Amending Your Way Into A Penalty

I have a set of tax returns in my office for someone who dropped off the tax grid for years. I suspect we will be fighting penalties and requesting a payment plan in the too-near future.

It reminded me of why not filing returns is a bad idea.

Here’s one: she has refunds she cannot use because the statute period has expired.

She could have used the refunds, as she has other years with tax due.

There is another reason.

Let’s say that you file a return, but you file it late. For example, you extend the return to October, but you don’t get around to filing until the following January or February. You have a refund so you do not care.

Many tax professionals would agree with you. Penalties apply on tax due. If there is no tax due, then – voila – no penalty (generally speaking).

But you later amend the return. Or the IRS adjusts the return for you. However it happened, you now owe tax.

Consider this:

          § 6651 Failure to file tax return or to pay tax

(a)  Addition to the tax.

In case of failure-

(1)    to file any return required under authority […]on the date prescribed therefor (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount required to be shown as tax on such return 5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate;

This is called the “late filing” penalty.

I am looking at a tax case from 1998. Greg Vinikoor (GK) married Melissa Vinikoor (MV). Best I can figure, her dad must have been loaded, as he was repeatedly transferring shares of stock to the newlyweds. GK graduated from college and took a job making $12 grand a year. They got everything out of that $12 grand, including:

·      trips to Hawaii, San Diego, Scottsdale and San Francisco

·      shopping trips to Saks Fifth Avenue, Neiman Marcus and Nordstrum

·      membership at the Tucson Country Club

We both know that they were not paying for this on that $12,000 salary. They were either borrowing against or selling stock that dad had transferred.

The IRS wanted to know why they were not reporting stock gains on their tax returns. There had been quite the run-up in value since dad had acquired the stock. In the case of a gift, dad’s low basis in the stock would carryover to the couple. Since gain = price – basis, that low basis meant a juicy gain, and the IRS wanted its cut.

Good question.

Uhhh…. Because we bought the stock from dad, they answered. Yeah, that’s it. We have a new – and higher! - basis because we bought the stock. We bought it on loan, and we have to pay dad back.

Fine, said the IRS. Show us the loan agreement.

Don’t have one, they replied.

Show us where you paid interest to dad.

We haven’t – not yet, they responded.

Is there a fixed repayment date?

Just an understanding, they susurrated.

How about security? Did you give any collateral for the loan?

No, not really, they murmured.

The Court was zero impressed.

After the stock rose, XXX [dad], the supposed creditor in these transactions never made any demand on petitioners for repayment, even though the value of the stock had increased substantially and petitioners were diminishing the stock with spendthrift habits.”

The Court decided this was a gift. There was gain, there was tax.

Guess who failed to file their tax return on time?

Yep, the Vinikoors.

Now they had penalties.

More specifically, that 25% penalty we talked about. It totaled over $38 grand.

And there is the trap. That late filing can haunt and hurt you if you later amend or the IRS adjusts the return to increase income. That penalty goes to back when, not the date you amended or the IRS adjusted.

File those returns on time, folks. Amend later if you do not have all the information, but at least you got the horse over the wire on time.

Our case this time – as you may have guessed – was Vinikoor v Commissioner.

TurboTax and Penalties

I am looking at a case that deals with recourse and nonrecourse debt.

Normally I expect to find a partnership with multiple pages of related entities and near-impenetrable transactions leading up to the tax dispute.

This case had to do with a rental house. I decided to read through it.

Let’s say you buy a house in northern Kentucky. You will have a “recourse” mortgage. This means that – if you default – the mortgage company has the right to come after you for any shortfall if sales proceeds are insufficient to pay-off the mortgage.

This creates an interesting tax scenario in the event of foreclosure, as the tax Code sees two separate transactions.

EXAMPLE:

          The house cost               $290,000

          The mortgage is             $270,000

          The house is worth        $215,000

If the loan is recourse, the tax Code first sees the foreclosure:

          The house is worth        $215,000

          The house cost               (290,000)

          Loss on foreclosure       ($75,000)

The Code next sees the cancellation of debt:

          The mortgage is worth  $270,000

          The house is worth        (215,000)

          Cancellation of debt       $55,000

If the house is your principal residence, the loss on foreclosure is not tax deductible. The cancellation-of-debt income is taxable, however.

