What Does It Take To Get Reasonable Cause Around Here?

My partner has a difficult IRS penalty issue.

He expects a client to be penalized for more than one year. This complicates how we handle the first year.

The IRS has reorganized its penalty review function to a system called the Reasonable Cause Assistant (RCA). There however is a problem: the system does not work well. The Treasury Inspector General for Tax Administration (TIGTA) reported that RCA was inaccurate 89% of the time in 2012.

Step away from RCA and you still have the following:

 * It used to be that penalties were assessed as a means to encourage voluntary compliance. Many tax pros feel that is no longer the case, and penalties are being used as a means to raise revenue.  An example is the penalty assessed for late filing of a partnership return: $195 per month per partner. Take a 10-person partnership, file a week late and face a $1,950 penalty. There is little consideration for the size of the partnership, its total assets or revenues - or the fact that partnerships do not pay federal taxes.            

* Penalties are assessed even when taxpayers are trying to do the right thing. For example, enter into a reportable transaction, disclose it on your tax return but forget to file a copy with a second office and you will be assessed a penalty. Fail to disclose the transaction at all and you will be subject to the same penalty.

 * The IRS is automatically asserting penalties. For example, for fiscal year 2015, the IRS assessed over 40 million penalties on individuals and businesses. To put that in context, there were approximately 243 million returns filed for the period.

* Many penalties can be waived if the taxpayer can show "reasonable cause," but many tax professionals believe the IRS has so narrowed the definition as to be almost unreachable, unless you are willing to die. To aggravate the matter, the IRS has also instructed its personnel to substitute "first time abatement" (FTA) for reasonable cause as a matter of policy. While the IRS argues that FTA is easier to review and administer than reasonable cause, there exists a high degree of skepticism. Why would a taxpayer automatically burn a "get out of penalty-jail free" card if the taxpayer otherwise has reasonable cause? Wouldn't a taxpayer want to keep that card available just in case?

My partner - by the way - has that last situation: burning his FTA chip without a reasonable-cause backup for the second year. Ironically, he may have reasonable cause for the first year, but that sequence does not follow IRS policy. I anticipate going to Appeals to obtain reasonable cause and preserve the FTA for the second year.

Let's talk about the Carolyn Rogers (Rogers v Commissioner) case.

Carolyn lived in New York. In 2006 she had a small business (Talk of the Town Singles) which she operated from her cooperative. In 2006 there was a fire which rendered the place uninhabitable.

She moved. In 2007 there was another fire, one she appears to have caused herself. The local newspaper called her out, and she was thereafter harassed by people in her neighborhood.

She moved to the YWCA until 2010. She did not have a pleasant time there, and in 2009 she fell off a subway platform and fractured her skull on the rails. She was in the hospital for days, and she continued to suffer from dizzy spells thereafter.

Prior to this period, she had a record of filing timely returns. She also made significant efforts to correctly prepare her tax returns, consulting books and references and more than once contacting the IRS. She did not use a paid preparer.

The IRS penalized her for not filing a 2009 return.

She explained that the insurance company settled the second fire in 2009, and she lost a bundle. According to her research, the casualty loss would wipe out her income, and she was therefore below the filing threshold. She did not need to file.

The IRS then trotted technical guidance on a casualty loss. While the layperson might think that the loss would be deferred until the insurance is settled, the tax Code uses a different test:

* If an insurance claim is not paid in the year of casualty AND there is a reasonable prospect of recovery, then the loss is deferred until one can determine the amount of recovery.

* If there is no hope for insurance - or the prospect of recovery is unreasonable - then the loss is deductible in the year of the casualty.

 The IRS said that she came under the second rule. She knew that insurance would not cover the full loss from the 2007 fire. The loss was therefore deductible in 2007.

COMMENT: There is enough "what if" to this rule that even a tax professional could blow it.

The IRS wanted penalties for not filing that 2009 return.  

