Tomato Supplier Must Change Accounting Method

 

Let’s talk about when we can deduct something on a tax return.

We are talking about accrual accounting. Cash accounting would be easy: you are not allowed to deduct something until it is paid.

Not surprisingly, there is a Code section for this.

Code § 461 - General rule for taxable year of deduction

            (h) Certain liabilities not incurred before economic performance

(1) In general

 

For purposes of this title, in determining whether an amount has been incurred with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.

We see two key terms: the all-events test and economic performance.

First, a potential deduction must pass the all-events test before it can even think of landing on a tax return.

Second, that potential deduction must next pass a second test – economic performance – before it is allowed as a deduction.

Let’s spend time today on the first hurdle: the all-events test.     

Back to the Code:

            All events test

For purposes of this subsection, the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.

There are two prongs there:

·       The fact  

·       The amount  

Much of the literature in this area concerns economic performance, which is the next test after the above two are met. One might presume that the all- events test is a low bar, and that an expense accrued under GAAP for financial reporting purposes would almost automatically meet the all-events test for tax reporting purposes.

You would be surprised how often this is not true, and tax accounting will not give the same answer as financial reporting accounting.

I was reviewing a case this past week. It comes from the Court of Appeals for the Ninth Circuit, a circuit which includes California.

Morning Star Packing Company and Liberty Packing Company appealed their Tax Court decisions. Both are based in California, and – combined – they supply approximately 40% of the U.S.’s tomato pastes and diced tomatoes. 

Tomato season in California lasts approximately 100 days – from June to September. During this period Morning Star runs its production facilities at maximum capacity 24 hours a day. When the season ends in October, the equipment has been traumatized and needs extensive reconditioning before going into production again. For assorted reasons, Morning Star normally waits near the start of the following season before doing such reconditioning.

Let’s assign dates so we can understand the tax issue.

Say that the frenetic 100-day production activity occurred in 2022.

Morning Star will recondition the equipment before the start of the next production cycle – that is, in 2023.

Reconditioning costs are substantial and can be north of $20 million.

Morning Star deducts the anticipated reconditioning costs to be incurred in 2023 on its 2022 tax return.

What do you think? Can Morning Star clear the all-events test?

Here is the taxpayer:

·       Our customers generally require that the tomato products meet certain quality and sanitary standards. Many customers require independent testing. The facilities are also inspected by the U.S. Department of Agriculture, the Food and Drug Administration and the California Department of Public Health.

·       An obligation to refurbish the equipment is strongly implied by the need to meet governmental regulations.

o   Failure to meet such standards could result in the company being required to pay farmers for spoiled tomatoes and/or paying customers for failure to provide tomato products. Any such payments could be catastrophic to the company.

·       The company has credit agreements with several banks. These agreements include numerous covenants such as the following:

o   Each borrower and its respective Subsidiaries shall (i) maintain all material licenses, Permits, governmental approvals, rights, privileges, and franchises reasonably necessary for the conduct of its business ….

o   Each borrower and its respective Subsidiaries shall … conduct its business activities in compliance with all laws and material contractual obligations applicable ….

o   Each borrower and its respective Subsidiaries shall …keep all property useful and necessary in its business in good working order and condition, ordinary wear and tear excepted….

·       An obligation to refurbish the equipment can be inferred from the “all property useful and necessary in its business in good working order” covenant.

Here is the IRS:

·       The credit agreements do not specifically fix the company’s obligation.

o   The agreements do not specify which laws or regulations must be complied with.

o   The agreements do not specify which property must be kept in good working order.

o   The term “wear and tear” refers to ordinary use; “ordinary” wear and tear is excepted; the agreements therefore do not require the company to refurbish its equipment because it would meet the “ordinary wear and tear” exception.

·       The customer agreements are production specific and do not directly require reconditioning costs. Granted, failure to perform could be financially catastrophic, which implies a high degree of certainty that reconditioning will occur, but a high likelihood is different from a certain obligation.

Both the Tax Court and the Appeals Court agreed with the IRS.

I am divided.

I believe that the IRS is technically correct. There was no explicit obligation, requirement, or guarantee that Morning Star will recondition its facilities before the start of the next season’s production run. I however consider that a false flag. Economic and business reality assures me that it will recondition, because a failure to do so could invite business and financial ruin. Would the USDA or FDA even allow them to start next year’s production run without reconditioning?