But all is not lost. Here is the Code:

§ 108 Income from discharge of indebtedness.

(a)  Exclusion from gross income.

(1)  In general.

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if-

(E)  the indebtedness discharged is qualified principal residence indebtedness which is discharged-

(i)  before January 1, 2018, or

(ii)  subject to an arrangement that is entered into and evidenced in writing before January 1, 2018.

The Section 108(a)(1)(E) exclusion will save you from the $55,000 cancellation-of-debt income, if you got it done by or before the December 31, 2017 deadline.

Let’s change the state. Say that you bought your house in California.

That loan is now nonrecourse. That lender cannot hound you the way he/she could in Kentucky.

The taxation upon cancellation of a nonrecourse loan is also different. Rather than two steps, the tax Code now sees one.

Using the same example as above, we have:

          The mortgage is             $270,000

          The house cost               (290,000)

          Loss on foreclosure       ($20,000)  

Notice that the California calculation does not generate cancellation-of-debt income. As before, the loss is not deductible if it is from your principal residence.

Back to the case.

A married couple had lived in northern California and bought a residence. They moved to southern California and converted the residence to a rental. The housing crisis had begun, and the house was not worth what they had paid.

Facing a loss of over $300 grand, they got Wells Fargo to agree to a short sale. Wells Fargo then sent them a 1099-S for taking back the house and a 1099-C for cancellation-of-debt income.

Seems to me Wells Fargo sent paperwork for a sale in Kentucky. Remember: there can be no cancellation-of-debt income in California.

The taxpayer’s spouse prepared the return. She was an attorney, but she had no background in tax. She spent time on TurboTax; she spent time reading form instructions and other sources. She did her best. You know she was reviewing that recourse versus nonrecourse thing, as well as researching the effect of a rental. She may have researched whether the short sale had the same result as a regular foreclosure.

COMMENT: There was enough here to use a tax professional.

They filed a return showing around $7,000 in tax.

The IRS scoffed, saying the correct tax was closer to $76,000.

There was a lot going on here tax-wise. It wasn’t just the recourse versus nonrecourse thing; it was also resetting the “basis” in the house when it became a rental.

There is a requirement in tax law that property convert at lower of (adjusted) cost or fair market value when it changes use, such as changing from a principal residence to a rental. It can create a no-man’s land where you do not have enough for a gain, but you simultaneously have too much for a loss. It is nonintuitive if you haven’t been exposed to the concept.

Here is the Court:

This is the kind of conundrum only tax lawyers love. And it is not one we've been able to find anywhere in any case that involves a short sale of a house or any other asset for that matter. The closest analogy we can find is to what happens to bases in property that one person gives to another.”

Great. She had not even taken a tax class in law school, and now she was involved with making tax law.

Let’s fast forward. The IRS won. They next wanted penalties – about $14,000.

The Court didn’t think penalties were appropriate.

… the tax issues they faced in preparing their return for 2011 were complex and lacked clear answers—so much so that we ourselves had to reason by analogy to the taxation of sales of gifts and consider the puzzle of a single asset with two bases to reach the conclusion we did. We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance …”

They owed about $70 grand in tax but at least they did not owe penalties.

And the case will be remembered for being a twist on the TurboTax defense. Generally speaking, relying on tax software will not save you from penalties, although there have been a few exceptions. This case is one of those exceptions, although I question its usefulness as a defense. The taxpayers here strode into the tax twilight zone, and the Court decided the case by reasoning through analogy. How often will that fact pattern repeat, allowing one to use this case against the imposition of future penalties?

The case for the homegamers is Simonsen v Commissioner 150 T.C. No. 8.

Cincinnati Reds, Tax And Bobbleheads

Did you hear about the recent tax case concerning the Cincinnati Reds?

