Pushing Accounting Methods Too Far

Way back when, when I was attending a one-room tax schoolhouse, some of the earliest tax principles we learned was that of accounting methods and accounting periods. An accounting method is the repetitious recording of the same underlying transaction – recording straight-line depreciation on equipment purchases, for example. An accounting period is a repetitious year-end. For example, almost all individual taxpayers in the U.S. use a December 31 year-end, so we say they use a calendar accounting period.

Introduce related companies, mix and match accounting methods and periods and magical things can happen.  Accountants have played this game since the establishment of the tax Code, and the IRS has been pretty good at catching most of the shenanigans.

Let’s talk about one.

Two brothers own two companies, India Music (IM) and Houston-Rakhee Imports (HRI). Mind you, one company does not own the other. Rather the same two people own two separate companies. We call this type of relationship as a brother-sister (as opposed to a parent-subsidiary, where one company owns another). IM sold sheet music. It used the accrual method of accounting, which meant it recorded revenues when a sale occurred, even if there was a delay in receiving payment. It bought its sheet music from its brother-sister HRI. Under accrual accounting, it recorded a cost of sale for the sheet music to HRI, whether it had paid HRI or not.

Let’s flip the coin and look at HRI. It used the cash basis of accounting, which meant it recorded sales only when it received cash, and it recorded cost of sales only when it paid cash. It is the opposite accounting from IM.

Both companies are S corporations, which means that their taxable income lands on the personal tax return of their (two) owners. The owners then commingle the business income with their other personal income and pay income taxes on the sum.

From 1998 to 2003 IM accrued a payable to HRI of over $870,000. This meant that its owners got to reduce their passthrough business income by the same $870,000.

But….

Remember that the other side to this is HRI, which would in turn have received $870,000 in income. That of course would completely offset the deduction to IM. There would be no tax “bang” there.

What to do, what to do?

Eureka! The two brothers decided NOT to pay HRI. That way HRI did not receive cash, which meant it did not have income. Brilliant!

The IRS thought of this accounting trick back when the tax Code was in preschool. Here is code Section 267:

             (a) In general

(1) Deduction for losses disallowed

No deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection (b). The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation.

(2) Matching of deduction and payee income item in the case of expenses and interest

If—

(A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

(B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b),  then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph). For purposes of this paragraph, in the case of a personal service corporation (within the meaning of section 441 (i)(2)), such corporation and any employee-owner (within the meaning of section 269A (b)(2), as modified by section 441 (i)(2)) shall be treated as persons specified in subsection (b).

What the Code does is delay the deduction until the related party recognizes the income. It is an elegant solution from a simpler time.

Our two brothers were audited for 2004, and the IRS immediately brought Section 267 to their attention. The IRS disallowed that $870,000 deduction to IM, and it now wanted $295 thousand in taxes and $59 thousand in penalties.

The brothers said “No way.” Some of those tax years were closed under the statute of limitations. “You cannot come back against us after three years,” they said.

What do you think? Do the brothers have a winning argument?

Let me add one more thing. To a tax practitioner, there are a couple of ways to increase income in a tax audit:

(1)  An adjustment

This is a one-off. You deducted your vacation and should not have. The IRS adds it back to income. There is no concurrent issue of repetition: that is, no  issue of an accounting method.

(2)  An accounting method change

There is something repetitious going on, and the IRS wants to change your accounting method for all of it.

The deadly thing about an accounting method change is that the IRS can force all of it on you in that audit year. In our case, the IRS forced IM to give back all of its $870,000 for 2004. It did not matter that the $870,000 had accreted pell mell since 1998.

With that sidebar, do you now think the brothers have a winning argument?

You can pretty much guess that the brothers were arguing that the IRS adjustment was a category (1): a one-off. The IRS of course argued that it was category (2): an accounting method change.

The case went to the Tax Court and then to the Fifth Circuit. The brothers were determined. They were also wrong. The brothers advanced some unconvincing technical arguments that the Court had little difficulty dismissing . The Court decided this was in fact an accounting method change. The IRS could make the catch-up adjustment. The brother owed big dollars in tax, as well as penalties.

The case was Bosamia v Commissioner, by the way.

My thoughts?

The brothers never had a chance .  Almost any tax practitioner could have predicted this outcome, especially since Section 267 has a long history and is relatively well known. This is not an obscure Code section.

