A CPA Goes Into Personal Audit

Folks, if you wind up before the Tax Court, please do not say the following:

… petitioner testified that allocating some of the expenses between his personal and business use required more time than he was willing to spend on the activity.”

Our protagonist this time is Ivan Levine, a retired CPA who was trying to get a financial service as well as a marketing business going. He worked from home. He used personal credit cards and bank accounts, as well as a family cellular plan. He also drove two vehicles – a Porsche 911 and a Chevrolet Suburban – for both personal and business reasons. All pretty standard stuff.

The IRS came down like a sack of bricks on his 2011 return. They challenged the following:

(1) Advertising

(2) Vehicle expenses

(3) Depreciation, including the vehicles

(4) Insurance (other than health)

(5) Professional fees

(6) Office expenses

(7) Supplies

(8) Utilities

(9) Cell phone

(10)       Office-in-home

Whoa! It seems to me that some of these expenses are straight-forward – advertising, for example. You show a check, hopefully an invoice and you are done. Same for professional fees, office expenses and supplies. How hard can it be?

It turns out that he was deducting the same expense in two categories. He was also confusing tax years – currently deducting payments made in the preceding year.

The office-in-home brings some strict requirements. One of them is that an office-in-home deduction cannot cause or increase an operating loss. If that happens, the offending deductions carryover to the subsequent year. It happens a lot.

It happened to Mr. Irvine. He had a carryover from 2010 to 2011, the year under audit. The IRS requested a copy of Form 8829 (that is, the office-in-home form) from 2010. They also requested documentation for the 2010 expenses.

COMMENT: Why would the IRS request a copy of a form? They have your complete tax return already, right? This occurs because the IRS machinery is awkward and cumbersome and it is easier for the revenue agent to get a copy from you.

Mr. Irvine refused to do either. The decision does not state why, but I suspect he thought the carryover was safe, as the IRS was auditing 2011 and not 2010. That is not so. Since the carryover is “live” in 2011, the IRS can lookback to the year the carryover was created. Dig in your heels and the IRS will disallow the carryover altogether.

The vehicles introduce a different tax technicality. There are certain expenses that Congress felt were too easily subject to abuse. For those, Congress required a certain level of documentation before allowing any deduction. Meals and entertainment are one of those, as are vehicle expenses.

Trust me on this, go into audit without backup for vehicle expenses and the IRS will just goose-egg you. You do not need to keep a meticulous log, but you need something. I have gotten the IRS to allow vehicle expenses when the taxpayer drives a repeating route; all we had to do was document one route. I have gotten the IRS to accept reconstructions from Outlook or Google calendar. The calendar itself is “contemporaneous,” a requirement for this type of deduction.

BTW the tricky thing about using Outlook this way is remembering to back-up Outlook at year-end. I am just saying.

You know Mr. Irvine did not do any of this.

Why?

Because it would have required “… more time than he was willing to spend on the activity.”

This from a CPA?

Being a CPA does not mean that one practices tax, or practices it extensively. I work tax exclusively, but down the hall is a CPA who has careered in auditing. He can exclaim about myriad issues surrounding financial statements, but do not ask him to do a tax return. There are also nouveau practice niches, such as forensic accountants or valuation specialists. One is still within the CPA tent, but likely far away from its tax corner.

Although a CPA, Mr. Irvine could have used a good tax practitioner. 

Paying Back The ObamaCare Subsidy

I do not see many tax returns with the ObamaCare health exchange subsidy.

Our fees make it unlikely.

However, take an ongoing client with variable income or business losses and we do see some.

I saw one this busy season that gave me pause.

Let’s discuss the McGuire case to set up the issue.

Mr. McGuire was working and Mrs. McGuire was not. In 2013, they applied with the Covered California and qualified for a monthly subsidy of $591, or $7,092 per year. They enrolled in a plan that cost $1,182 monthly. After the subsidy, their cost was (coincidentally) $591 monthly.

Mrs. McGuire started a job that paid $600 per week. She contacted Covered California, as she realized that her paycheck would affect that subsidy.

This being a government agency, you can anticipate the importance they gave Mrs. McGuire.

That would be “none.”

Several months later they did send a letter stating that the McGuires did not qualify for a subsidy.

The letter did not talk about switching to a lower cost plan. Or dropping the plan altogether. Or – be still my heart - provide a phone number to speak with an actual government bureaucrat.

It did not matter.

The McGuires had moved. They tried to get Covered California to update their address, but it was the same story as getting Covered California to update their premium subsidy for her new job.

