questions, as bad debts are a notorious area of contention with the IRS. After some back and forth the IRS agrees to the deduction.

Question: Can the IRS audit your 2014 tax return again?

Answer: Of course it can, at least until the statute of limitations expires. What it cannot do is audit your 2014 bad debt again. It already looked at that issue and did not propose an audit adjustment. There is only one bite at the apple.

This does not mean that you are untouchable, however.

Let’s say that you incur a huge net operating loss in 2016. You decide, after meeting with your tax advisor, to carryback the loss to 2014 and get a tax refund. You could really use the cash, with that loss and all.

Question: Can the IRS audit your 2014 bad debt again?

The answer may surprise you: Yes.

Here is the Court:

This is not a case where the IRS is subjecting the Taxpayer to onerous and unnecessarily frequent examinations and investigations. The reexamination of Year 1 is not a unilateral action on the part of the IRS, but in response to the Taxpayer’s election to carry back net operating losses and claim a refund.”

In other words, you started it.

Let me give you a second scenario: 

You have a large donation in 2014 and another large donation in 2015. You were audited for 2014. The IRS made no change to your return.

Question: Can the IRS audit your 2015 for the donation? 

Here is Internal Revenue Manual 4.10.2.13:

(1) Repetitive audit procedures apply to individual tax returns without a Schedule C or Schedule F, when the following criteria are met:

·        a. An examination of one or both of the two preceding tax years resulted in a no change or a small tax change (deficiency or overassessment), and

·        b. The issues examined in either of the two preceding tax years are the same as the issues selected for examination in the current year.  

Answer: You should be able to stop this audit. The IRS looked at the same issue in the preceding year and found nothing.

BTW, note the references to Schedule “C” and “F” in para 1 above. Schedule C means that someone is self-employed, and Schedule F means that someone is a farmer. Those are two situations where a tax advisor would love to have this IRM protection. The IRS knows that too, which is why the IRS left out self-employeds and farmers.  

Question: What if the IRS audits you in 2014 for mileage and in 2015 for office-in-home expenses?  

Answer: You being are audited for two different things. What we are talking about is the IRS looking at the same thing, either more than once for the same year or more than once over a three-year period.

Let’s clarify a crucial point: what halts the second audit is NOT that you were previously audited on the same issue. What halts it is that you were audited and there was no change or an insignificant change. If you owed big bucks on the audit then you are fair game. 

A word of advice: you will have to let the examiner know. My experience is that he/she will be unaware until you bring it up. Address this issue early – for example, when the examiner is trying to schedule the visit – and you can stop the audit altogether. 

Bitcoin and Fred

I am going to dedicate this post to Fred.

Fred likes to talk about Bitcoin. He is a believer. He may as well be on the payroll.

I do not want to talk about blockchain or cryptocurrencies or any of that.

Let’s talk about the taxation of the thing, in case Fred has gotten to you.

As I write this Bitcoin is selling for around $15 grand.

On January 1, 2017 – less than a year ago – it sold for around $1 grand.

COMMENT: There is a reason why we are still working, folks.

There are even Bitcoin ATMs. I understand there around 70 or so locations around Miami alone. You can tap into one if you are going to the Orange Bowl at the end of this month.

Mind you, if you withdraw dollars-for-Bitcoins you probably have a tax consequence.

You see, the IRS has said (in 2014) that Bitcoin is not a currency. Given this thing’s propensity to swing hundreds if not thousands of dollars of day, it makes sense that it is not a currency. Currencies are supposed to have some stable value, at least until politicians run them into the ground.

No, Bitcoins are property, like stocks or a mutual fund. Like a stock or mutual fund, you have a tax consequence on the sale.

Let’s use the following numbers for the sake of discussion:

          Bought on 1/1/17                    $1,000

          Cashed-in on 12/31/17           $16,500

Let’s say you cash-in a Bitcoin while you are at the Orange Bowl. What have you got?

Way I see it, you have ...

    $16,500 (proceeds) - $1,000 (cost) = $15,500 gain

You are supposed to report $15,500 as income on your tax return.

What type of income is it?