The question I have is how the brothers found a tax practitioner who would sign off on the tax returns. The IRS can bring a CPA up on charges (within the IRS, mind you, not in court) for unprofessional conduct. The IRS could then suspend – or bar – that CPA from practice before the IRS. To a tax CPA – such as me – that is tantamount to a career death sentence. I would never have signed those tax returns. It would have been out of the question.

Social Security Disability Payments and IRS Penalties

I have been thinking about IRS penalties.  I had a client that racked up payroll tax penalties, and we tried to get them waived. The IRS thought otherwise. Many tax practitioners will tell you that penalty abatement rests as much on drawing a sympathetic IRS officer as any technical argument the practitioner can offer. I am increasingly a member of that camp.

Let’s briefly discuss my client, and then let’s discuss the Arthur and Cheryl English Tax Court decision.

I acquired a new client from a sole practitioner. He had been their accountant for a number of years, and it was his usual routine to go out, review the books, prepare a payables listing, run payroll and whatnot. Fairly routine stuff. The client then bought a business. In addition to more complicated accounting, the accountant now had some additional payroll tax issues to address.

It did not go well. The accountant miscalculated certain third-quarter payroll tax deposits. Others he simply deposited late. He continued this into the fourth quarter. The client sensed something was wrong, and then decided something was in fact wrong. This took time, of course. By the time my client hired me, the prior accountant had affected two tax quarters.

The IRS –of course – came back quickly with penalties.

I disagreed with the penalties. My client – relying on a tax professional – paid as and when instructed. Granted, my client eventually realized that something was amiss, but surely there is permitted a reasonable period to investigate and replace a tax advisor. Payroll can have semiweekly tax deposit requirements, which timeframe may be among the most compressed in the tax Code. It does not mesh at all with replacing a nonperforming professional.

We got the third quarter penalties waived.

Then the IRS came after quarter four. I once again trotted out my reasonable cause request. The IRS denied abatement, in response to which we requested an Appeals hearing.  My heart sank a bit to learn that our case went before a newly minted Appeals officer. She could not understand why the client had not “resolved” the payroll issue by the end of quarter three. Surely, she insisted, my client “must have known” that there was a problem, and he should have done an “investigation” or something along those lines. She trotted out the well-worn trope that is the bane to many a reasonable cause request: a taxpayer is not allowed to “delegate” his tax responsibility to another, even if that other is a tax professional.

At what point does reliance on a tax professional extend to “delegation” of responsibilities? Apparently, my scale was quite different from that of this brand-new Appeals officer.

We lost the appeal.

Sigh. I suspect that – in about ten years – she would decide the same case differently.

Let’s talk about Cheryl English.

Cheryl became disabled in 2007. She carried a private disability policy with Hartford Insurance, and Hartford paid while she filed and waited on her social security disability claim. There was a catch, however. If Cheryl were successful in receiving social security, her Hartford benefits would be reduced by any social security benefits she received.

In 2010 she won her social security claim. She received a check of approximately $49,000, from which she forwarded approximately $48,000 to Hartford. She netted approximately $1,500 when the dust cleared.

And there is a nasty tax trap here.

If one purchases a private disability policy and pays for it on an after-tax basis, then any benefits received on the policy are tax-free. It is one of the reasons that many tax advisors – including me – frown on using a cafeteria plan to purchase disability coverage.

Cheryl received tax-free benefits from Hartford.

Then she received social security.

She consulted with two CPAs. Both assured her that – since the social security was being used to repay nontaxable benefits – it would be nontaxable.

There is symmetry to their answer.

However, taxes are not necessarily symmetrical. The Code states what is taxable. Both CPAs were wrong.

Social security can be taxable. The same is true for social security disability.

The IRS wanted tax of approximately $10,500. They also wanted an “accuracy” penalty of approximately $2,100.

OBSERVATION: Remember that Cheryl only cleared approximately $1,500 from the transaction. The IRS wanted approximately $12,600 in taxes and penalties. There clearly is lunacy here.

Cheryl took the case pro se to the Tax Court. 

            NOTE: “Pro se” means she represented herself.

The Court reviewed the Code, where it found that social security benefits could be nontaxable if one repays the benefits. That is not what happened here, however. Cheryl received social security benefits but repaid an insurance company, not the Social Security Administration. The Court looked for other exceptions, but finding none it determined that the benefits were taxable.

She owed the tax.

The Court struck down the “accuracy” penalty, though, observing that she sought the opinion of two CPAs and acted with reasonable cause and in good faith. The Court commented on the complexity of the tax law in this area, stating:

The disparate treatment of private and public disability benefits for tax purposes is curious and somewhat confusing,”

I am curious why Cheryl made no claim-of-right argument. There is a provision in the Code for (some) tax relief when a taxpayer recognizes something as income and later has to pay it back. I presume the reason is that Cheryl did not have tax (or much tax) in the Hartford years, so the tax break would have been zero or close to it when she repaid Hartford.        

