A Failure To Keep Records

You have to keep records.

Depending upon, this can be easy. Say that you have a job and a money market account – two sources of income. At year-end you receive a W-2 and a 1099-INT. File them with your individual tax return and you have kept records.

Dial this up to business level and the recordkeeping requirement can be more substantial.

Maybe you do not need a bookkeeper or accountant, but you can open a separate business bank account, running all deposit and disbursements through it. You can buy an expanding file – one with a pocket for each month – and keep invoices and receipts throughout the year. That might not be sufficient were you a regional contractor, with equipment and employees and whatnot, but it may be more than enough for what you do.

Why do this?

Because of taxes.

There is a repetitive phrase in tax cases - I have read it a thousand times:

Deductions are a matter of legislative grace, and the taxpayer must prove his or her entitlement to deductions.”

To phrase it another way:

Everything is taxable and nothing is deductible unless we say it is deductible.

One of the things the IRS says is that you must keep records. You can extrapolate what the IRS can do to you concerning deductions if you do not.

“But they can’t eat me, right, CTG?” you ask.

No, but here is what they can do.

Sam Fagenboym was a 50% owner of Alcor Electric, which provided electrical installation for midsize commercial projects. Alcor was a sub to a general contractor. Alcor in turn had suppliers and its own subs.

With the possible exception of the second round of subs, this is pretty routine stuff.

Alcor was an S corporation. It allocated Fagenboym a loss of approximately $110,000 on his 2015 Schedule K-1.

The IRS examined Alcor’s 2015 business return.

Alcor could not document over a quarter million dollars of purchases from a supplier.

Half of that audit adjustment went to Fagenboym, as he was a 50% owner.

The IRS next looked at Fagenboym’s personal return.

So much for the loss he had claimed from Alcor.

Fagenboym went to Tax Court. He went pro se, generally meaning that he was without tax representation.  As we have discussed before, that technically is not correct, as I could represent someone in Tax Court and they would be considered pro se.

Fagenboym argued for Cohan treatment of Alcor’s business expenses.

COMMENT: I would have expected Alcor to fight this issue during its business audit, but here is Fagenboym doing the fighting during his individual audit.    

Cohan is old tax case, going back to 1930 and involving someone who was known for entertaining but not for keeping receipts and records. The Court considered his situation, reasoning there was no doubt that Cohan had incurred expenses. It would be inequitable to disallow all expenses, so the question became: how much to allow?

Cohan has triggered tax changes ever since. It was responsible for the hyper-technical rules concerning meals and entertainment, for example, as well as business use of a vehicle.

Fagenboym wanted some of that Cohan.

I presume there truly were no records. There is no way that I would lead with Cohan if I had any other argument.

Why?

Think about it from the Court’s perspective.

(1) The Court will require a rational basis to estimate the expenses, and

(2)  The Court will consider the taxpayer’s culpability in creating this situation.

Perhaps if there were extenuating circumstances: illness of a key employee, a data loss, a pandemic, something that compromised the taxpayer.  The more one is responsible for causing the mess, the less likely the Court will be to clean-up the mess.

Fagenboym tried. He presented the Court with estimates of job profitability. He then subtracted labor and other known expenses to arrive at what the missing purchases should have been. He submitted four pages of handwritten analysis, but he did not or could not support it with business bank statements or other records, such as an accounts payable history for the supplier in question. Despite how earnest he seemed and how well he understood the business, there were no records backing him up.

Fagenboym could not overcome the two factors above. Even if the Court allowed some leniency on his culpability, it decided it could not independently arrive at a reasonable estimate of the costs involved.

No Cohan. No tax deduction. Bad day in Court for Fagenboym.

Mean It When You Elect S Corporation Status

I am looking at an odd case.

I see that the case went to Tax Court as “pro se,” which surely has a great deal to do with its general incoherence. Pro se generally means that the taxpayer is representing himself/herself. Technically this is not correct, as I could represent someone in Tax Court and the case still be considered pro se. There was no accountant involved here, however, and it shows.