The McGuires never received the letter.

It goes without saying that they never received Form 1095-A in 2014 either. This is the tax form for reporting an Exchange subsidy.

There are two main individual penalties under the Affordable Care Act:

(1) There is a penalty for not having “qualified” insurance. This is not the same as being uninsured. Have insurance that the government disapproves of and you are treated as having no insurance at all. 

(2) Subsidies received have to be reconciled to your actual household income. Make less that you thought and you may get a few bucks back. Make more and you may have to repay your subsidy. While technically not a “penalty,” it certainly acts like one.

The McGuires indicated on their tax return that they had health insurance (thereby avoiding penalty (1), but they did not complete the subsidy reconciliation (which is penalty (2)).

The IRS did, however.

Sure enough, the McGuires did not qualify for a subsidy. The IRS wanted its money back. All of it.

The McGuires fired back:

We would never have committed to paying for medical coverage in excess of $14,000 per year.”

True that.

We cannot afford it and would have continued to shop in the private sector to purchase the minimal, least expensive coverage or gone without coverage completely and suffered the penalties.”

That is, they would have avoided penalty (2) by not accepting subsidies and instead paid penalty (1), which would have been cheaper.

If we are deemed responsible for paying back this deficiency, it would be devastating and completely unjust. ….  The whole purpose of the Affordable Care Act was to provide citizens with just that, affordable healthcare. This has been an absolute nightmare and we hope that you will rule fairly and justly today.”

Here is the Tax Court:

But we are not a court of equity, and we cannot ignore the law to achieve an equitable end.”

Equity means fairness, so the Court is saying that – if the law is otherwise bright-line – they cannot decide on the grounds of fairness. 

Although we are sympathetic to the McGuires’ situation, the statute is clear; excess advance premium tax credits are treated as an increase in the tax imposed. The McGuires received an advance of a credit to which they were ultimately not entitled.”

The McGuires had to pay back $7 grand, despite the incompetence of Covered California.

Ouch.

Let’s return to CTG Galactic Command. How did my client get into a subsidy-repayment situation?

Gambling.

The tax Code is odd about gambling. It forces you to take gambling winnings into income. The subsidy calculation keys-off that income number.

Wait, you say. What about gambling losses?

The tax Code requires you to take gambling losses as an itemized deduction.

The subsidy calculation pays no attention to itemized deductions.

Win $40 grand and the subsidy calculation includes it. Your household income just went up.

Say that you also lost $40 grand. You netted nothing in real life.

Tough. The subsidy calculation does not care about your losses.

Heads you lose. Tails you lose. 

That was my client’s story.

Your Child Wins A Beauty Pageant

We are in a mini “tax season” here at Galactic Command, with September 15 being the deadline for business returns. Next month is the extended due date for the individual returns.

I wanted to find something light-hearted to discuss. Call it a salve to my sanity.

Let’s talk about your kid. Yes, the one who will soon be discovered on America’s Got Talent. It could happen. He could be the next Jonathan, or she the next Charlotte.

COMMENT: Jonathan and Charlotte were discovered on Britain’s Got Talent. It is worth watching their first appearance, if only for Simon’s reaction.

Say your kid wins prize money.

This being a tax blog: who pays tax on the money – the kid or you? After all, the kid is your dependent. He/she is nowhere near emancipated.

Here is a Code section one could spend a career in practice and not see:

 § 73 Services of child.

(a)  Treatment of amounts received.

Amounts received in respect of the services of a child shall be included in his gross income and not in the gross income of the parent, even though such amounts are not received by the child.

(b)  Treatment of expenditures.

All expenditures by the parent or the child attributable to amounts which are includible in the gross income of the child (and not of the parent) solely by reason of subsection (a) shall be treated as paid or incurred by the child.

The daughter of our protagonists (Lopez) started competing in beauty pageants at age nine. There were expenses involved with this, such as travel, outfits, cosmetics and so on. In 2011 and 2012 she won a couple of dollars, approximately $3,200 to pin it down.

Which was nowhere near the expenses of over $37 grand across the two years.

They used an Enrolled Agent with over 40-years’ experience to prepare their return.

COMMENT: An E.A. is an IRS-administered exam on tax proficiency. While perhaps not as well-known as the CPA, it is a substantial credential. There are many CPAs who practice outside tax, for example, but all E.A.’s practice tax.

The E.A. decided to put the daughter’s income on the parent’s return. He arrived at that conclusion by reviewing state child labor laws. He gave it a lot of thought, but he missed Code Section 73.

