Keeping Records For More Than Three Years

 

How long should you keep tax records?

We have heard that one should keep records for at least three years, as the IRS has three years to examine your return.

There is a lot of wiggle room there, however.

Let’s look at a wiggle that repeats with some frequency: a net operating loss (NOL) carryover.

An NOL occurs when a business’ tax deductions exceed its tax revenues.

I include the word “business” intentionally. Nonbusiness income - think interest, dividends, royalties – will not generate NOLs, unless you happen to own a bank or something. That would be rare, but it could happen.

An NOL is a negative (net) number from a business.

How does this negative number get on your personal return?

Several ways. Here is one: you own a piece of a passthrough business and receive a Schedule K-1.  

A passthrough normally does not pay taxes on its own power. Its owners do. If that passthrough had a big enough loss, your share of its loss might wipe out all the other income on your personal return. It happens. I have seen it.

You would go negative. Bingo, you have an NOL.

But what do you do with it?

The tax law has varied all over the place on what to do with it. Sometimes you could take it back five years. Sometimes two. Sometimes you could not take it back at all. What you could not take back you could take forward to future years. How many future years? That too has varied. Sometimes it has been fifteen years. Sometimes twenty. Right now, it is to infinity and beyond.

Let’s introduce Betty Amos.

Betty was a Miami CPA and restaurateur.  In the early 1980s she teamed up with two retired NFL players to own and operate Fuddruckers restaurants in Florida.

She wound up running 15 restaurants over the next 27 years.

She was honored in 1993 by the National Association of Women Business Owners. She was named to the University of Miami board of trustees, where she served as chair of the audit and compliance committee.

I am seeing some professional chops.

In 1999 her share of Fudddruckers generated a taxable loss. She filed a joint tax return with her husband showing an NOL of approximately $1.5 million.

In 2000 she went negative again. Her combined NOL over the two years was pushing $1.9 million.

Let’s fast forward a bit.

On her 2014 tax return she showed an NOL carryforward of $4.2 million.

We have gone from $1.9 to $4.2 million. Something is sinking somewhere.

On her 2015 tax return she showed an NOL carryforward of $4.1 million.

That tells me there was a positive $100 grand in 2014, as the NOL carryforward went down by a hundred grand.

Sure enough, the IRS audited her 2014 and 2015 tax years.

More specifically, the IRS was looking at the big negative number on those returns.

Prove it, said the IRS.

Think about this for a moment. This thing started in 1999. We are now talking 2014 and 2015. We are well outside that three-year period, and the IRS wants us to prove … what, specifically?

Just showing the IRS a copy of your 1999 return will probably be insufficient. Yes, that would show you claiming the loss, but it would not prove that you were entitled to the loss. If a K-1 triggered the loss, then substantiation might be simple: just give the IRS a copy of the K-1. If the loss was elsewhere – maybe gig work reported on Schedule C, for example - then substantiation might be more challenging. Hopefully you kept a bankers box containing bank statements, invoices, and other records for that gig activity.

But this happened 15 years ago. Should you hold onto records for 15 years?

Yep, in this case that is the wise thing to do.

Let me bring up one more thing. In truth, I think it is the thing that got Betty in hot water.

When you have an NOL, you are supposed to attach a schedule to your tax return every year that NOL is alive. The schedule shows the year the NOL occurred, its starting amount, how much has been absorbed during intervening years, and its remaining amount. The IRS likes to see this schedule. Granted, one could fudge the numbers and lie, but the fact that a schedule exists gives hope that one is correctly accounting for the NOL.

Betty did not do this.

Betty knew better.

Betty was a CPA. 

The IRS holds tax professionals to a higher standard.

BTW, are you wondering how the IRS reconciles its Indiana-Jones-like stance on Betty’s NOL with a three-year-statute-of-limitations?

Easy. The IRS cannot reach back to 1999 or 2020; that is agreed.

Back it can reach 2014 and 2015.

The IRS will not permit an NOL deduction for 2014 or 2015. Same effect as reaching back to 1999 or 2000, but it gets around the pesky statute-of-limitations issue.

And in the spirit of bayoneting-the-dead, the IRS also wanted penalties.

Betty put up an immediate defense: she had reasonable cause. She had incurred those losses before Carter had liver pills. Things are lost to time. She was certain that she carried numbers correctly forward from year to year.

Remember what I said about tax professionals? Here is the Court:

More significantly, Ms. Amos is a longtime CPA who has worked for high-profile clients, owned her own accounting firm, and been involved with national and state CPA associations. It beggars belief that she would be unaware that each tax years stands alone and that it was her responsibility to demonstrate her entitlement to the deductions she claimed.”