Decisions like this unfortunately pull tax practice closer to a wizard’s incantation. The practitioner must be certain to include the magic words, intonating appropriately at proper moments to evoke the intervention of unseen eldritch forces. Fail to include, intone, or evoke correctly and lose the spell – or tax deduction.

Here is Judge Bumatay’s dissent:

The Internal Revenue Service (“IRS”) has a shocking view of taxpayer’s money. According to the IRS’ counsel at oral argument, any disagreement on when a tax payment is due constitutes ‘an interest-free loan from the government' to the taxpayer. That’s completely wrong. Simply, the income of everyday Americans is not government property.”

In fact, Morning Star has used this method since its founding. And the IRS had endorsed this practice – it audited Morning Star in the early 1990s and concluded that this practice was acceptable. But now, after Morning Star’s deductions for years, the IRS changes its mind and demands that Morning Star alter how it recognizes the reconditioning costs.”

Morning Star’s liability was fixed at the end of each season’s production run.”

… the law does not require the taxpayer to prove the fixed obligation to a metaphysical certitude.”

You go, Judge B.

I am not impressed that the IRS previously looked at the accounting method, found it acceptable and now wants to change its mind. That is not the way it works in professional practice, folks. The CPA cannot be reviewing every possible accounting issue de novo every year.

And I am less than impressed that an IRS representative argued that the change was necessary because the government was assuming the risk that the company would not be able to pay its taxes should it encounter a bad harvest or other financial malady.

Seriously? The owners of Morning Star face multiple business dangers every day and the government is “assuming the risk?” We cannot DOGE these people and bureaucracies soon enough.

But then again, Morning Star could have boosted its case with a minor change to its credit agreements. How? Include annual reconditioning as a requirement to retain its credit facility. If Morning Star is going to recondition anyway, making it a requirement might be the magical incantation we need.

Our case this time is Morning Star Packing Company L.P., 9^th Circuit, No. 21-71191.

An Accounting Firm Gets Sued

I just saw that Baker Tilly has acquired Seiler LLP, a CPA firm located in San Francisco and practicing for well over half a century.

There is nothing unusual here. Many older CPAs are looking to retire. In some cases, the firm may have planned for transition and brought in, developed, and retained a pipeline of ownership-interested younger CPAs.  The older CPAs retire, the younger CPAs step up and the firm continues.

In other cases, there is no such pipeline, and the older CPA’s exit plan is a sale to another firm.

The matter caught my eye because a client is suing Seiler for negligence. The matter is still in court. I thought the grounds for negligence was … different.

It is not our usual brew of java, but let’s talk about it.

It starts with a married couple: Eric Freidenrich and Amy Macartney. They hired Seiler to prepare their 2019 joint tax return. The return was filed in December 2020.

COMMENT: You may be thinking that the return was filed late (that is, after October 15) and penalties and interest would be due. That is not true here, as the return showed an overpayment of almost $450 grand. There normally will be no interest and penalties on refund-due returns, as penalties and refunds normally apply only when balances are due the IRS. The risk to a refund return is waiting too long to file a return. Remember, the statute of limitations on filing is three years. Wait past those three years and you will lose your refund.

For some reason, Eric and Amy did not use a home address on their return. They instead used their financial advisor’s address, a practice they had followed for years.

Now, a couple of things happened after 2019 and during 2020 before Seiler filed the return:

·       Eric and Amy divorced.

·       The financial advisor moved.

On first blush, I would be concerned about the divorce. A CPA (or his/her firm) should think long and hard about representing a divorcing couple. The reason is simple: which one of the two is the client? Representing both can create a conflict of interest, and a CPA is supposed to maintain independence and avoid such conflicts. Failure to do so can result in a hearing before a State Board of Accountancy.

The refund arrived in April 2022.

The two had signed their separation agreement in June 2021.

The separation agreement included language that Eric would be responsible for additional taxes due during the term of marriage, but - to be fair - he would also be entitled to any refunds.

Amy did not know that the IRS refund got held up. The couple’s routine was to deposit in the couple’s Fidelity account, and the separation agreement had Amy receiving 60% of the Fidelity account.

The refund was almost $450 grand, and 60% of that – approximately $270 grand – would have gone to Amy.

She was not amused.

I would not be either.

She sued Seiler for negligence.

Notice that she did not sue her ex-husband.

Where is the negligence?