As I said, it is rare that one would blow dust off that section.

He prepared the parent’s return, including the daughter’s prize money.

That part was only $3 grand or so. The sweet part was the $37 grand in expenses. The parents took a BIG tax loss.

And the IRS tagged the return.

The Lopez’s fought the IRS. There was also a second IRS adjustment, so I presume they decided that fighting one was the same effort as fighting both.

The kid’s income and expenses, however, was a clear loser.  

The IRS adjusted their income by over $30 grand, so they came in with a souped-up penalty – the “accuracy related” penalty. That bad boy parachutes in at 20%. The IRS likes to toss that one out like hot-sauce packets at Gold Star.

Remember the E.A.?

The Court pointed out that the Lopez’s hired a tax professional. He researched the issue. Granted, he arrived at the wrong answer, but that was not the Lopez’s fault. They hired a professional, and they reasonably relied upon the advice of the professional.

The Court dismissed the penalties.

Small consolation, but something.

When Your Employer Bungles Your Retirement Plan Loan

I admit that I am not a fan of borrowing from an employer retirement plan, except perhaps as a next-to-last step before being evicted.

Things go wrong.

Lose your job, for example, and not only are you looking for work but you also have a tax bill on a loan you cannot pay back.

You do not even have to lose your job.

Ms. Frias participated in her company’s retirement plan. She was getting ready to go on maternity leave when she borrowed $40,000 from her 401(k). Her employer was to withhold from her paycheck (to be paid biweekly), and there was a make-up provision allowing her to correct any shortfall by the end of the following month.

COMMENT: Retirement plan proceeds are normally tax-free if repaid over a period of five years or less.

She went on leave on or around August 1^st.  She was drawing on her accumulated vacation and sick time.  Sounds pretty routine.

She returned to work October 12th.

In November, she learned that her employer had failed to withhold any monies for her 401(k) loan.

She immediately wrote a $1,000 check and increased her withholding to get caught-up.

Nonetheless, at the end of the year the plan administrator (Mutual of America Life) sent her a $40,000 Form 1099R on the loan.

They however sent it to her electronically. Having no reason to expect one, she did not realize that she had even received a 1099. Goes without saying it was not on her tax return.

You know the IRS matched this up and sent her a notice.

What do you think: does she have a tax issue?

No question her employer messed up.

And that she tried to correct it.

However, the law is strict:

Although a loan may satisfy the section 72(p) requirements, “a deemed distribution occurs at the first time that the requirements … of this section are not satisfied, in form or operation.”

Her first payment was due in August, the month following the loan. If she had a deemed distribution, it would have occurred then. A distribution – even a “deemed” one – would be taxable.

There remained hope, though:

The plan administrator may provide the plan participant with an opportunity to cure the failure, and a deemed distribution does not occur unless the participant fails to pay the delinquent payment within the cure period.”

This is a nice safety valve. If the employer gives you a “cure” period, you can still avoid having the fail and its associated tax.

What was her cure period?

The end of the following month: September.

When did she write a check?

November, when she realized that there was a problem.

Too late.

She had one last long shot: a “leave of absence” exception.

Which is Code section 72(p)(2)(C), and it provides for interruption in a loan repayment schedule if one is not drawing a paycheck or not drawing enough to meet the minimum loan payment.

Her argument? She was not receiving her “regular” paycheck. She instead was drawing on her vacation and sick time bank.

Problem: she nonetheless received a check, and the Court was unwilling to part-and-parcel its source. She was collecting enough to make the loan payments.

She was hosed.

She did nothing wrong, but her employer’s negligence cost her somewhere near $15 grand in unnecessary taxes.

It’s A Trap

Let’s talk about an IRS trap.

It has to do with procedure.

Let’s say that the you start receiving notices from the IRS. You ignore them, perhaps you are frightened, confused or unable to pay.

Granted, I would point out that this is a poor response to the chain-letter sequence you will be receiving, but it is a human response. It happens more frequently than you might think. Too many times I have been brought into these situations rather late, and sometimes options are severely limited.

The BIG notice from the IRS is called a 90-day letter, also known as a Statutory Notice of Deficiency. Tax nerds refer to it as a SNOD.

This is the final notice in the chain-letter sequence, so one would have been receiving correspondence for a while. The IRS is going to assess, and one has 90 days to file with the Tax Court.

Assessment means that the IRS has 10 years to collect from you. They can file a lien, for example, and damage your credit. They might levy or garnish, neither of which is a good place to be.