I see a buy. I see a sell. I would argue this is capital gain. It would be short-term, as you did not own it for a year.

Let’s throw a curve ball.

Let’s say that you did some work for somebody in 2016. The paid you with that Bitcoin on January 1, 2017 – the one worth $1,000 at the time.

What are your tax consequences now?

You got paid with a Bitcoin worth $1,000. You have $1,000 of ordinary income. If you got paid for work, it is also subject to self-employment tax.

Then you sell it.

I see the following …

   $1,000 (ordinary) + $15,500 (capital gain) = $16,500   

This is what happens when Bitcoin is considered “property” rather than “currency.” It would be the same as you writing checks on your Fidelity or Vanguard mutual fund. Every time you do you are selling some of your mutual fund. And it all gets reported to the IRS at year-end.

Except that most of Bitcoin does not get reported to the IRS at year-end. Not yet, at least. In fact, in 2015 only 802 people reported Bitcoin on their tax return. You know that doesn’t make sense.

Which is why the IRS served a “John Doe” summons on Coinbase in November, 2016. Coinbase is an exchange for virtual currencies like Bitcoin and Ethereum. A “John Doe” summons substitutes a group or class or people for a specific person. It could be as easy as “anyone who sold more than $600 of Bitcoin between 2013 and 2015.”

Coinbase fought back, of course, but in the end the two wound up compromising. Coinbase will not provide 100% of its account data, but the IRS is getting information on over 14,000 account holders and almost 9 million transactions.

Bitcoin and other virtual currencies have become the new overseas bank accounts. It is time to come clean on this stuff, folks.

And yes, I believe there will be IRS reporting – akin to what the stock brokerages do – in the near-enough future. The government is flipping the sofa cushions for every nickel it can find. Until they get us to a 100% tax rate, they are going to keep looking for new sofas.

Someone – probably Fred - was telling me about a Bitcoin credit card.

That is a tax nightmare

Why?

Say that you bust to Starbucks in the morning. You put your coffee on the card. You stop for fuel – on the card. You go to lunch – on the card. You stop at the dry cleaners and Krogers on the way home – both on the card.

You have 5 “sales” that day. Each one has a cost, and who knows how we are going to come up with that number. Say that you do something comparable almost every work day. I will probably “fee discourage” you from using me as your tax advisor.

BTW, a similar thing can occur if you accept Bitcoin as payment for your services. Say that you are an independent contractor and two or three of your clients pay you in Bitcoin. You are going to have to price the Bitcoin every time you get paid with one, as your “proceeds” are its value on the day you receive it.

That is an accounting hassle.

Can you think of a nightmare scenario?

I  can.

What if you get paid with Bitcoin next year when it is worth $20,000. You hold onto it. Let’s say Bitcoin drops to $9,000 by December 31, 2018. You bring me the info for your taxes. How much do you have to report as income from that Bitcoin?

You have to report $20,000.

But it is only worth $9,000 now!

Yep. That is how it works since Bitcoin is not considered a currency.

What can I do to get my taxes down? Should I sell it?

Now you have a different problem. If that thing is a capital asset – and we said earlier that it was – you will have a capital loss upon sale. You will report a $11,000 capital loss on your return.

And unless you have capital gains to absorb those losses, you continue to have tax problems. Capital losses are allowed to offset only $3,000 of your “other” (read: Bitcoin) income on your tax return. You get no bang on the remaining $8,000 ($11,000 - $3,000), at least until the following year when you can use another $3,000. 

Don’t forget that you are also paying self-employment taxes on that $20,000 and not on $9,000.

This is ridiculous. If I were you, I would fire me as your tax advisor.

I do not accept Bitcoin for my fees, but I am waiting for someone to bring it up. I might do it for an isolated transaction or two. 

But no way am I using a Bitcoin credit card.

Not Filing Because You Expect A Refund

I received a call from a client this past week. He is keen on getting his taxes caught-up.

Mind you, he is not a timely filer.  He files every two or three years, at best.

How does he get away with it?

He has the ultimate tax shelter: a net operating loss (NOL).