We are talking about Hong Jun Chan. 

He founded a restaurant named Younique Café Inc (YCI) in August, 2010.

In March, 2011 he filed an election with the IRS to be treated as an S corporation. All the owners have to agree to such an election, and we learned that Chan was a 40% shareholder of YCI.  

Let’s fast forward to 2016.

Chan and his wife filed a joint tax return for 2015, but they did not include any numbers from YCI. That does not make sense, as the purpose of an S corporation is to avoid corporate tax and instead report the entity’s tax numbers on the shareholder’s individual/separate return.

A year later the Chan’s did the same with their 2016 joint tax return.

This caught the attention of the IRS, which started an audit in 2019. The revenue agent (RA) found that no business returns had ever been filed.

Standard procedure for the IRS is to contact the taxpayer: perhaps the taxpayer is to visit an IRS office or perhaps the audit will be conducted via correspondence. The IRS did not hear from Chan. Chan later explained that they had moved to Illinois and received no IRS correspondence.

The RA went all Kojak and obtained YCI’s bank records. The RA added up all the deposits and determined that the Chan underreported his taxable income by $1,139,879 and $731,444 for 2015 and 2016 respectively.

Yep, almost $2 million.

Off to Tax Court they went.

Chan had a straightforward argument: YCI was not an S corporation. It was a C corporation, meaning it filed its own tax returns and paid its own taxes. Let’s be fair: the restaurant had gone out-of-business. It is unlikely it ever made money. Unless there was an agency issue, the business tax could not be attributed to Chan personally.

Got it.

ISSUE: YCI filed an S election. The IRS had record of receiving and approving the election. YCI was therefore an S corporation until it (1) was disqualified from being an S, (2) revoked its election, or (3) failed an obscure passive income test.

PROBLEM: YCI was not disqualified, had no passive income and never revoked its election.

But …

Chan presented C corporation tax returns for 2015 and 2016. They were prepared by a professional preparer but were not signed by the preparer.

COMMENT: That is odd, as a paid preparer is required to sign the taxpayer’s copy of the return. I have done so for years.

The IRS of course had no record of receiving these returns.

COMMENT: We already knew this when the RA could not find a copy of the business return. Any search would be based on YCI’s employer identification number (EIN) and would be insensitive to whether the return was filed as a C or S corporation.

Hopefully Chan mailed the business return using certified mail.

Chan had no proof of mailing.

Of course.

At this point in the case, I am supposed to believe that Chan went to the time and trouble of having a professional prepare C corporation returns for two years but never filed them. Righhhttt ….

But maybe Chan thought the preparer had filed them, and maybe the preparer thought that Chan filed them. It’s a low probability swing, but weird things happen in practice.

This is easy to resolve: have the preparer submit a letter or otherwise testify on what happened with the business returns.

Crickets.

The IRS in turn was not above criticism.

It added up deposits and said that the sum was taxable income.

Hello?? This is a RESTAURANT. There would be food costs, rent, utilities and so forth. Maybe the RA should have spent some time on the disbursement side of that bank statement.

Then the IRS charged 100% of the income to Chan.

Hold on here: didn’t Form 2553 show Chan as owning 40% - not 100% - of YCI?

We don’t believe that, said the IRS.

Both sides are bonkers.

Chan went into Tax Court without representation after the IRS tagged him with almost $2 million of unreported income. This appears a poor decision.  

The IRS - relying on a Form 2553 to treat Chan as a passthrough owner – could not keep reading and see that he owned 40% and not 100%.

Can you imagine being the judge listening to this soap opera?

The Court split its decision:

(1) Yep, Chan is an S corporation shareholder and has to report his ownership share of the restaurant’s profit or loss for 2015 and 2016.

(2)  Nope, both sides must go back and do something with expenses, as well as decide Chan’s ownership for the two years.