The Tax Court reviewed her filing history and her chaotic life. It noted:

Petitioner's error (regarding the proper year of deduction of the portion of a casualty loss for which there is no reasonable prospect of recovery from insurance) is considerably different from the errors made by a taxpayer whose failure to file, late filing, or late payment is chronic. Erroneously deducting a loss in a year later than the correct year is not usually considered to be a blatant tax avoidance technique ..."

Ouch. The Court did not appreciate the IRS wasting its time.

Taking into account all of the facts and circumstances, we conclude that petitioner exercised ordinary business care and prudence under the difficult circumstances in which she was living at the time leading up to the due date of her 2009 return...."

The Court found reasonable cause. She owed the tax, but she did not owe the penalties.

The IRS should have found reasonable cause too. It is troubling that it didn't.

Deducting Everything - The Tanzi Doctrine

I admit: I got a chuckle from reading the case.

The taxpayers (Tanzi's) are married, and for the year in question they were employed by Seminole State College, which is Sanford, Florida. I remember a conversation with a Sanford CPA a year or two ago lamenting that there no longer was separation between Orlando and Sanford. I was in Orlando this year, and he is right - there isn't.

Our taxpayer was an adjunct instructor teaching communications, and his wife worked at the campus library. Although an adjunct, he held a PhD in communications, so we can presume he was hoping for a permanent full-time position.

On their 2011 return they deducted the following as employee expenses:

            (1) 100% of their telephone, internet and television

            (2) depreciation

            (3) books, CDs and DVDs

            (4) computer expenses

The IRS bounced the employee expenses and sent them a notice for approximately $3,000.

Employee expenses are a subset of "miscellaneous deductions." One has to itemize to get to miscellaneous deductions, and even then these miscellaneous deductions are not what they used to be. The common itemized deductions are mortgage interest, real estate taxes and contributions. Living in Florida, our taxpayers did not have to concern themselves with another common itemized deduction - state income taxes. Chances are the first three got them into itemized deduction range, and their miscellaneous deductions then became usable. It is rare that miscellaneous deductions by themselves will be enough to get you to itemize.

Miscellaneous deductions are not tax-efficient, though. The Code requires that you reduce your miscellaneous deductions by 2% of your adjusted gross income, so that portion is immediately forfeited.

EXAMPLE: You and your spouse make a combined $150,000. You would have to immediately reduce your miscellaneous deductions by $3,000 (i.e., $150,000 times 2%). If your miscellaneous deductions totaled $3,500, only $500 would be deductible. And yes, it is intentional. It is a way for Congress to pry a few more tax dollars from everyone who incurs employee expenses.

COMMENT: My daughter is working before returning to graduate school. She is required to use her car for work. Although reimbursed something for mileage, it is not the full rate permitted by the IRS. Her employer explained to her that she could deduct the difference come tax time. As her dad and tax advisor, I explained that this was not true. She would not have enough to itemize, and her unreimbursed mileage would be deductible only if she itemized.

By the way, you forfeit all miscellaneous deductions if you are subject to the AMT (alternative minimum tax). As I said, they are not efficient.

The Tanzi's were deducting employee business expenses. The IRS was questioning how 100% of their telephone and internet - just to start - became business. There is a long-standing doctrine that an employee is "in the business" of being an employee, but one still has to show some nexus between the expenses and being an employee. I receive a W-2, for example, but I cannot deduct my Starbucks tab solely for the reason that I am an employee. I would have a business nexus if I met a client there, but not because I was picking up coffee for my commute to the office.

The IRS wanted to know what that nexus was.

The Tanzi's argued that they must constantly expand their "general knowledge" to be effective at their jobs. Mr Tanzi explained that individuals holding terminal degrees - such as himself, coincidently - especially bear a lifelong burden of "developing knowledge, exploring [and] essentially self-educating."   Mr. Tanzi insisted that all expenses paid in pursuing his general knowledge should be deductible as unreimbursed business expenses.