You have to have a business to have an NOL. It means a business loss so large that it overwhelms whatever other sources of income you may have. It leaves behind a net negative number, and you can use that negative to recoup taxes paid in a prior year (2 prior years, to be exact) or you can use it to reduce your taxes going forward (up to 20 years).

It makes tax planning easy.

Say you have a $1 million NOL carryforward. You anticipate earning $400,000 next year. What tax planning advice would you give?

Here’s one: stop the withholding on that $400,000, if you can.

Why?

$400,000 - $1,000,000 = ($600,000).

There is no tax on minus $600,000. There is no point in withholding.

And that is why my client is somewhat lackadaisical about filing his taxes.

Won’t there be penalties for late filing?

Most likely: No. Penalties are normally calculated on any taxes due. No taxes due = no penalties. This is not always true, but it is true enough in his case.

A more common variation on this theme is a taxpayer who always gets a refund. A refund = no taxes due = no penalties. One has to be careful with this, however, because once enough years go by (more specifically: 3 years), the government will keep your money.

I was looking at the Parekh case this week. Here is the Tax Court:

… we conclude that petitioners did not exercise ordinary business care and prudence and that they have not established reasonable cause for failing to file their 2012 tax return timely.”

COMMENT: if you see the words “ordinary business care and prudence” or “reasonable cause,” rest assured that someone is being penalized. Those are code words when one is trying to remove or reduce penalties.

What did Parekh get into?

Let’s see:

• Mr and Mrs Parekh filed 2009 only after the IRS prepared a substitute tax return for them.
• They were late in filing 2010 and 2011.
• They did not extend their 2012 return. They eventually filed it in 2014.

Wouldn’t you know the IRS decided to audit 2012?

Who cares, right? They are always overpaid.

There was something different in 2012: retirement plan distributions. The IRS determined that they owed over $8 grand of Alternative Minimum Tax (AMT).

Now that there was tax due the IRS also assessed a penalty.

Parekh went to Appeals. He wanted the penalty for late filing abated.

His reason?

He always had refunds. How was he supposed to know that 2012 was different?

Here is Parekh:

I figured, reasonably so I thought, that since I’d be getting a refund it was OK to file late ***. In fact, I had considered the de facto deadline for filing to be three years if one is getting a refund since after that the refund is forfeited. As I take a quick look at some tax advice websites that is pretty much what they say.”

Here is the IRS:

The Appeals officer noted that petitioners had also been delinquent in filing their 2009-2011 returns and that, as of […], they had not filed a return for 2013 or 2014 either.”

One they got to Tax Court – and hired an attorney - the Parekhs added another reason for filing late: his mom was ill and he was routinely travelling to India in 2013 and 2014 to help his father care for her.

The Court did not like the attorney slapping the India thing into the record at the last minute.

Even if we were to credit petitioner husband’s testimony about his heavy travel schedule, it is inconceivable that he could not have found two days in which to fulfill petitioners’ filing obligation, as opposed to filing that return 15 months late.”

The Court said no reasonable cause for not extending and not filing on time. They had to pay the penalty.

Did Parekh’s track record with the IRS hurt him with the Court?

No doubt.

And there is the risk if you routinely file your returns late – perhaps because you expect a refund or because you have always gotten refunds. Have your taxes spike unexpectedly, and it is unlikely you will avoid the penalties that will come with them.

When The IRS Says Loan Repayments Are Taxable Wages

Here is a common-enough fact pattern:

(1) You have a company.

(2) You loan the company money.

(3) The company has an unprofitable stretch.

(4) Your accountant tells you to reduce or stop your paycheck.

(5) You still have bills to pay. The company pays them for you, reporting them as repayments of your loan.

What could go wrong?

Let’s look at the Singer Installations, Inc v Commissioner case.

Mr. Singer started Singer Installations in 1981. It was primarily involved with servicing, repairing and modifying recreational vehicles, although it also sold cabinets used in the home construction.

After a rough start, the business started to grow. The company was short of working capital, so Mr. Singer borrowed personally and relent the money to the company. All in all, he put in around two-thirds of a million dollars.

PROBLEM: Forget about the formalities of debt: there was no written note, no interest, no repayment schedule, nothing. All that existed was a bookkeeping entry.