Yep, she was liable for penalties too.

Our case this time was Betty Amos v Commissioner, T.C. Memo 2022-109.

Happy Thanksgiving

 

Can A Severance Be A Gift?

I am looking at a case wondering why a tax practitioner would take it to Tax Court.

Then I noticed that it is a pro se case.

We have talked about this before: pro se means that the taxpayer is representing himself/herself. Technically that is not correct (for example, someone could drag me in and still be considered pro se), but it is close enough for our discussion.

Here is the issue:

Can an employer make a nontaxable gift to an employee?

Jennifer Fields thought so.

She worked at Paragon Canada from 2009 to 2017. Apparently, she was on good terms with her boss, as the company …

·      Wired her 35,000 Canadian dollars in 2012

·      Wired her $53,020 in 2014 to help with the down payment on a house in Washington state.

I am somewhat jealous. I am a career CPA, and CPA firms are not known for … well, doing what Paragon did for Jennifer.

She separated from Paragon in 2017.

They discussed a severance package.

Part of the package was forgiveness of the loan arising from those wires.

Forgiveness here does not mean what it means on Sunday. The company may forgive repayment, but the IRS will still consider the amount forgiven to be taxable income. The actual forgiveness is therefore the after-tax amount. If one’s tax rate is 25%, then the actual forgiveness would be 75% of the amount forgiven. It is still a good deal but not free.

Paragon requested and she provided a Form W-9 (the form requesting her social security number).

Well, we know that she will be getting a W-2 or a 1099 for that loan.

A W-2 would be nice. Paragon would pick-up half of the social security and Medicare taxes. If she is really lucky, they might even gross-up her bonus to include the taxes thereon, making the severance as financially painless as possible.

She received a 1099.

Oh well.

She left the 1099 off her tax return.

The IRS computers caught it.

Because … of course.

Off to Tax Court they went.

This is not highbrow tax law, folks. She worked somewhere. She received a paycheck. She left work. She received a final paycheck. What is different about that last one?

·      She tried to get Paragon to consider some of her severance as a gift.

The Court was curt on this point. You can try to be a bird, but you better not be jumping off tall buildings thinking you can fly.

·      She was good friends with her boss. She produced e-mails, text messages and what-not.

That’s nice, said the Court, but this is a job. There is an extremely high presumption in the tax Code that any payment to an employee is compensatory.

But my boss and I were good friends, she pressed. The law allows a gift when the relationship between employer and employee is personal and the payment is unrelated to work.

Huh, I wonder what that means.

Anyway, the Court was not buying:

Paragon’s inclusion of the disputed amount in the signed and executed severance agreement and the subsequent issuance of a Form 1099-MISC indicates that the payments were not intended to be a gift.”

She really did not have a chance.

The IRS also wanted penalties. Not just your average morning-drive-through penalties, no sir. They wanted the Section 6662(a) “accuracy related” penalty. Why? Well, because that penalty is 20%, and it is triggered if the taxpayer omits enough income to underpay tax by the greater of $5 grand or 10% of what the tax should have been.

Think biggie size.

The Court agreed on the penalty.

I was thinking what I would have done if Jennifer had been my client.

First, I would have explained that her chance of winning was almost nonexistent.

COMMENT: She would have fired me then, realistically.

Our best course would be to resolve the matter administratively.

I want the penalties dropped.

That means we are bound for Appeals. There is no chance of getting that penalty dropped before then.

I would argue reasonable cause. I would likely get slapped down, but I would argue. I might get something from the Appeals Officer.

Our case this time was Fields v Commissioner, T.C. Summary Opinion 2022-22.

 

Thinking About Private Foundations

 

I’ll admit it: last month (October) left room for improvement. An unresponsive IRS and a dearth of hirable accounting talent is taking its toll here at Command Center. I am hoping that recent hiring at the IRS will take the edge off the former; I see little respite from the latter, however.

This month many of our nonprofit returns are due. That is OK, as those do not approach the volume of individual returns we prepare.

I find myself thinking about private foundations.

I would set-up a family foundation if I came into megabucks. It would, among other things, allow the CTG family to aggregate, review, discuss and decide our charitable giving as a family unit.  

But I have also been in practice long enough to see family foundations misused. A common-enough practice is to hire an … unmotivated … family member as a foundation employee.  

Let’s talk about the self-dealing rules and foundations.

First, let’s clarify what we mean when we use the term private (or family) foundation.