It has to do with sales and use tax. This area is considered dull, even by tax pros, who tend to have a fairly high tolerance for dull. But it involves the Reds, so let’s look at it.

The Reds bought promotional items - think bobbleheads - to give away. They claimed a sales tax exemption for resale, so the vendor did not charge them sales tax.

Ohio now wants the Reds to pay use tax on the promotional items.

COMMENT: Sales tax and use tax are (basically) the same thing, varying only by who is remitting the tax. If you go to an Allen Edmunds store and buy dress shoes, they will charge you sales tax and remit it to Ohio on your behalf. Let’s say that you buy the shoes online and are not charged sales tax. You are supposed to remit the sales tax you would have paid Allen Edmunds to Ohio, except that now it is called a use tax. 

The amount is not insignificant: about $88 grand to the Reds, although that covers 2008 through 2010.

What are the rules of the sales tax game?

The basic presumption is that every sale of tangible personal property and certain services within Ohio is taxable, although there are exemptions and exceptions. Those exemptions and exceptions had better be a tight fit, as they are to be strictly construed.

The Reds argued the following:

·      They budget their games for a forthcoming season in determining ticket prices.

·      All costs are thrown into a barrel: player payroll, stadium lease, Marty Brennaman, advertising, promotional items, etc.

·      They sell tickets to the games. Consequently, the costs – including the promotional items – have been resold, as their cost was incorporated in the ticket price.

·      Since there is a subsequent sale via a game ticket, the promotional items were purchased for resale and qualify for an exemption.

Ohio took a different tack:

·      The sale of tangible personal property is not subject to sales tax only if the buyer’s purpose is to resell the item to another buyer. Think Kroger’s, for example. Their sole purpose is to resell to you.

·      The purpose of the exemption is meant to delay sales taxation until that final sale, not to exempt the transaction from sales tax forever. There has to be another buyer.

·      The bobbleheads and other promotions were not meant for resale, as evidenced by the following:

o   Ticket prices remain the same throughout the season, irrespective of whether there is or isn’t a promotional giveaway.

o   Fans are not guaranteed to receive a bobblehead, as there is normally a limited supply.

o   Fans may not even know that they are purchasing a bobblehead, as the announcement may occur after purchase of the ticket.

The Ohio Board of Appeals rejected the Reds argument.

The critical issue was “consideration.”

Let’s say that you went to a game but arrived too late to get a bobblehead. You paid the same price as someone who did get a bobblehead, so where is the consideration? Ohio argued and the Board agreed that the bobbleheads were not resold but were distributed for free. There was no consideration. Without consideration one could not have a resale.

Here is the Board:

The evidence in the record supports our conclusion that the cost of the subject promotional items is not included in the ticket price.”

The Reds join murky water on the issue of promotional items. The Kansas City Royals, for example, do not pay use tax on their promotional items, but the Milwaukee Brewers do. Sales tax varies state by state.

Then again perhaps the Reds will do as the Cavaliers did: charge higher ticket prices for promotional giveaway games.

This is (unsurprisingly) heading to the Ohio Supreme Court. We will hear of The Cincinnati Reds, LLC v Commissioner again.

Deducting a Divorce

I am looking at two points on a case:

(1)  The IRS wanted $1,760,709; and

(2)  The only issue before the Court was a deduction for legal and professional fees.

That is one serious legal bill.

The taxpayer was a hedge fund manager. The firm had three partners who provided investment advisory services to several funds. For this they received 1.5% of assets under management as well as 20% of the profits (that is, the “carry”). The firm decided to defer payment of the investment and performance fees from a particular fund for 2006, 2007 and 2008.

2008 brought us the Great Recession and taxpayer’s spouse filing for divorce.

By 2009 the firm was liquidating.

The divorce was granted in 2011.

Between the date of filing and the date the divorce was granted, taxpayer received over $47 million in partnership distributions from the firm.

You know that point came up during divorce negotiations.

To be fair, not all of the $47 million can be at play. Seems to me the only reachable part would be the amount “accrued” as of the date of divorce filing.

He hired lawyers. He hired a valuation expert.