The business was growing. Singer had problems, but they were good problems.

Let’s fast-forward to 2008 and the Great Recession. No one was modifying recreational vehicles, and construction was drying up. Business went south. Singer had tapped-out his banks, and he was now borrowing from family.

He lost over $330 grand in 2010 and 2011 alone. The company stopped paying him a salary. The company paid approximately $180,000 in personal expenses, which were reported as loan repayments.

The IRS disagreed. They said the $180 grand was wages. He was drawing money before and after. And – anyway – that note did not walk or quack like a real note, so it could not be a loan repayment. It had to be wages. What else could it be?

Would his failure to observe the niceties of a loan cost him?

Here is the Court:

We recognize that Mr. Singer’s advances have some of the characteristics of equity – the lack of a promissory note, the lack of a definitive maturity date, and the lack of a repayment schedule …”

This is going to end poorly.

 … but we do not believe those factors outweigh the evidence of intent.”

Wait, is he going to pull this out …?

 … because intent of parties to create [a] loan was overwhelming and outweighed other factors.”

He won …!

However, we cannot find that all of the advances were loans.”

Then what would they be?

While we believe that Mr. Singer had a reasonable expectation of repayment for advances made between 2006 and 2008, we do not find that a similarly reasonable expectation of repayment existed for later advances.”

Why not, Sheldon?

 After 2008 the only source of capital was from Mr. Singer’s family and Mr. Singer’s personal credit cards.”

And …?

No reasonable creditor would lend to petitioner.”

Ouch.

The Court decided that advances in 2008 and earlier were bona fide loans. Business fortunes changed drastically, and advances made after 2008 were not loans but instead were capital contributions.

This “no reasonable creditor would lend” can be a difficult standard to work with. I have known multimillionaires who became such because they did not know when to give up. I remember one who became worth over $30 million – on his third try.

Still, the Court is not saying to fold the company. It is just saying that – past a certain point – you have injected capital rather than made a loan. That point is when an independent third party would refuse to lend money, no matter how sweet the deal.

Why would the IRS care?

The real-world difference is that it is more difficult tax-wise to withdraw capital from a business than it is to repay a loan. Repay a loan and you – with the exception of interest – have no tax consequence.

Withdraw capital – assuming state law even allows it – and the weight of the tax Code will grind you to dust trying to make it taxable – as a dividend, as a capital gain, as glitter from the tax fairy.

It was a mixed win for Singer, but at least he did not have to pay taxes on those phantom wages.

When The IRS Does Not Believe You Filed An Extension

I have a certain amount of concern whenever we approach a major due date. Let’s use your personal tax return as an example. It is due on April 15; an extension stretches that out to October 15. 

What is the big deal?

Penalties. Fail to extend the return, for example.

How does this happen?

A client moves to another city. A client was unhappy with your fees last year, and you are uncertain if the client is staying with you. A client’s kid starts working, prompting a tax return for the first time. A client gets involved with some business, and the first time you hear about it is when his/her information comes in. A client does business in a new state.

Or – let’s be frank here – you just miss it.

There are two common penalties; think of them as the salt and pepper of penalties:

·      Failure to file

·      Failure to pay

We associate the IRS with taking our money, so one would easily assume that the more onerous penalty is failure to pay. It is not. Owe money past April 15 and the IRS will charge a penalty of ½% per month.

Fail to file, however, and the penalty is 5% per month.

Yep, 10 times as much.

And when does the penalty start?

Miss that extension and it starts April 16.

Huh? Don’t you have until October 15 to file that thing?

Yes, IF you file an extension.

You do not want to miss that extension.

I was reading a case about the Laidlaw brothers. They sold Harley Davidson motorcycles, and they got pulled into Court for a welfare benefit plan that went awry.

There was one issue left: did their accountant file extensions for the two brothers by April 15? If not, those penalties included 5 zeroes. We are talking enough-to-buy-a-house money.

To add to the stress, the trial occurred about a decade after the tax year in question.