COMMENT: If Mr Tanzi won this argument, I would immediately try to expand the Tanzi doctrine to include tax CPAs with Masters degrees who also maintain a tax blog. Our burdened ranks must constantly expand our general knowledge to be effective at our jobs. I for example sometimes work with and write about international tax matters. Seems to me that a trip overseas to visit my wife's family should be deductible, as it expands my knowledge of being overseas, or some reasoning along those lines.

The tax Code recognizes that some expenses are simply personal in nature. There is even a Code section that says this out loud:

  Section 262 - Personal, living, and family expenses

      (a) General rule

Except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses.

Here is the Court:

While we find credible the Tanzi's testimony that they spent significant time and resources educating themselves, we do not believe the expenses are ordinary and necessary for the trades of being a professor or a campus librarian but rather are personal, living or family expenses nondeductible under section 262(a)."

No surprise for the Tanzi's, but I am a bit disappointed. Looks like I won't be able to deduct my life expenses as ordinary and necessary to the business of being a tax CPA and blogger. Those tax refunds would have been sweet.

CTG University: Part One

Let's discuss a famous tax case, and then I will ask you how you would decide a second case based on the decision in the first.

We are going back to 1944, and Lewis received a $22 thousand bonus.  He reported it on his 1944 tax return. It turns out that the bonus had been calculated incorrectly, and he returned $11,000 in 1946. Lewis argued that the $11,000 was mistake, and as a mistake it should not have been taxed to him in 1944. He should be able to amend his 1944 return and get his taxes back. This had an extra meaning since his tax rate in 1946 was lower (remember: post-war), so if he could not amend 1944 he would never get all his taxes back.

The IRS took a very different stand. It pointed out that the tax Code measures income annually. While arbitrary, it is a necessary convention otherwise one could not calculate income or the tax thereon, as there would (almost) always be one or more transactions not resolving by the end of the year. Think for example of writing a check to the church on December 31 but the check not clearing until the following year. The Code therefore taxes income on a "period" concept and not a "transactional" concept. With that backdrop, Lewis would have a deduction in 1946, when he returned the excess bonus.

The case went to the Supreme Court, which found that the full bonus was taxable in 1944. The Court reasoned that Lewis had a "claim of right," a phrase which has now entered the tax literature. It means that income is taxable when received, if there are no restrictions on its disposition. This is true even if later one has to return the income. The reasoning is that there are no limits on one's ability to spend the money, and there is also no immediate belief that it has to be repaid. Lewis had a deduction in 1946.

Looks like the claim of right is a subset of "every tax year stands on its own."

Let's roll into the 1950s. There was a company by the name of Skelly Oil. During the years 1952 through 1957 it overcharged customers approximately $500 thousand. In 1958 it refunded the $500 thousand.

You can pretty much see the Lewis and claim-of-right issue.

But there was one more fact.

Skelly Oil had deducted depletion of 27.5%. Depletion is a concept similar to depreciation, but it does not have to be tied to cost. Say you bought a machine for $100,000. You would depreciate the machine by immediately expensing, allocating expense over time or whatever, but you would have to stop at $100,000. You cannot depreciate more than what you spent. Depletion is a similar concept, but without that limitation. One would deplete (not depreciate) an oil field, for example. One would continue depleting even if one had fully recovered the cost of the field. It is a nice tax gimmick.

Skelly Oil had claimed 27.5% depletion against its $500,000 thousand or so, meaning that it had paid tax on a net of $366,000.

Skelly Oil deducted the $505,000 thousand.

Skelly Oil had a leg up after the Burnet v. Sanford & Brooks and Lewis decisions, as every tax year was to stand on its own. It refunded $505,000, meaning it had a deduction of $505,000. Seemed a slam dunk.

The IRS said no way. The $505,000 had a trailer attached - that 27.5% depletion - and wherever it went that 27.5% went. The most Skelly Oil could deduct was the $366,000.

But the IRS had a problem: the tax Code was based on period reporting and not transactional reporting. The 27.5% trailer analogy was stunning on the big screen and all, but it was not tax law. There was no ball hitch on the $505,000 dragging depletion in its wake.

Here is the Supreme Court: 

[T]he Code should not be interpreted to allow respondent 'the practical equivalent of double deduction,' *** absent a clear declaration of intent by Congress."