Turns out that approximately $4.7 million of the $47 million represented deferred compensation and was therefore a marital asset. That put the marital estate at slightly over $15 million.

Upon division, the former spouse received a Florida house and over $6.6 million in cash.

He in turn paid approximately $3 million in professional fees. Seems expensive, but they helped keep over $42 million out of the marital estate.

He deducted the $3 million.

Which the IRS bounced.

What do you think is going on here?

The issue is whether the professional fees are business related (in which case they are deductible) or personal (in which case they are not). Taxpayer argued that the fees were deductible because he was defending a claim against his distributions and deferred compensation from the hedge fund. He was a virtual poster boy for a business purpose.

He has a point.

The IRS fired back: except for her marriage to taxpayer, the spouse would have no claim to the deferred compensation. Her claim stemmed entirely because of her marriage to him. The cause of those professional fees was the marriage, which is about as personal as an event can be. The tax Code does not allow for the deduction of personal expenses.

The IRS has a point.

The tax doctrine the IRS argued is called origin-of-the-claim. It has many permutations, but the point is to identify what caused the mess in the first place. If the cause was business or income-producing, you may have a deduction. If the cause was personal, well, thanks for playing.

But a divorce can have a business component. For example, there is a tax case involving control over a dividend-paying corporation; there is another where the soon-to-be-ex kept interfering in the business. In those cases, the fees were deductible, as there was enough linkage to the business activity.

The Court looked, but it could not find similar linkage in this case.

In the divorce action at issue, petitioner was neither pursuing alimony from Ms [ ] nor resisting an attempt to interfere with his ongoing business activities.

Petitioner has not established that Ms [ ] claim related to the winding down of [the hedge fund]. Nor has petitioner established that the fees he incurred were “ordinary and necessary” to his trade or business.

While the hedge fund fueled the cash flow, the divorce action did not otherwise involve the fund. There was no challenge to his interest in the fund; he was not defending against improper interference in fund operations; there was no showing that her action led to his winding down of the fund.

Finding no business link, the Court determined that the origin of the claim was personal.

Meaning no deduction for the professional fees.

NOTE: While this case did not involve alimony, let us point out that the taxation of alimony is changing in 2019. For many years, alimony – as long as the magic tax words were in the agreement – was deductible by the payor and taxable to the recipient. It has been that way for my entire professional career, but that is changing. Beginning in 2019, only grandfathered alimony agreements will be deductible/taxable, with “grandfathered” meaning the alimony agreement was in place by December 31, 2018.

Mind you, this does not mean that there will be no alimony for new divorces. What it does mean is that one will not get a deduction for paying alimony if one divorces in 2019 or later. Conversely, one will not be taxed upon receiving alimony if one divorces in 2019 or later.

The Congressional committee reports accompanying the tax change noted that alimony is frequently paid from a higher-income to a lower -income taxpayer, resulting in a net loss to the Treasury. Changing the tax treatment would allow the Treasury to claw back to the payor’s higher tax rate. Possible, but I suspect it more likely that alimony payments will eventually decrease by approximately 35% - the maximum federal tax rate – as folks adjust to the new law.

Our case this time was Sky M Lucas v Commissioner.

When Do You Really Start A Business?

It doesn’t sound like much, but it can present a difficult tax issue.

When does a business start?

It helps to have sales. Sales are good. But sometimes you do not have sales.

Then what?

The issue is that tax law allows deductions for expenses incurred in a trade or business. This presumes that the activity has started and is occurring on a regular and continuous basis. Before that point it is more like an intent or hope than an actual business.   

Let’s set-up our story.

Taxpayer was a tax specialist, although I am not sure what that means. His wife was a nurse. For 2013 and 2014 he reported self-employed real estate losses of $15 and $22 thousand, respectively.

Got it. He is tax specialist when is he is not working real estate.

In 2010 he obtained a real estate license. He got together with friends and family and decided to invest in residential real estate. They were going to flip houses. The investor group decided to look in West Sacramento, California, (fortuitously, where he lived). On Saturdays he would leave home, drive 192 miles to Marina, California and pick-up one or more members of the group. They would return to Sacramento to check out houses and then back to Marina. At days-end, our protagonist would finally return home to West Sacramento.