The accountant’s name was Morgan, and he presented extensions showing zero tax due for each brother. The IRS said it never received any extensions. Morgan did not send the extensions certified mail, but he recalled sending both extensions in the same envelope. He remembered taking the envelope to the post office and checking for proper postage. He took pride that the Post Office had never returned an extension request for insufficient postage.

He pointed out that there was no question about an extension for the year before, and the year before that, and so forth. The brothers were significant clients to his firm, and he went the extra mile.

The IRS was having none of it. They pointed out that Morgan had many clients, and the likelihood that he could remember something that specific from a decade ago was dubious. Additionally, any memory was suspect as self-serving.

Sounds like Morgan needed to present well in front of the Court.

And there is the rub. The Laidlaw case went Rule 122, meaning that depositions were submitted to the Court, but there was no opportunity for face-to-face questioning.

Here is the Court:

… we had no opportunity to observe Mr. Morgan’s credibility as a witness. The reliability of a witness’ testimony hinges on his credibility. We were not provided a full opportunity – so critical to our being able to find the witness reliable – to evaluate Mr. Morgan’s credibility on the issue of timely filing because petitioners never offered his live testimony in a trial setting. While we can learn much from reading the testimony, it is not the same as a firsthand observation of the witness’ demeanor and sincerity, both essential aspects of credibility and reliability.

The brothers lost, and the IRS collected a sizeable penalty amount.

Back in the day, we used to log all extensions going to the IRS. We would certify each envelope and then attach the receipt to a log detailing each envelope’s contents. Granted, that log could not prove that a given envelope contained a given extension, but it did show our attention to policies and procedures. I recall getting out of at least one sizeable penalty by arguing that point to the IRS.

Those were different times, and many (including me) would say that today’s IRS is less forgiving of basic human error

And, to some extent, we are talking ancient history with extension procedure. Today’s practices, our included, has moved to electronic filing. Our software tracks and records our extensions and returns and their receipt by the IRS. I do not need to keep a mail log as my software does it for me.

Morgan needed something like a log. It would have given the Court confidence in and support for his recollection of acts occurring a decade earlier, even without him being present to testify in person.

Can You Depreciate a Battle Axe?

Mr. and Mrs. Eotvos (Eotvos) ran a day care out of their house.

There are special tax rules for a day care provider.

(1) For example, how would you depreciate your personal house for the day care activity?

The first rule that comes to mind is the office-in-home, but that rule doesn’t work for a provider. The office-in-home requires “exclusive” use in order to claim a deduction. By that standard a provider wouldn’t be able to claim any depreciation, unless one had a room used only for the day care.

In response, the IRS loosened that rule from “exclusive” to “regular” use. For example, a provider would use the kitchen, dining room and bathrooms regularly, making them eligible for depreciation.

Can you claim 100% of the cost of your house?

You already know the answer is “no.” That is what the shift from “exclusive use” to “regular use” means.

But what percentage do you use?

You probably use hours.

Let’s say you have kids in your house 45 hours a week.

You still spend time cleaning, lesson planning, preparing meals and so on. Say that it comes to another 14 hours per week.

There are 168 hours in a week. You spend 59 hours on daycare activities. Seems to me that 35% (59/168) would be reasonable.

(2) If you travel, you likely know about the per diem rate. This is something the IRS publishes annually, and – in general – you can deduct this rate for each day you are away-from-home for business purposes. You do not have to. You can claim actual expenses if you wish, but you will need to step-up your document retention procedures if you go that route.

Did you know that there are per diem rates for a day care provider? Yep, there is a rate for breakfast, lunch and snack. You can claim the per diem and skip the hassle of segregating how much of your grocery bill was for the day care and how much was personal.

The IRS looked at Eotvos’ 2012 through 2014 tax returns. They claimed depreciation on their house. The Court wanted to see the calculation.

Eotvos photographed numerous pieces of furniture and furnishings and estimated what they were worth.

COMMENT: We will not get into Accounting 101 here, but this is not the way it is done.

The furnishings they were depreciating – best the Court could tell - included a battle axe and jewelry.

Folks, there has to be some connection to a business activity to even start this conversation. You cannot bring home a pair of Nike sneakers and claim that 35% of the cost is deductible because you brought them inside the house.