Seiler – as a firm – knew that that advisor had moved. It should have used the new address.

Did the tax team – a subset of Seiler – also know that the advisor had moved? Information moves well enough in a CPA firm, but it would be false to say that it moves flawlessly. It is possible that the tax department did not know, but Amy is suing Seiler, not the tax department.

Seiler (or rather, their attorney) tried to get the motion dismissed.

And there is a quick lesson here about torts. Torts are civil law. Think of torts as suing someone. You bring suit, not the government. It is conduct between private parties.

The idea behind a tort is to restore the injured party (as much as possible in the circumstance) to where he/she would have been had the other party not acted or failed to act. A goal of tort law is to see the world as it could have been, not as the world is now.

Well, under that description Amy would have received 60% of the IRS refund. Seiler injured her. Her ex did not injure her, as he stated in the divorce decree that he would keep any tax refunds relating to the marriage term.

The Court therefore saw reason for tort action and would not grant summary motion for dismissal.

What does this mean? It means that the Court will hear the case against Seiler for negligence.

As a tax CPA, it bothers me that I could get my firm sued for something I did not even know. That said, I get it. The firm knew. However, Eric and Amy saw the address on the return. Their attorneys would also have seen the address. Do we know if the financial advisor timely filed a change of address with the IRS? Seiler might not be the only party with some measure of fault. 

Why Do We Keep Vehicle Logs?

  

November proved to be an interesting month here at Galactic Command. Everything changes; we have changed; there is sadness about the change. We may talk about this someday, but for today let’s keep our discussion to matters of tax.

Here is an easy one, but many get it wrong: can you estimate your auto expenses?

The use of estimates in accounting is prevalent: a bad debt reserve, an inventory write-down, even something as prosaic as depreciation.  It has to be this way, otherwise you could not get financial results out in time to be useful. For example, say you have a warranty program on a newer – and significant – product line. You may want to accrue a warranty reserve on this product line, but the line does not have sufficient track record to be statistically reliable.  I suppose you could skip a reserve altogether (not a good answer) or wait until there is enough history before issuing financials (also not a good answer).

Tax returns also use these numbers. Mind you, a tax return has a separate purpose from financial accounting - the purpose of a tax return being to separate you from your money. Depending upon, the IRS may flat-out tell you what accounting method to use. In most cases, though, tax and financial accounting coexist well enough.

There was a case in the 1930s that many tax advisors have studied: Cohan.

George Cohan was a famous Broadway star, producer and manager in the early part of the 1900s. He was known for his over-the-top entertaining of both fans and critics, and entertainment was a significant part of his business expenses. What George was not good at, though, was keeping receipts and records. He got audited, and the IRS proposed to disallow a raft of deductions because Cohan could not substantiate them. The IRS won before the Tax Board of Appeals (think the predecessor to today’s Tax Court).

Cohan had no intention of rolling over. He appealed.

And he won on his appeal.

The Court reasoned that approximating his expenses may be unsatisfactory, but an outright denial of his expenses was erroneous.

So, the Court estimated what his expenses would be. Mind you, there were some guardrails, such as the proving a right to deduct the expenses and providing some basis for the deduction (restaurant booking registers, for example), such that an independent person could agree that an expense was incurred and when.

This estimating of expenses has since been known as the Cohan rule.

But you know who did not like the rule? Congress. They wrote the following into the tax Code:

Section 274(d)

               (d) Substantiation required

No deduction or credit shall be allowed—

(1) under section 162 or 212 for any traveling expense (including meals and lodging while away from home),

(2) for any expense for gifts, or

(3) with respect to any listed property (as defined in section 280F(d)(4)),

unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of such expense or other item, (B) the time and place of the travel or the date and description of the gift, (C) the business purpose of the expense or other item, and (D) the business relationship to the taxpayer of the person receiving the benefit. The Secretary may by regulations provide that some or all of the requirements of the preceding sentence shall not apply in the case of an expense which does not exceed an amount prescribed pursuant to such regulations. This subsection shall not apply to any qualified nonpersonal use vehicle (as defined in subsection (i)).

Yes, it reads like gobbledygook but note the phrase “unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement.” Congress was saying that – for certain expenses – Cohan would be insufficient to save the day. One of those expenses was “listed property” which normal people refer to as a car or truck.

The Cohan rule will not save you when it comes to car and truck expenses. You have to keep records, such as a log or something similar for the business use of the vehicle.