Fortunately, he kept logs for all this driving. He racked up 24,882 miles in 2013 and 25,220 in 2014.

They never bought any property.

He also made no money as a real estate agent.

The IRS audited 2013 and 2014 and bounced the real estate expenses.

Off they went to Tax Court.

His argument was simple: are you kidding me? He was a realtor. He kept mileage logs. He had third parties who could testify that he did what he said he did. What more did the IRS want?

The IRS said that – whatever he was doing – it was not a trade or business.

There was no evidence that he was regularly and continuously working as a real estate agent for those years. You know, no income and all. 

So, what did the IRS think he doing with the family-and-friends consortium?

He was trying to start a business, a business flipping houses. But he and they never flipped a house, Heck, they never even bought a house. He was as much a house flipper as I am a retired ex-NFL player.

That put him in a tough spot.

Here is the Tax Court:

At best, petitioner husband’s activity in 2013 and 2014 was in the exploratory or formative stages of forming a business of flipping houses. Carrying on a trade or business requires more than initial research into a potential business opportunity; it requires that the business have actually commenced.

Section 162(a) does not permit current deductions for startup or preopening expenses incurred by a taxpayer before beginning business operations.”

He lost.

The IRS now wanted penalties – “substantial underpayment” penalties. This is a “super” penalty, for when the regular penalty is just not enough.

Remember that taxpayer listed his occupation as “tax specialist.”

Bad idea when you are trying to get penalties abated.

Here is the Court:

Petitioner husband considered his occupation to be a “tax specialist” and operated a tax preparation services business as a sole proprietorship. However, in preparing their tax returns petitioners failed to exercise due care or to do what a reasonable person would do under the circumstances to determine whether petitioner husband was in a trade or business ….”

Ouch.

The case is Samadi v Commissioner, for the home gamers.

Self-Renting a Big Green Egg

Sometimes tax law requires you to witness the torture of the language. Other times it herds you through a sequence of “except for” clauses, almost assuring that some future Court will address which except is taking exception.

And then you have the laughers.

I came across an article titled: Corporation’s self-leasing rental expense deduction denied.”

I was curious. We tax nerds have an exceptionally low threshold for curiosity.

Before reading the article, I anticipated that:

(1)  Something was being deducted

(2)  That something was rent expense

(3)  Something was being self-leased, whatever that means, and

(4)  Whatever it means, the deduction was denied.

Let us spend a little time on (3).

Self-lease (or self-rental) means that you are renting something to yourself or, more likely, to an entity that you own. It took on greater tax significance in 1986 when Congress, frustrated for years with tax shelters, created the passive activity (PAL) rules. The idea was to separate business activities between actually working (active/material participation) and living the Kennedy (passive activity).

It is not a big deal if all the activities are profitable.

It can be a big deal if some of the activities are unprofitable.

Let’s go back to the classic tax shelter. A high-incomer wants to shelter high income with a deductible tax loss.

Our high-incomer buys a partnership interest in a horse farm or oil pipeline or Starbucks. The high-incomer does not work at the farm/pipeline/Starbucks, of course. He or she is an investor.

In the lingo, he/she is passive in the activity.

Contrast that with whatever activity generates the high income. Odds are that he/she works there. We would refer to that as active or material participation.

The 1986 tax act greatly restricted the ability of the high-incomer to use passive losses to offset active/material participation income.

Every now and then, however, standard tax planning is flipped on its head. There are cases where the high-incomer wants more passive income.

In the name of all that is holy, why?

Has to do with passive losses. Let’s say that you had $10,000 in passive losses in 2015. You could not use them to offset other income, so the $10,000 carried over to 2016. Then to 2017. They are gathering dust.

If we could create passive income, we could use those passive losses.

How to create passive income?

Well, let’s say that you own a company.

You rent something to the company.

Let’s rent your car, your office-in-home or your Big Green EGG XXL.