Here is the Court:

Battle axes were not used as children’s playthings, and their acquisition and maintenance was not in furtherance of the day care business.”

What happens when you tell the Court silly stuff?

And a witness who can testify with a straight face about the nexus between a battle axe and a day care business earns no credibility.”

This is going south.

The IRS had calculated some depreciation, as there was no question that there was a day care there. Eotvos very much disagreed with the calculation, arguing – among other things – that the allowable business-use percentage should be 100%.

This blanket assertion, like the battle axe, strains credulity.”

They hit south and just kept going.

The Court allowed the IRS-calculated depreciation. The Court however slapped an accuracy-related penalty on the excess of their depreciation over the IRS number.

They sort of brought that upon themselves.

Owing A Million Dollar Penalty

What caught my attention was the size of the penalty.

The story involves Letantia Russell, a dermatologist from California who has been in the professional literature way too much over too many years. The story started with her attorneys reorganizing her medical practice into a three-tiered structure and concealing ownership through use of nominees. Then there was the offshore bank account.

Let’s talk about that offshore account.

Back when I came out of school, one had to report foreign accounts above a certain dollar balance. The form was called the “TD 90-22.1.” I remember accountants who had never heard of it. It just wasn’t a thing.

The requirement hasn’t changed, but the times have.

If you have an overseas bank account, you are supposed to disclose it. The IRS has a question on Schedule B (where you report interest and dividends) whether you have a foreign bank account. If you answer yes, you are required to file that TD 90-22.1. The form does not go to the IRS; it instead goes to the Treasury Department. Mind you, the IRS is part of Treasury, but there are arcane rules about information sharing between government agencies and whatnot. Send to Treasury: good. Send to IRS: bad.

The rules were fairly straightforward: bank account, balance over $10 grand, own or able to sign on the account, required to file. There was no rocket science here.

Don’t play games with account types, either. A checking account is the same as a savings account which is the same as a money market and so on. Leave that hair-splitting stuff to the lawyers.

About a decade or so ago, the government decided to pursue people who were hiding money overseas. Think the traditional Swiss bank account, where the banker would risk jail rather than provide information on the ownership of an account. That Swiss quirk developed before the Second World War and was in response to the unstable Third Republic of France and Weimar government of Germany. Monies were moving fast and furious to Switzerland, and Swiss bankers made it a criminal offense to break a strict confidentiality requirement.

Thurston Howell III joked about it on Gilligan’s Island.

Travel forward to the aughts and the UBS scandal and the U.S. government was not laughing.

Swiss banks eventually agreed to disclose.

The IRS thundered that those who had … ahem, “underreported” … their foreign income in the past might want to clean-up their affairs.

The government dusted-off that old 90-22.1 and gave it a new name: FinCen 114 Report of Foreign Bank and Financial Accounts.

The IRS was still miffed about that government-agency-sharing thing, so it came up with its own form: Form 8938 Statement of Foreign Financial Assets.

So you had to report that bank account to Treasury on the FinCen and to the IRS on Form 8938.  Trust me, even the accountants were trying to understand that curveball.

Resistance is futile, roared the IRS.

Many practitioners, me included, believed then and now that the IRS went fishing with dynamite. The IRS seemed unwilling to distinguish someone who inherited his/her mom’s bank account in India from a gazillionaire hedge-fund manager who knew exactly what he/she was doing when hiding the money overseas.

And you always have … those people.

Letantia Russell is one of those people.

The penalties can hurt. Fail to fail by mistake and the penalty begins at $10,000. Willfully fail to file and the penalty can be the greater of

·      $100,000 or

·      ½ the balance in the account

Letantia dew a $1.2 million penalty on her 2006 tax return. I normally sympathize with the taxpayer, but I do not here. One has to be a taxpayer before we can have that conversation.

It went to District Court. It then went to Appeals, where her attorneys lobbed every possible objection, including the unfortunate trade of Jimmy Garappolo from the New England Patriots to the San Francisco 49ers.

It was to no avail. She gets to pay a penalty that would make a nice retirement account for many of us.