It is a charity – like the March of Dimes or United Way – but not as much. Think of foundations as the milk chocolate to the public charity dark chocolate. The dark chocolate is – let’s be frank – the better chocolate. Contributions to both are tax deductible, but there are restrictions on the private foundation that do not exist for a public charity. Why? Because a public charity tends to have a diverse and diffuse donor base. A private foundation can be one family – or one person. A private foundation can therefore be more disposed to get its nose in traps than a public charity.

Let’s introduce two terms: disqualified persons and self-dealing.

There are two main categories of disqualified persons. I will use the CTG Foundation (and its one donor – me) as an example.

·      Category One

o  A substantial contributor (that would be me)

o  Members of my family

o  A corporation, partnership or trust wherein I am at least a 35% owner

·      Category Two

o  Foundation directors and officers

o  Their families

A family foundation might keep everything in the family, in which case categories one and two are the same people. It does not have to be, though.

We have the players. Now we need an event, such as:

·      Buying or selling property from or to a disqualified (person)

·      Renting from or to a disqualified (unless from and for free)

·      Lending money to or borrowing from a disqualified (unless from and interest free)

·      Allowing disqualifieds to use the foundation’s assets or facilities, except on terms available to all members of the public

·      Paying or reimbursing unreasonable or unrelated expenses of a disqualified

·      Paying excessive compensation to a disqualified

In theory, that last one would discourage hiring the … unmotivated … family member. In reality … there is very little discouragement. The deterring effect of punishment is impacted by its likelihood: no likelihood = no deterrence.

A key thing about self-dealing transactions is that, as a generalization, the tax Code does not care whether the foundation is getting a “deal.”  Say that I own rental real estate in Pigeon Forge. I sell it to the CTG Foundation for pennies on the dollar. Financially, the foundation has received a significant benefit. Tax-wise, there is self-dealing. The Code says “NO” buying or selling to or from a disqualified. There is no modifying language for “a deal.”

So, what happens if there is self-dealing?

There are two tiers of penalties.

·      Tier One

o  A 10% annual penalty on the self-dealer. In our Pigeon Forge example, that would be me. If the violation is not cleaned-up quickly, the 10% applies every year until it is.

o  There may be a 5% penalty on a foundation manager who participated in the act of self-dealing, knowing it to be such. Again, the penalty applies annually.

·      Tier Two

o  The Code wants the foundation and disqualified to reverse and clean-up whatever they did. In that spirit, the penalty becomes severe if they blow it off:

§  The penalty on the self-dealer goes to 200%

§  The penalty on the foundation manager goes to 50%

You clearly want to avoid tier two.

What would impel the foundation to even report self-dealing and pay those penalties?

I like to think that the annual 990-PF preparation by a reputable accounting or law firm would provide motivation. I would immediately fire a private foundation client which entered into and refused to unwind a self-deal. I am more concerned about my reputation and licensure. I can always get another client.

Then there is the possibility of an IRS audit.

It happens. I was reading one where the private foundation made a loan to a disqualified. The disqualified never made payments or even paid interest, and this went on for so long that the statute of limitations expired. According to the IRS, it might not be able to get to those closed years for penalties, but it could force the foundation to increase the loan balance by the missed interest payments (even for closed tax years) when calculating penalties for the open years.

Yep, that is what got me thinking about private foundations.

For the home gamers, this time we discussed CCA 202243008.

Is Found Money Taxable?

Say that you found a money clip with several hundred dollars. There is no identification, so there is no way to return it.

Question: Do you have taxable income?

Let’s look at a famous tax case.

In 1957 the Cesarinis purchased a used piano at an auction for $15. Their daughter took lessons using this piano.

In 1964, while cleaning the piano, they discovered $4,467 in old currency bills. They exchanged the old currency for new at the bank. They also reported the $4,467 as income on their tax return.

By October 1965 they were having second thoughts. They amended their 1964 tax return, reversing the $4,467 from income and asking for a tax refund of $836.

The IRS rejected the refund claim.

Off to Court they went.

The Cesarinis had three arguments:

(1)  The $4,467 was not income under the tax Code.

(2)  If it was, then it was income in 1957, when they purchased the piano. Since 1957 was a closed tax year, there was no further tax consequence.

(3) Even if it was taxable in 1964, it should be taxable as capital gains and not as ordinary income.

The Court was methodical:

·      Code section 61(a) stated “except as otherwise provided in this subtitle, gross income means all income from whatever source derived….” 

Granted, there are other sections that may keep a source from being taxed – or delaying its taxation – but the general rule is to consider all accessions to wealth as taxable. The language was intentional, and it was deliberately used by Congress to assert the full measure of its taxing power under the 16^th amendment.