I have sometimes used a SNOD as a backdoor way to get to IRS appeals. Perhaps the taxpayer had ignored matters until it reached critical mass, or perhaps the first Appeals had been missed or botched. I had a first Appeals a few years back with a novice officer, and her lack of experience was the third party on our phone call.

Let the 90 days run out and the Tax Court cannot hear the case.

NOTE: Most times a Tax Court filing never goes to court. The Tax Court does not want to hear your case, and the first thing they do is send it back to Appeals. The Court wants to machinery to solve the issue without them getting involved.

Our case this time involves Caleb Tang. He filed pro se with the Tax Court, meaning that he represented himself. Technically Caleb does not have to go by himself – he can hire someone like me – but there are limitations.  

There is a game here, and the IRS has used the play before.

The taxpayer makes a mistake with the filing. In our story, Caleb filed but he forgot to pay the filing fee.

Technically this means the Court would not have jurisdiction.

Caleb also filed an amended return.

As I said, sometimes there are few good options.

The IRS contacted Caleb and said that they would not process his amended return unless he dropped the Tax Court petition.

Trap.

You see, Caleb was past the 90-day window. If he dropped his filing, the IRS would automatically get its assessment, and Caleb would have no assurance they would process his amended return.

Caleb would then not be able to get back to Tax Court. Procedure requires that he pay the tax and then sue in District Court or Court of Federal Claims. There is no pro se in that venue, and Caleb would have no choice but to hire an attorney.

That will weed out a lot of people.

Fortunately, the Court (Chief Judge L Paige Marvel) knew this.

He allowed Caleb additional time to pay his application fee.

Meaning that the case got into the Tax Court’s pipeline.

What happens next?

It could go three different ways:

(1) Both parties drop the case.

(2) They do not drop the case and the matter goes back to Appeals.

(3) The Court hears the case.

I suspect the IRS will process Caleb’s amended return now.

Keep It Believable

Our protagonists this time are the Ohdes from West Virginia. The issue concerns charitable contributions. The Ohdes claimed they made dozens of trips to Frederick, Maryland and donated over 20,000 distinct items in 2011.

Half of this would have been clothing. There was furniture. There also were over 3,000 books.

They did at least get that minimalist Goodwill receipt that says:

Goodwill does not return goods or services in exchange for donations of property.”

The receipt doesn’t provide detail of the items, their count or their condition, but at least it is a start.

At the end of the year they entered this information into TurboTax.

And according to TurboTax they donated over $146,000.

You know what else?

They should have expected the almost-certain notice from the IRS. Donate a piece of real estate and a $100,000-plus donation makes sense. Donate 20,000-plus items of men’s and women’s clothing – and not so much.

There are rules for noncash donations. The IRS knows the scam. The rules tighten-up as the donations get more expensive.

If you donate property worth $250 or more, you have to get “contemporaneous written acknowledgement” (CWA). This does not mean the same day, but it does mean within a reasonable time. The CWA must include a description of the property.  That Goodwill receipt should be adequate here, as it has pre-printed categories for

·      Clothing

·      Shoes

·      Media

·      Furniture

·      Household items

Go over $500 and there are more requirements. In addition to a description of the property, you also have to provide:

·      How you acquired it

·      When you acquired it

·      How much you paid for it

That Goodwill receipt is no longer enough. You are going to have to supplement it somehow. Some tax practitioners advise taking photographs and including them with the tax records for the year.

Go over $5,000 and you get into appraisal territory, unless you donated publicly-traded stocks.

Where were the Ohdes on this spectrum? Their lowest donation was $830; their highest was $14,999.

They were therefore dealing with the $500 and $5,000 rules.

What did they have?

They had that lean and skinny receipt from Goodwill. You know, the receipt that is good enough for $250 donations.

But they had no $250 donations.

They had a problem. Their paperwork was inadequate. It would help to have a sympathetic Court.

Here is the Court:

Petitioners claimed large deductions for charitable contributions of property, not only for 2011 but also for years before and after 2011.”

Where was the Court going with this?

 For 2007—2010 they claimed deductions in the aggregate amount of $292,143 for noncash charitable contributions."

Are you hearing skepticism?

For 2012-2013 they claimed deductions in the amount of $104,970 for noncash charitable contributions.”

Yep, skepticism.

The Court had a whole range of options to bounce the deduction.

Petitioners did not maintain contemporaneous records establishing any of these facts.”     

That is one option.

Stay within the lines and the Court might cut you some slack.  Deduct half a million dollars over a few years and …. Let’s just say you had better make a lot of money to even get to the realm of possible.