The dissent argued (in my words):           

So what? Every year stands on its own. Since when is the Code concerned with the proper measurement of income?

Odd thing, though: the dissent was right. The Lewis decision does indicate that Skelly Oil had a $505,000 deduction, even though it might not have seemed fair. The Court reached instead for another concept - the Arrowsmith concept. 

[T]he annual accounting concept does not require us to close our eyes to what happened in prior years."

There is your ball hitch. The concept of "net items" would drag the 27.5% depletion into 1958. "Net items" would include revenues and deductions so closely related as to be inseparable. Like oil revenues and its related depletion deduction.

The Court gave us the following famous quote: 

In other situations when the taxes on a receipt do not equal the tax benefits of a repayment, either the taxpayer or the Government may, depending on circumstances, be the beneficiary. Here, the taxpayer always wins and the Government always loses."

And over time the Skelly Oil case has come to be interpreted as disallowing a tax treatment where "the taxpayer always wins and the Government always loses." The reverse, however, is and has always been acceptable to the Government.

But you can see something about the evolution of tax law: you don't really know the law until the Court decides the law. Both Lewis and Skelly Oil could have gone either way.

Now think of the tax law, rulings and Regulations being published every year. Do we really know what this law means, or are we just waiting our turn, like Lewis and Skelly Oil?

Can You Have Cancellation Of Debt Income If You Are Still Paying On The Debt?

Harold is a native Hawaiian. He has worked in the telecommunications industry for more than 40 years. In 1996 he founded Summit Communications, Inc (Summit), which he served in the capacity of president, chief executive officer and director.

Al has a background similar to Harold's, but his company was called Sandwich Isles Communications, Inc (SIC). In 1997 he desperately needed a telecommunications executive. Al met Harold and wanted Harold to come work for him.

Harold was already involved with Summit, which was having business issues. Harold felt a commitment to the company and his employees.

But Al was not going to let go easily.

In 1998 Al sweetened the offer by including a $450,000 loan. He knew that Harold would immediately loan the monies to Summit. In fact, that is why Al offered the deal. He wanted to loan to be to Harold so that he and SIC did not have to deal with Summit's board of directors.

SIC also wanted to contract with Summit for operations and technical support.

Harold signed on with SIC, and Al let him stay on as Summit's director and chief executive officer.

They signed a note, stipulating that Harold had to repay the loan if he ever left SIC's employment.

The relationship went well, and by the end of 1999 Summit was booming, although - granted - SIC represented 60% of its revenues. It was growing so much that it need Harold back. Al, basically being a good guy, agreed that Harold should return.

No one remembered that Harold had to repay the loan.

SIC then received a large loan from the U.S. Department of Agriculture, which it used to upgrade its operations and technical staff. As it did, SIC's reliance on Summit decreased. By 2002 Summit filed a bankruptcy petition. By 2005 Harold had gone back to work for Al.

In 2010 the IRS audited SIC.

In 2011 Al met with Harold and reminded him that the loan was still due. Harold arranged for payroll deductions - first for $300 per month, then $600 and finally a $1,000 a month - to repay the loan.

The IRS sent a notice to Harold. The IRS said that SIC had discharged his loan, and he had cancellation of indebtedness income.

Think about this for a moment. The IRS wanted taxes from Harold because he had been let off the hook for a $450,000 loan. The problem is that Harold was still paying on the loan. Both cannot be true at the same time, so what was the IRS' reasoning?

It primarily had to do with how many years SIC had to pursue collection before the statute of limitations ran out. Remember: Harold did not start paying the loan until 2011. According to the IRS, there was no enforceable loan at that time, as SIC had gone too long without any evident collection activity. That was the triggering event for income to Harold: when the debt was no longer enforceable.

The IRS had a good point.

The IRS also argued that Harold starting repaying on the loan because it had noticed the defaulted loan on audit and Harold did not want to pay taxes on it.