·      The IRS did not, but the Court did, point to the following Regulation:

Treasure trove, to the extent of its value in United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession.”

The Cesarinis, seeing an opening, pressed on the year they obtained undisputed possession.

That is not a tax question per se, so the Court looked at state law. Say the Cesarinis had sold the piano in 1958, not knowing about the cash. Would they have an action against a purchaser who later found the cash? In Ohio (their state of residence) they would not. Extrapolating, the Court determined that “undisputed possession” occurred in 1964, when the cash was found.

·      The Court acknowledged that both the piano and the cash could be construed as capital assets, and that capital gains derive from the sale or exchange of capital assets. 

And this is where word selection is critical: neither the piano or the currency had been sold or exchanged. No sale or exchange = no capital gain.

The Cesarini case cemented that found money – sometimes called “treasure trove” – is taxable just like any other type of income.

You are not really surprised at the answer, are you?

Our case this time was Cesarini v United States 296 F Supp 3 (N.D. Ohio 1969).

The Obamacare Subsidy Cliff

 

I am looking at a case involving the premium tax credit.

We are talking about the Affordable Care Act, also known as Obamacare.

Obamacare uses mathematical tripwires in its definitions. That is not surprising, as one must define “affordable,” determine a “subsidy,” and - for our discussion – calculate a subsidy phase-out. Affordable is defined as cost remaining below a certain percentage of household income. Think of someone with extremely high income - Elon Musk, for example. I anticipate that just about everything is affordable to him.

COMMENT: Technically the subsidy is referred to as the “advance premium tax credit.” For brevity, we will call it the subsidy.

There is a particular calculation, however, that is brutal. It is referred to as the “cliff,” and you do not want to be anywhere near it.

One approaches the cliff by receiving the subsidy. Let’s say that your premium would be $1,400 monthly but based on expected income you qualify for a subsidy of $1,000. Based on those numbers your out-of-pocket cost would be $400 a month.

Notice that I used the word “expected.” When determining your 2022 subsidy, for example, you would use your 2022 income. That creates a problem, as you will not know your 2022 income until 2023, when you file your tax return. A rational alternative would be to use the prior year’s (that is, 2021’s) income, but that was a bridge too far for Congress. Instead, you are to estimate your 2022 income. What if you estimate too high or too low? There would be an accounting (that is, a “true up”) when you file your 2022 tax return.

I get it. If you guessed too high, you should have been entitled to a larger subsidy. That true-up would go on your return and increase your refund. Good times.

What if it went the other way, however? You guessed too low and should have received a smaller subsidy. Again, the true-up would go on your tax return. It would reduce your refund. You might even owe. Bad times.

Let’s introduce another concept.

ACA posited that health insurance was affordable if one made enough money. While a priori truth, that generalization was unworkable. “Enough money” was defined as 400% of the poverty level.

Below 400% one could receive a subsidy (of some amount). Above 400% one would receive no subsidy.

Let’s recap:

(1)  One could receive a subsidy if one’s income was below 400% of the poverty level.

(2)  One guessed one’s income when the subsidy amount was initially determined.

(3)  One would true-up the subsidy when filing one’s tax return.

Let’s set the trap:

(1)  You estimated your income too low and received a subsidy.

(2)  Your actual income was above 400% of the poverty level.

(3)  You therefore were not entitled to any subsidy.

Trap: you must repay the excess subsidy.

That 400% - as you can guess – is the cliff we mentioned earlier.

Let’s look at the Powell case.

Robert Powell and Svetlana Iakovenko (the Powells) received a subsidy for 2017.

They also claimed a long-term capital loss deduction of $123,822.

Taking that big loss into account, they thought they were entitled to an additional subsidy of $636.

Problem.

Capital losses do not work that way. Capital losses are allowed to offset capital losses dollar-for-dollar. Once that happens, capital losses can only offset another $3,000 of other income.

COMMENT: That $3,000 limit has been in the tax Code since before I started college. Considering that I am close to 40 years of practice, that number is laughably obsolete.

The IRS caught the error and sent the Powells a notice.

The IRS notice increased their income to over 400% and resulted in a subsidy overpayment of $17,652. The IRS wanted to know how the Powells preferred to repay that amount.

The Powells – understandably stunned – played one of the best gambits I have ever read. Let’s read the instructions to the tax form:

We then turn to the text of Schedule D, line 21, for the 2017 tax year, which states as follows:

         If line 16 is a loss, enter ... the smaller of:

·      The loss on line 16 or

·      $3,000

So?