Cheryl won on the penalty front, but she still had to pay taxes of $10,500 on approximately $1,500 of net benefits. Frankly, she may have been better off not having the Hartford policy in the first place.

The IRS Updates a Real Estate Professional Tax Rule

I am glad to see that the IRS has reversed course on an issue concerning real estate professionals.

You may remember that “passive losses” entered the tax Code in 1986 as retaliation against tax shelters. The IRS had previously battled tax shelters using challenges such as “at-risk,” but 1986 brought a new and updated weapon to the IRS armory.

The idea is simple: separate business activities into two buckets: one bucket for material participation and a second for passive. The classic material participation is an activity where one works more than 500 hours. Activities in the material participation bucket can offset each other; that is, losses can offset income.

Move on to the second bucket. Losses can offset income – but not beyond zero. The best one can do (with exceptions, of course) is get to zero. One cannot create a net loss to offset against net income from bucket one.

Consider that tax shelters were placed into bucket two and you understand how Congress changed the tax Code to pull the rug out from under the classic tax shelter.

It was quickly realized that the basic passive activity rules were unfair to people who made their living in real estate. For example, take a real estate developer who keeps a few self-constructed office condominiums as rentals. If one went granular separating the activities, then the real estate development would be a material participation activity but the condominium rentals would be a passive activity. This result does not make sense, as all the income in our example originated from the same “activity.”

So Congress came in with Section 469(c)(7):

   469(c)(7) SPECIAL RULES FOR TAXPAYERS IN REAL PROPERTY BUSINESS.—

469(c)(7)(A) IN GENERAL.— If this paragraph applies to any taxpayer for a taxable year—

469(c)(7)(A)(i)   paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and

469(c)(7)(A)(ii)   this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.

Notwithstanding clause (ii), a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

469(c)(7)(B) TAXPAYERS TO WHOM PARAGRAPH APPLIES.— This paragraph shall apply to a taxpayer for a taxable year if—

469(c)(7)(B)(i)   more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

469(c)(7)(B)(ii)   such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

Look at Section 469(c)(7)(B)(ii) and the reference to 750 hours. There was confusion on what happened to the plain-vanilla 500-hour rule. Was a real estate pro to be held to a higher standard?

Here for example is the Court in Bahas:

Mrs. Bahas misconstrues section 469. Because petitioners did not elect to aggregate their real estate rental activities, pursuant to Section 469(c)(7)(A) petitioners must treat each of these interests in the real estate as if it were a  separate activity. Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties.”

How in the world did we get from 500 hours to 750 hours for each of Mrs. Bahas’ activities?  This is not what Section 469(c)(7) appears to say. There was a torrent of professional and academic criticism on Bahas and related decisions, but in the interim practitioners (me included) elected to aggregate all the real estate activities into one activity. Why? To make sure that one got to the 750 hours, that is why.

Academicians could argue the sequence of phrases and the intent of the law. Practitioners had to prepare annual tax returns, protect their clients and wait their time.

And now it is time.

The IRS released ILM 201427016 to discuss how the “750-hour test” works when one has multiple real estate activities. It includes the following obscuration:

However, some court opinions, while reaching the correct result, contain language which may be read to suggest that the election under Treas. Reg. 1.469-9(g) affects the determination of whether a taxpayer is a qualified taxpayer.”

The IRS finally acknowledged that the 750-hour rule is not a substitute or override for the generic 500-hours-to-materially-participate rule. A real estate taxpayer goes activity-by-activity to determine if he/she is materially participating in each activity. If it is advantageous, the taxpayer can also make an election to aggregate all real estate activities before determining material participation status.

Then, once all that is done, the IRS will look at whether the taxpayer meets the more-than-half and more-than-750-hours tests to determine whether the taxpayer is a real estate pro.

There are two separate tests. One is to determine material participation and a second to determine real estate pro status. 

A bit late for Mrs. Bahas, though.

Suboptimal Tax Laws Are Still Valid Tax Laws

I have a family member who has accepted in position in, and will be moving to, Chicago. You can bet that we have discussed the compensation package, and I am to review the deferred compensation package when provided. His is a “C suite” position, so deferred compensation means more than just the 401(k) with which you and I are familiar.