Our case this time was Hong Jun Chan and Suzhen Mei v Commissioner, T.C. Memo 2021-136.

Starting A Business In The Desert

 

Tax has something called “startup costs.”

The idea is to slow down how quickly you can deduct these costs, and it can hurt.

Let’s take a common enough example: starting a restaurant.

You are interested in owning a restaurant. You look at several existing restaurants that may be available for purchase, but you eventually decide to renovate existing space and open your own- and new – restaurant. You lease or buy, then hire an architect for the design and a contractor for the build-out of the space.

You are burning through money.

You still do not have a tax deduction. Expenses incurred when you were evaluating existing restaurants are considered investigatory expenses. The idea here is that you were thinking of doing something, but you were not certain which something to do – or whether to do anything at all.

Investigatory expenses are a type of startup expense.

The contractor comes in. You are installing walls and windows and floors and fixtures. The equipment and furniture are delivered next.

You will depreciate these expenses, but not yet. Depreciation begins when an asset is placed in service, and it is hard to argue that assets are placed in service before the business itself begins.

You still do not have a tax deduction.

You will be the head chef, but still need your sous and line chefs, as well as a hostess, waitpersons, bartender and busboys. You have payroll and you have not served your first customer.

It is relatively common for a restaurant to have a soft launch, meaning the restaurant is open to invited guests only. This is a chance to present the menu and to shakedown the kitchen and floor staff before opening doors to the general public. It serves a couple of purposes: first, to make sure everyone and everything is ready; second, to stop the startup period. 

Think about the expenses you have incurred just to get to your soft launch: the investigatory expenses, the architect and contractor, the construction costs, the fixtures and furniture, employee training, advertising and so on.

Carve out the stuff that is depreciable, as that has its own rules. The costs that are left represent startup costs.

The tax Code – in its wisdom or jest – allows you to immediately deduct up to $5,000 of startup costs, and even that skeletal amount is reduced if you have “too many” startup costs.

Whatever remains is deductible pro-rata over 15 years.

Yes, 15 years. Almost enough time to get a kid through grade and high school.

You clearly want to minimize startup costs, if at all possible. There are two general ways to do this:

·      Start doing business as soon as possible.  Perhaps you start takeout or delivery as soon as the kitchen is ready and before the overall restaurant is open for service.

·      You expand an existing business, with expansion in this example meaning your second (or later) restaurant. While you are starting another restaurant, you are already in the business of operating restaurants. You are past startup, at least as far as restaurants go.

Let’s look at the Safaryan case.

In 2012 or 2013 Vardan Antonyan purchased 10 acres in the middle of the Mojave desert. It was a mile away from a road and about 120 miles away from where Antonyan and his wife lived. It was his plan to provide road access to the property, obtain approval for organic farming, install an irrigation system and subdivide and rent individual parcels to farmers.  

The place was going to be called “Paradise Acres.” I am not making this up.

Antonyan created a business plan. Step one was to construct a nonlivable structure (think a barn), to be followed by certification with the Department of Agriculture, an irrigation system and construction of an access road.

Forward to 2015 and Antoyan was buying building materials, hiring day laborers and renting equipment to build that barn.

Antoyan and his wife (Safaryan) filed their 2015 tax return and claim approximately $25 thousand in losses from this activity.

The IRS bounced the return.

Their argument?

The business never started.

How did the IRS get there?

Antonyan never accomplished one thing in his business plan by the end of 2015. Mind you, he started constructing the barn, but he had not finished it by year-end. This did not mean that he was not racking-up expenses. It just meant that the expenses were startup costs, to be deducted at that generous $5,00/15-year burn rate starting in the year the business actually started.

The Court wanted to see revenue. Revenue is the gold standard when arguing business startup. There was none, however, placing tremendous pressure on Antonyan to explain how the business had started without tenants or rent – when tenants and rent were the entirety of the business.  Perhaps he could present statements from potential tenants about negotiations with Antonyan – something to persuade the Court.   