The Powells pointed out that a loss of $123,822 is (technically) smaller than a loss of $3,000. Following the literal instructions, they were entitled to the $123,822 loss.

It is an incorrect reading, of course, and the Powells did not have a chance of winning. Still, the thinking is so outside-the-box that I give them kudos.

Yep, the Powells went over the cliff. It hurt.

Note that the Powell’s year was 2017.

Let’s go forward.

The American Rescue Plan eliminated any subsidy repayment for 2020.

COVID year. I understand.

The subsidy was reinstated for 2021 and 2022, but there was a twist. The cliff was replaced with a gradual slope; that is, the subsidy would decline as income increased. Yes, you would have to repay, but it would not be that in-your-face 100% repayment because you hit the cliff.

Makes sense.

What about 2023?

Let’s go to new tax law. The ironically named Inflation Reduction Act extended the slope-versus-cliff relief through 2025.

OK.

Congress of course just kicked the can down the road, as the cliff will return in 2026.

Our case this time was Robert Lester Powell and Svetlana Alekseevna Iakovenko v Commissioner, T.C. Summary Opinion 2002-19.

An Intelligence Site, A Tax Treaty, and a Closing Agreement

I am looking at a case involving IRS closing agreements and the U.S. Pine Gap facility in Australia.

It gives us a chance to talk about closing agreements, an uncommon topic.

It also gives a chance to talk about Pine Gap, which is a U.S. Intelligence-gathering facility in the Northern Territory of Australia. It started decades ago as a monitoring station for Soviet ballistic testing, and with the years it has acquired several new roles. Think of drone attacks in Pakistan, and you have an idea of what happens at Pine Gap.

FIRST ACT: we have a spooky intelligence site.

Let’s move on to a treaty.

Under general tax rules, Australia would be able to tax American workers at Pine Gap. They are - after all – working in Australia. This was not the desired result, so a treaty in the 1960s exempted American workers at Pine Gap from Australian tax. There was a requisite, though: to be exempt, the wages had to be taxed by the U.S.

Got it. There was a one-bite-at-the-apple rule. Australia would back off if the U.S. got the first bite.

But U.S. tax law also includes a foreign earned income exclusion, whereby an American worker overseas could exempt some (or all) of his/her wages from tax, if certain requirements were met.  

How could Australia be sure that the wages were being taxed by the U.S.? Mind you, the alternative was for Australia to apply the default rule, meaning that both Australia and the U.S. would tax the wages. Sure, the worker could claim a foreign tax credit on his/her U.S. tax return, but the tax consequences of working at Pine Gap would have escalated unappealingly.  

The treaty was revised in the 1980s to allow American workers at Pine Gap to relinquish their foreign earned income exclusion by entering into a closing agreement with the IRS.

SECOND ACT: we have an income tax treaty.

Cory was a U.S. Air Force veteran and engineer. In 2009 he received a job offer from Raytheon to work at Pine Gap. He was informed that Australia would not tax him, but to get there he would have to sign a closing agreement with the IRS. The agreement was straightforward: he would not claim the foreign earned income exclusion.

Mind you, he did not have to sign a closing agreement. Australia would then tax him, and his U.S. return would get a little more complicated.

Cory signed the agreement.

The point behind a closing agreement is finality. Both sides agree, settle, and move on. Excepting fraud or malfeasance, there are no “do-overs.” That is - as you would expect - the reason that one requests one. An example is the wrap-up of a taxable estate. The tax practitioner does not want that estate resurrecting later, causing headaches when all parties considered the matter closed.

Cory wanted out of his closing agreement.

Problem.

Closing agreements arise under a Code section. This means that the Court would be reviewing statutory law (that is, the Code as statute on the matter) and not just the general principles of contract law (offer, acceptance, and all that).

That Code section doesn’t let one off the hook without showing malfeasance or misrepresentation of a material fact.

Cory argued that he met that standard. Somebody somewhere at the IRS did not have appropriate signature authority; the IRS committed malfeasance by sharing information with his employer, Raytheon; he was induced to sign by false representations.

I think Cory was grasping at straws.

The Court apparently thought the same way. The Court decided Cory was stuck with the agreement. He signed it; he owned it.

THIRD ACT: we have a closing agreement.

This is a specialized case pulling-in several different areas of the Code.

I get Cory’s point. He wanted exemption both from Australian tax AND some/all U.S. tax.

Me too, Cory. Me too.

Our case this time was Cory H Smith v Commissioner, 159 T.C. No. 3 (Aug 25,2022).