Harold and Al appeared before the Court and testified that they both considered the loan outstanding, and the Court found them both to be "honest, forthright, and credible."

The Court could not help but notice that Harold and Al were on separate sides with respect to the loan.

 ... respondent argues that any repayment activity taken after the commencement of the examination should be discounted. We disagree. The testimony suggests instead that [Harold] sought to repay the SIC loan because he understood that it was his obligation to repay it. Additionally, a reasonable person in this case would not agree to pay an unenforceable debt to save a fraction of that debt on taxes. Repayment, in other words, is against [Harold's] economic interests."

The Court agreed that cancellation of income requires a triggering event, but it disagreed that the expiration of the statute automatically rose to that level.

... the expiration of the period of limitations generally does not cancel an underlying debt obligation but simply provides an affirmative defense for the debtor in an action by the creditor."

The Court decided that Harold owed the debt. He did not have income.

Why did the IRS pursue this? It certainly did not put a smiley face on their public persona.

I suspect the IRS considered themselves backed into a corner. If the loan really was uncollectible AND the IRS did not pursue, then the regular three-year statute on tax assessments would close on Harold's tax year. At that point, the IRS could not reach Harold again if it wanted to. If however the IRS went to Court - even if it lost - it would mean that the loan was either still in place or discharged in a later year. In either case, the IRS could reach Harold.

Can You Have A Mortgage Interest Deduction Without A Mortgage?

A new client comes in to meet with you. Let's call him Burley. Burley lives with his girlfriend, Julie, who purchased a house. The deed and mortgage is in her name, as Burley has lousy credit. He would have been no help with a mortgage approval.

Burley and Julie consider themselves domestic partners with equal ownership of the house.

Burley pays Julie $1,000 a month as "interest only" mortgage payments. Burley is not a big fan of bank accounts, preferring to conduct much of his activity in cash. This means he does not have cancelled checks to back-up his claim.

QUESTION: Does Burley have a tax deduction for mortgage interest?

The first problem is that Burley does not own the house.

This may seem fatal, but there is a loophole. Many states recognize the doctrine of equitable ownership, and their courts will enforce express or implied contracts between nonmarital partners. It is possible to have a tax deduction, even if you are not on the deed or mortgage, as long as your nonmarital partner is and you can prove such a contract.

But while a necessary first step, the tax Code goes further. It wants to see that the equitable owner has taken on the burdens of ownership as well as the benefits. Such burdens, for example, would include:

            (1) the right to use the property and enjoy its use

            (2) a duty to maintain the property

            (3) a responsibility to insure the property

            (4) the assumption of risk of loss

            (5) a responsibility to pay taxes and assessments

            (6) the right to improve the property

Burley pays $1,000 a month, which amount would cover his share of the mortgage payment, as well as (supposedly) his share of the insurance, taxes and other expenses of ownership. The amount does not vary for repairs, or for snow removal in the winter or lawn-mowing in the summer.

That sounds a lot like rent.

It would help if the arrangement between Burley and Julie were reduced to writing. After all, real estate is a significant purchase for most people, and it is not be unreasonable to want the agreement documented.

Burley and Julie of course have no such document.

Well, at least Julie could show up in person at the hearing and answer the judge's questions. Considering that Burley has little proof to provide on his own power, her testimony would be important.

Julie doesn't want to do that, however, but she is willing to send a letter instead.

The case is Jackson, and it is a pro se Tax Court case decided in July.

Jackson lost, which is about as surprising as daily summer showers in south Florida.

Here is the Court:

           

Because she held legal title to the residence and was the sole mortgagee, [Julie's] testimony would have been highly relevant to the question whether she and petitioner had agreed (expressly or impliedly) that he would hold an interest in the property.... Despite ample advance notice of the trial date and the Court's considerable flexibility in scheduling the trial in these cases, [Julie] did not appear as a witness."

What happens when you anger the Court?

Under the circumstances, we give no weight to [Julie's] ... letter to respondent's counsel related to petitioner's history of transferring funds to her."                              

This was the Court's polite way of saying "we do not believe you."