Rent is passive income, right? The tax on our passive income will be zero, as the losses will mop up every dollar of income.

That is the “self-rental” the tax Code is after.

But it also triggers one of those “except for” rules: if the self-rental results in income, the income will not qualify as passive income.

All your effort was for naught. Thank you for playing.

Back to the article I was reading.

There is a doctor. He is the only owner of a medical practice. He used the second story of his house solely for the medical practice. Fair be fair, he had the practice pay him rent for that second floor.

I have no problem with that.

The Tax Court disallowed the corporation a rent deduction.

Whaaat? That makes no sense.

The purpose of the passive/active/material participation rules is not to deny a deduction altogether. The purpose is to delay the use of losses until the right type of income comes around.

What was the Tax Court thinking?

Easy. The doctor never reported the rental income on his personal return.

This case has nothing to do with self-rental rules. The Court simply was not permitting the corporation a deduction for rent that its shareholder failed to report as income.

The case for the home gamers is Christopher C.L. Ng M.D. Inc.

Medical Deduction For Nonconventional Treatments

Is a tax deduction available for alternative medical care?

“Alternative” does not necessarily mean unusual. It includes, for example, chiropractic care. As a decades-long gym rat and chiropractic patient, I find that rather amusing.

What does the tax Code want to see before you are permitted a deductible medical expense?

You may ask: who cares? Starting in 2018 more and more people will claim the standard deduction rather than itemize under the new tax law. And – even if you itemize – what is the nondeductible percentage for medical expenses anyway – 2%, 7.5%, 10%, 100% of adjusted gross income? Congress abuses this deduction like an unwanted toy.

I’ll tell you why: because you have flexible spending accounts, health savings accounts and their siblings. To be reimbursable the expense must meet the definition of a deductible medical expense. This is a separate matter from whether you actually deduct any medical expenses on your tax return.

Let’s look at the Malev case.

Victoria Malev suffers from spinal disease. She had seen a chiropractor, but that offered only temporary and partial relief from pain.

You can probably guess the next type of doctor she would see, but Malev wanted nothing to do with surgery and its associated risks.

She instead decided to try four different alternative treatments.

The Court was diplomatic:

… Petitioner subscribed to various forms of treatment from four individuals, none of whom would be commonly recognized as a conventional medical caregiver. And to be sure, none of the methods utilized by these individuals would commonly be recognized as a conventional medical treatment. The methods Petitioner subscribed to might be termed “alternative medicine” by the polite, but we expect the less tolerant would characterize the treatments in other than legitimate or complimentary terms.”

When asked, Malev said that she had greatly improved.

She went to see an M.D a few years later – in 2016 – and the doctor suggested surgery. The doctor further suggested she investigate “integrative” medical care.

Seems to me she was already doing that.

Question: does she have a medical deduction?

The Court pointed out the obvious: had she seen the M.D. first, there would be no issue, as the M.D. recommended she investigate alternative medicine. By reversing the order, she was claiming medical deductions before the (traditional) medical diagnosis.

One can tell that the Court liked Malev. The Court acknowledged her “sincere belief” that the treatments received were beneficial, pointed out that she had not previously known the four providers and there was no reason to believe she would pay them except for the treatments given.

The Court looked at what the Code and Regulations do NOT require of deductible medical expenses:

(1) The services do not have to be furnished by one licensed to practice medicine in any particular discipline;

(2) The services do not have to be provided in-person;

(3) The services do not need to be universally accepted as effective; and

(4) The services do not have to be successful.

Malev could immediately use (1) and (3).

The Court was skeptical, but it wanted to allow for the wild card: the role a person’s state of mind plays in the treatment of disease.

Malev believed. The Court believed that she believed.

She got her medical deduction.

However, in an effort to indicate how fact-specific the case was, the Court continued:

… it is appropriate to note that we fully appreciate the position taken by the Respondent in this case, and [we] consider their position to be more than justified.”

I read Malev as a one-off. If you are thinking of alternative or integrative health care, see an M.D. – preferably an open-minded one – first. It will save both of us tax headaches.