Lisa Nkonoki deducted $22,936 for vehicle expenses on her 2009 federal tax return. Most of it was for the use of her Mercedes, but there were also rental cars during the year. She did not have a fixed office, meaning that she travelled – a lot.

The IRS wanted that mileage log.

Lisa refused. Off to Court they went.

Now the Court wanted the log.

Lisa told the Court that she had provided the log to the accountant who prepared her return, but the accountant failed to return it to her.

This placed the Court in a tough spot.

Her word alone was insufficient to substantiate the deduction.  The Court knew that her work involved travel – meaning that vehicle expenses were to be expected – but Section 274(d) would not let the Court estimate those expenses.

The Court disallowed her vehicle expenses.

I am curious why Nkonoki did not provide an alternative:

Using her e-mail, telephone and credit card records, could she have recreated an alternate log of her travel, including clients, dates and distances? We think of a log as being created at the moment (“contemporaneous”), but the Courts have noted that is not the correct meaning. Contemporaneous also encompasses other information (think e-mails) created at or near the time the expenses were incurred. Perhaps one transcribes that information into more usable form at a later time (such as a Tax Court hearing), but the information underlying such transcription was created at or near the time – that is, it was contemporaneous.

Our case this time was Nkonoki v Commissioner, T.C. Memo 2016-93.

An IRS Employee And Unreported Income

 

You may have heard that Congress is tightening the 1099 reporting requirements for third party payment entities such as PayPal and Venmo. The ultimate goal is to report cumulative payments exceeding $600. Because of implementation issues, the IRS has adjusted this threshold to $5,000 for 2024.

Many, I suspect, will be caught by surprise.

Receiving a 1099-K does not necessarily mean that you have taxable income. It does mean that you were paid by one of the reporting organizations, and that payment will be presumed business-related. This is of concern with Venmo, for example, as a common use is payment of group-incurred personal expenses, such as the cost of dining out. Venmo will request one to identify a transaction as business or personal, using that as the criterion for IRS reporting  

What you cannot do, however, is ignore the matter. This IRS matching is wholly computerized; the notice does not pass by human eyes before being mailed. In fact, the first time the IRS reviews the notice is when you (or your tax preparer) respond to it. Ignore the notice however and you may wind up in Collections, wondering what happened.

The IRS adjusted the 2004 and 2005 returns for Andrea Orellana.

The IRS had spotted unreported income from eBay. Orellana had reported no eBay sales, so the computer match was easy.

There was a problem, though: Orellana worked for the IRS as a revenue officer.

COMMENT: A revenue officer is primarily concerned with Collections. A revenue agent, on the other hand, is the person who audits you.

Someone working at the IRS is expected to know and comply with his/her tax reporting obligations. As a revenue officer, she should have known about 1099-Ks and computer matching.

It started as a criminal tax investigation.

Way to give the benefit of the doubt there, IRS.

There were issues with identifying the cost of the items sold, so the criminal case was closed and a civil case opened in its place.

The agent requested and obtained copies of bank statements and some PayPal records. A best guess analysis indicated that over $36 thousand had been omitted over the two years.

Orellana was having none of this. She requested that the case be forwarded to Appeals.

Orellana hired an attorney. She was advised to document as many expenses as possible. The IRS meanwhile subpoenaed PayPal for relevant records.

Orellana did prepare a summary of expenses. She did not include much in the way of documentation, however.

The agent meanwhile was matching records from PayPal to her bank deposits. This proved an unexpected challenge, as there were numerous duplicates and Orellana had multiple accounts under different names with PayPal.

The agent also needed Orellana’s help with the expenses. She was selling dresses and shoes and makeup and the like. It was difficult to identify which purchases were for personal use and which were for sale on eBay.

Orellana walked out of the meeting with the agent.

COMMENT: I would think this a fireable offense if one works for the IRS.

This placed the agent in a tough spot. Without Orellana’s assistance, the best she could do was assume that all purchases were for personal use.

Off they went to Tax Court.

Orellana introduced a chart of deposits under dispute. She did not try to trace deposits to specific bank accounts nor did she try to explain – with one exception - why certain deposits were nontaxable.

Her chart of expenses was no better. She explained that any documents she used to prepare the chart had been lost.