Many of those aggregate dollar figures are suspect on their face.”

The Court spotted them a $250 deduction.

Leaving approximately $33 grand in tax and over $6 grand in penalties.

Keep it believable, folks.

RERI-ng Its Ugly Head - Part Two

Let’s continue our story of Stephen Ross, the billionaire owner of the Miami Dolphins and of his indirect contribution of an (unusual) partnership interest to the University of Michigan.

What made the partnership interest unusual was that it represented a future ownership interest in a partnership owning real estate. The real estate was quite valuable because of a sweet lease. When that ship came in, the future interest was going to be worth crazy money.

That ship was a “successor member interest” or “SMI.”

We talked about the first case, which went before the Tax Court in 2014 and involved legal motions. The case then proceeded, with a final decision in July, 2017.

COMMENT: Yes, it can take that long to get a complex case through Tax Court. Go after Apple, for example, and your kid will likely be finishing high school before that tax case is finally resolved.

The SMI was purchased for $2.95 million.

Then donated to the University of Michigan for approximately $33 million.

COMMENT: This is better than FaceBook stock.

After two years, the University of Michigan sold the SMI (to someone related to the person who started this whole story) for around $2 million.

OBSERVATION: Nah, FaceBook stock would have been better.

Now RERI was in Court and explaining how something that was and will be worth either $2 or $3 million is generating a tax deduction of $33 million.

And it has to do with the SMI being “part of” of something but not “all of” something.  SMI is the “future” part in “all of” a partnership owning valuable leased real estate in California.

The concept is that someone has to value the “all of” something. Once that is done, one can use IRS tables to value the “part of” something. Granted, there are hoops and hurdles to get into those tables, but that is little obstacle to a shrewd tax attorney.

Ross found a shrewd tax attorney.

Virtually all the heavy lifting is done when valuing the “all of” part. One then dumps that number into the IRS tables, selects a number of years and an interest rate and – voila! The entrée round, my fellow tax gastronomes, featuring a $33 million tasty secret ingredient.

The pressure is on the first number: the “all of.”

This will require a valuation.

There are experts who do these things, of course.

Their valuation report will go with your tax return.  No surprise. We should be thankful they do not also have to do a slide presentation at the IRS. 

And there will be a (yet another) tax form to highlight the donation. That is Form 8283, and – in general – you can anticipate seeing this form when you donate more than $5,000 in property.

There are questions to be answered on Form 8283. We have spoken about noncash donations in the past, and how this area has become a tax minefield. Certain things have to be done a certain way, and there is little room for inattention. Sometimes the results are cruel.

Form 8283 wants, for example:

·      A description of the property

·      If a partial interest, whether there is a restriction on the property

·      Date acquired

·      How acquired

·      Appraised fair market value

·      Cost

I suspect the Court was already a bit leery with a $3 million property generating a $33 million donation.

And the Court noticed something …

The Form 8283 left out the cost.

Yep, the $3 million.

Remember: there is little room for inattention with this form.

Question is: does the number mean anything in this instance?

Rest assured that RERI was bailing water like a madman, arguing that it “substantially complied” with the reporting requirements. It relied heavily on the Bond decision, where the Court stated that the reporting requirements were:

“… directory and not mandatory”

The counterpunch to Bond was Smith:

“ the standard for determining substantial compliance under which we ‘consider whether … provided sufficient information to permit … to evaluate the reported contributions, as intended by Congress.’”

To boil this down to normal-speak: could RERI’s omission have influenced a reasonable person (read: IRS) to question or not question the deduction. After all, the very purpose of Form 8283 was to provide the IRS enough information to sniff-out stuff like this.

Here is the Court:

“The significant disparity between the claimed fair market value and the price RERI paid to acquire the SMI just 17 months before it assigned the SMI to the University, had it been disclosed, would have alerted respondent to a potential overvaluation of the SMI”

Oh oh.

“Because RERI failed to provide sufficient information on its Form 8283 to permit respondent to evaluate its purported contribution, …we cannot excuse on substantial compliance grounds RERI’s omission from the form of its basis in the SMI.”

All that tax planning, all the meetings and paperwork and yada-yada was for naught, because someone did not fill-out the tax form correctly and completely.

I wonder if the malpractice lawsuit has already started.

The Court did not have to climb onto a high-wire and juggle dizzying code sections or tax doctrines to deny RERI’s donation deduction. It could just gaze upon that Form 8283 and point-out that it was incomplete, and that its incompleteness prejudiced the interests of the government. It was an easy way out.

And that is precisely what the Court did.