He couldn’t.

Meaning he did not start in 2015.

Our case this time was Safaryan v Commissioner, T.C. Memo 2021-138.

Happy New Year

 

Seeking Tax Exempt Status By Lessening The Burden Of Government

Let’s introduce Captain Obvious: if you want charitable tax-exempt status from the IRS, you need to have a charitable purpose.

Let’s look at New World Infrastructure Organization’s application for tax-exempt status.

It starts with two individuals: Scott and Pam Johnston.

They owned a business called The Pipe Man Corp (TPMC). Scott was the president and Pam the vice-president

TPMC was organized to develop a portable pipe manufacturing system, working and shaping pipe in larger-than-usual sizes. Combine these pipes with road infrastructure and a business opportunity was created.

TPMC never got started. I guess it needed angel investors, and the investors never appeared.

The Johnstons then organized a nonprofit corporation called New World Infrastructure Organization (New World).  Scott and Pam were its only officers and directors. TPMC granted New World permission to use its copyrights and patents, whatever that meant, given that Scott and Pam were the only two officers and were on both sides of the equation.

New World submitted an application for tax-exempt status, stating that its …

… ultimate purpose and core focus will be charitable, with … [its] main beneficiary being Federal, State and Local Government Agencies.

OK, its purpose has something to do with government.

… our research will result in encouraging Economic Development throughout the United States. It will save time, money and lessen the burden of government. The prototype machinery, after testing, will be placed into service making very large corrugated metal pipe. The pipes need to make a Highway Overpass can be made and arched in less than a week. The cost of these pipes represent a fraction of the cost of traditional methods.”

Lessening the burden of government can be a charitable mission. For tax-exempts, this generally means that a governmental unit considers the organization to be acting on its behalf. The organization is freeing up resources – people, material, money – that the governmental unit would have to devote were it to conduct the activity itself.   

It would be helpful to present a prearranged understanding with one or more government units, especially since New World was hanging so much of its hopes on the lessening-the-burden-of-government hook.

Helpful but not happening.

I am not clear how New World was lessening anything.

According to the narrative description, … [New World] intends to fulfill its charitable purpose by working with governmental agencies, engineering firms, and businesses to reduce the cost of infrastructure projects to ‘as little as one fourth current costs.’”

Wait a second. Is New World saying that its exempt purpose was to reduce the cost of projects to the government? That is not really an exempt purpose, methinks. Let’s say that you start a business and guarantee the government that you will beat a competitor’s price by 10%. That may or may not be a good business model, but you are still in business and still for-profit. Maybe a little less profit, but still for-profit.

How about if New World provided its services at cost?

… while petitioner has suggested … that it would be willing to enter into an exclusivity agreement … to sell its product at cost, it has not established through its bylaws or otherwise that it would in fact do so.”

Seems that New World wanted a profit. It is not clear what it would do with a profit, although there is the old reliable saw of paying-out profits via salaries and bonuses to its two officers and directors.

The Court saw a failed business effort slapped into a tax-exempt application. The supposed charitable purpose was to offer a lower price on infrastructure projects, which was not quite as inspiring as clothing the poor or feeding the hungry. It appeared that no governmental unit had asked to have its burdens reduced. It further appeared that there was a more-than-zero possibility of personal benefit and private inurement to the Johnstons.

Why even go to all this effort?    

I suppose the (c)(3) status would have allowed New World to obtain the funding that its predecessor – TPMC – was unable to obtain. TPMC would have issued stock or borrowed money. New World would have raised capital via tax-deductible charitable contributions.   

The Tax Court said no dice.

Our case this time was New World Infrastructure Organization v Commissioner, T.C. Memo 2021-91. 

Merry Christmas

 

Botching An IRS Bank Deposit Analysis

 

What caught my eye was the taxpayer’s name. I am not sure how to pronounce it, and I am not going to try.

I skimmed the case. As cases go, it is virtually skeletal at only 6 pages long.