Orellana maintained that she was not in business and that any eBay activity was akin to a garage sale. No one makes a “profit” from a garage sale, as nothing is sold for more than its purchase price.

The IRS pointed out that many items she bought were marketed as “new." Some still had tags attached.

Orellana explained that she liked to shop. In addition, she had health issues affecting her weight, so she always had stuff to sell.

As for “new”: just a marketing gimmick, she explained.

I always advertise as new only because you can get a better price for that.” 

… I document them as new if it appears new.”

Alright then.

If she can show that there was no profit, then there is no tax due.

Orellana submitted records of purchases from PayPal.

… but they could not be connected or traced to her.

She used a PayPal debit card.

The agent worked with that. She separated charges between those clearly business and those clearly personal. She requested Orellana’s help for those in between. We already know how that turned out.

How about receipts?

She testified that she purchased personal items and never kept receipts.

That would be ridiculous, unheard of. Unless there was some really bizarre reason why I keep a receipt, there were no receipts.”

The IRS spotted her expenses that were clearly business. They were not enough to create a loss. Orellana had unreported income.

And the Court wanted to know why an IRS Revenue Officer would have unreported income.

Frankly, so would I.

Petitioner testified that she ‘had prepared 1040s since she was 16’ and that she ‘would ‘never look at the instructions.’”

Good grief.

The IRS also asked for an accuracy penalty.

The Court agreed.

Our case this time was Orellana v Commissioner, T.C. Summary Opinion 2010-51.

Firing A Client

We fired a client.

Nice enough fellow, but he would not listen. To us, to the IRS, to getting out of harm’s way.

He brought us an examination that started with the following:

We filed in Tax Court. I was optimistic that we could resolve the matter when the file returned to Appeals. There was Thanos-level dumb there, but there was no intentional underreporting or anything like that.

It may have been one of the most demanding audits of my career. The demanding part was the client.

Folks, staring down a $700 grand-plus assessment from the IRS is not the time to rage against the machine.  An audit requires documentation: of receipts, of expenses. Yes, it is bothersome (if not embarrassing) to contact a supplier for their paperwork on your purchases in a prior year. Consider it an incentive to improve your recordkeeping.

At one point we drew a very harsh rebuke from the Appeals Officer over difficulties in providing documentation and adhering to schedules. This behavior, especially if repetitive, could be seen as the bob and weave of a tax protester, and the practitioner involved could also be seen as enabling said protestor.

As said practitioner I was not amused.

We offered to provide a cash roll to the AO. There was oddball cash movement between the client and a related family company, and one did not need a psychology degree to read  that the AO was uncomfortable. The roll would show that all numbers had been included on the return. I wanted the client to do the heavy lifting here, especially since he knew the transactions and I did not. There were a lot of transactions, and I had a remaining book of clients requiring attention. We needed to soothe the AO somehow.

He did not take my request well at all.

I in turn did not take his response well.

Voices may have been raised.

Wouldn’t you know that the roll showed that the client had missed several expenses?

Eventually we settled with the IRS for about 4 percent of the above total. I knew he would have to pay something, even if only interest and penalties on taxes he had paid late. 

And that deal was threatened near the very end.

IRS counsel did not care for the condition of taxpayer’s signature on a signoff. I get it: at one point there was live ink, but that did not survive the copy/scan/PDF cycle all too well. Counsel wanted a fresh signature, meaning the AO wanted it and then I wanted it too.

Taxpayer was on a cruise.

I left a message: “Call me immediately upon return. There is a wobble with the IRS audit. It is easily resolved, but we have time pressure.”

He returned. He did not call immediately. Meanwhile the attorneys are calling the AO. The AO is calling me. She could tell that I was beyond annoyed with him, which noticeably changed her tone and interaction. We were both suffering by this point.

The client finally surfaced, complaining about having to stop everything when the IRS popped up.

Not so. The IRS reduced its preliminary assessment by 96%. We probably could have cut that remaining 4% in half had we done a better job responding and providing information. Some of that 4% was stupid tax.”

And second, you did not stop everything. You had been in town a week before calling me.”

We had a frank conversation about upping his accounting game. I understand that he does not make money doing accounting. I am not interested in repeating that audit. Perhaps  we could use a public bookkeeper. Perhaps we could use our accountants. Perhaps he (or someone working for him) could keep a bare-boned QuickBooks and our accountants would review and scrub it two or three times a year.

Would not listen.

We fired a client.