I find myself reviewing a Federal Court of Claims decision on an airline pilot that got on the wrong side of FICA taxation of deferred compensation.

His name is Louis Balestra, and he was a pilot with United Airlines from 1979 until his retirement in 2004. There may have been no tax case, except that United Airlines filed for bankruptcy in 2002.

Let’s talk about the “general timing rule” for FICA taxation. It is easy: you pay FICA when you are paid. No pay, no tax. No fair to not cash your paycheck!

We also have deferred compensation, more specifically “nonqualified” deferred compensation, which means a retirement plan which deviates, either a little or a lot, from somewhat rigid IRS requirements in order to be “qualified.” There is then a ‘special timing rule” (I am not making this up, I swear), the purpose of which is to speed-up when the income is taxed for FICA. The Code section is 3121(v)(2):

   3121(v)(2) TREATMENT OF CERTAIN NONQUALIFIED DEFERRED COMPENSATION PLANS.—

3121(v)(2)(A) IN GENERAL.— Any amount deferred under a nonqualified deferred compensation plan shall be taken into account for purposes of this chapter as of the later of—

3121(v)(2)(A)(i)   when the services are performed, or

3121(v)(2)(A)(ii)   when there is no substantial risk of forfeiture of the rights to such amount.

We have a new shiny: “substantial risk of forfeiture.” If the company funds your benefit, for example, chances are that your FICA tax will be accelerated, perhaps many years before you actually receive any money.

Let’s work through this with an extremely simplified example. The company agrees to pay you $100,000 five years from now. Let’s also posit that you clear the second requirement of “no substantial risk of forfeiture.” Congratulations, you have FICA tax. Right now.

Being a tax accountant by training if not by temperament, I have to ask the question: how do I calculate the income to be taxed? Is it $100,000? That doesn’t make sense, as you will receive the money five years from now. A hundred grand then is not the same as a hundred grand now, if for no other reason than you could put it n a CD (if you received it now) and have more than a hundred grand five years hence. Is it the present value of the $100,000, discounted at some interest rate and for five years? That makes more sense, and that is the guidance provided by the Regulations.

Remember what I said about United Airlines filing for bankruptcy in 2002, two years before Balestra retired? Shouldn’t we take into consideration that United Airlines might not pay everything to which Balestra is entitled?

Makes sense to me. For example, Balestra paid FICA on approximately $289,000 of deferred compensation. United actually paid him approximately $63,000. He had paid FICA on that entire $289,000, and he wanted some of it back.

CLARIFICATION: It would be more correct to say that he paid the Medicare portion of FICA, as the social security side only applies up to an income limit.  Let’s continue. We are on a roll.

Balestra sued.  

And the Court was looking at the Shakespearean prose of Reg 31.3121(v)(2)-1(c):

(ii) Present value defined.— For purposes of this section, present value means the value as of a specified date of an amount or series of amounts due thereafter, where each amount is multiplied by the probability that the condition or conditions on which payment of the amount is contingent will be satisfied, and is discounted according to an assumed rate of interest to reflect the time value of money. For purposes of this section, the present value must be determined as of the date the amount deferred is required to be taken into account as wages under paragraph (e) of this section using actuarial assumptions and methods that are reasonable as of that date. For this purpose, a discount for the probability that an employee will die before commencement of benefit payments is permitted, but only to the extent that benefits will be forfeited upon death. In addition, the present value cannot be discounted for the probability that payments will not be made (or will be reduced) because of the unfunded status of the plan, the risk associated with any deemed or actual investment of amounts deferred under the plan, the risk that the employer, the trustee, or another party will be unwilling or unable to pay, the possibility of future plan amendments, the possibility of a future change in the law, or similar risks or contingencies.

Balestra tried, but he could not overcome the fact that the Regulations did not include “employer bankruptcy” as a possible reason to discount the amount of income accelerated for FICA tax – or, at least, to allow some of the FICA to be refunded once the actual payments are known.

Balestra lost his case.

The Court did realize the unfairness of the law, however.

It might have been wiser to have selected as a trigger something other than there being ‘no substantial risk of forfeiture’ … and instead considered the financial solvency of the employer – or to have deferred taxation while an employer is in bankruptcy, rather than until promised benefits are ‘reasonable ascertainable.”

You think?

But these are matters for law makers, not judges – suboptimal laws are still valid tax laws.”

I know. I would be more optimistic if I had any regard for the suboptimals in Congress.

Tile 26 of the United States Code would be a good deal shorter if the unwise tax laws could be purged by the judiciary.”

You must admit, it is easy to like this Court.