There is something happening here.

Let’s look at Haghnazarzadeh v Commissioner.

The IRS wanted taxes, penalties and interest of $2,424,100 and $1,152,786 for years 2011 and 2012, respectively.

Sounds like somebody is a heavy hitter.

Here is the Court:

“… the only remaining issue is whether certain deposits into petitioners’ nine bank accounts are ordinary income or nontaxable deposits.”

For the years at issue, Mr H was in the real estate business in California. Together, Mr and Mrs H had more bank accounts than there are days of the week. The IRS did a bank deposit analysis and determined there was unreported income of $4,854,84 and $1,868,212.

Got it.

Here is the set-up:

(1) The tax Code requires one to have records to substantiate their taxable income. For most of us, that is easy to do. We have a W-2, maybe an interest statement from the bank or a brokers’ statement from Fidelity. This does not have to be rocket science.

This may change, however, if one is in business. It depends. Say that you have a side gig reviewing articles before publication in a professional journal. What expenses do you have? I suspect that just depositing the money to your bank account might constitute adequate recordkeeping.

Say you have a transportation company, with a vehicle fleet and workforce. You are now in need of something substantial to track everything, perhaps QuickBooks or Sage, for example. 

(2) Let’s take a moment about being in business, especially as a side gig.

Many if not most tax practitioners will advise a separate bank account for the gig. All gig deposits should go into and all business expenses should be paid from the gig account. What about taking a draw? Transfer the money from the gig account to a personal account. You can see what we are doing: keep the gig account clean, traceable.

  (3) Bad things can happen if you need records and do not keep any.

We know the usual examples: you claim a deduction and the IRS says: prove it. Don’t prove it and the IRS disallows the deduction.

The tax Code allows the IRS to use reasonable means to determine someone’s income when the records are not there.  

(4) One of those methods is the bank deposit analysis.

It is just what it sounds like. The IRS will look at all your deposits, eliminating those that are just transfers from other accounts. If you agree that what is left over is taxable, the exercise is done. If you disagree, then you have to provide substantiation to the IRS that a deposit is not taxable income.

The substantiation can vary. Let’s say that you took a cash advance on a credit card. You would show the credit card statement – with the advance showing – as proof that the deposit is not taxable.

Let’s say that your parents gifted you money. A statement or letter from your parents to that effect might suffice, especially if followed-up with a copy of their cancelled check.

You might be wondering why you would deposit everything if you are going to be flogged you with this type of analysis. There are several reasons. The first is that it is just good financial and business practice, and you should do it as a responsible steward of money. Second, you are not going to wind up here as default by the IRS. Keep records; avoid this outcome. A third reason is that the absence of bank accounts – or minimal use of the same – might be construed as an indicator of fraud. Go there, and you may have leaped from being perceived as a lousy recordkeeper to something more sinister.

Back to the H’s.

They have to show something to the IRS to prove that the $4.8 million and $1.8 million does not represent taxable income.

Mr H swings:

For 2011 he mentioned deposits of $1,556,000 $130,000, and $60,000 for account number 8023 and $1,390,000, $875,000, and $327,000 for account number 4683”

All right! Show your cards, H.

Why would I need to do that? asks Mr H.

Because ……. that is the way it works, H-man. Trust but verify.

Not for me, harumphs Mr H.

Here is the Court:

Petitioner husband did not present evidence substantiating his claim that any of these deposits should be treated as nontaxable.”

Maybe somebody does not understand the American tax system.

Or maybe there is something sinister after all.

What it is isn't exactly clear.

COMMENT: This was a pro se case. As we have discussed before, pro se generally means that the taxpayer was not represented by a tax professional. Technically, that is not correct, as someone could retain a CPA and the decision still remain pro se. With all that hedge talk, I believe that the H’s were truly pro se. No competent tax advisor would make a mistake this egregious.  

Our case (again) was Haghnazarzadeh v Commissioner, T.C. Memo 2021-47.