Happy Halloween

 

A School And Obamacare Penalties

 

How would you like to get the following notice in the mail?

 

Believe it or not, the IRS sent this to a public school system in Virginia. I am looking at the Tax Court petition as I write this.

This notice is for a Section 6721 penalty, assessed for failure to file certain information forms with the IRS. Common information forms include:

·      Form W-2 (Wage and Tax Statement)

·      Forms(s) 1099 (Interest, Dividends, and numerous others)

·      Form 8027 (Tip Income and Allocated Tips)

·      Forms(s) 1094 & 1095 (Health Insurance)

There is a virtually automatic companion to this penalty - Section 6722 – which assesses another penalty for failure to provide an information form to the recipient.

Combined we are talking over $2.2 million.

To a school?

Let’s go through this.

The school (Arlington) received the above notice dated June 13, 2022.

The second notice (for Section 6722 penalties) was dated June 27, 2022.

The IRS wanted payment by July 12, 2012.

COMMENT: Arlington had an issue. While they knew the IRS was assessing penalties for information returns, they had no idea which information forms the IRS was talking about.

The IRS Revenue Officer (RO) issued a Final Notice of Intent to Levy on July 12, 2022.

COMMENT: The same day?  I have been leaving messages with a Revenue Agent for over two weeks now concerning an individual tax audit, and this RO issued a FINAL on the same day stated in the notice?

COMMENT: There is also a procedural error here. The IRS must issue notices in a certain order, and the RO is not entitled to jump the line and go straight to that FINAL notice.

We learn that this specific RO had previously assessed penalties (without explanation) and filed liens (again, without explanation) on a middle school in the Arlington school system. These miraculously went away before an Appeals hearing could occur.

COMMENT: Sounds like something personal.

On August 10, 2022, Arlington requested a collection due process hearing on the June 13 and June 27 notices. It faced a formidable obstacle, however, as it did not know what the IRS was talking about.

The IRS sent a letter dated December 5, 2022, scheduling an Appeals conference on January 18, 2023. That letter also suggested that Arlington had not filed Forms 1042, which concerns withholding on payments to foreign persons.

COMMENT: Seems an odd one. I would have thought Forms W-2, if anything.

It turns out that the 1042 reference was mistaken.

COMMENT: Clown show.

Arlington (more specifically, Arlington’s attorneys) tried repeatedly to contact the Appeals Officer (AO). It appears that he inadvertently answered his phone one time, and the Appeals conference was moved to January 31, 2023. Arlington still wanted to know what form was costing them over $2.2 million.

The attorneys marched on. They contacted the IRS Practitioner Line, which told them that the penalties might relate to the Affordable Care Act (Obamacare). They also sent a written request to IRS Ogden for explanation and copies of any correspondence concerning the matter.

COMMENT: I’ve done the same. Low probability swing, in my experience.

The attorneys also contacted the Taxpayer Advocate.

Receiving nothing, the attorneys again requested to postpone the Appeals hearing. They learned that two additional penalties had been added. What were the two penalties about? Who knows.

The two late penalties were “abated” before the Appeals hearing on February 10, 2023.

The AO failed to show up to the Appeals hearing on February 10, 2023.

COMMENT: That sounds about right.

At the re-rescheduled hearing on February 24, 2023, the AO wanted to know what Arlington intended to do. Arlington replied that they were still trying to figure out what the penalties were for, and that a little help would be welcome.

That however would require the AO to – gasp – actually work, so he attempted to transfer the case to another AO. He was unsuccessful.

COMMENT: Fire the guy.

On June 30, 2023, the AO sent the attorneys re-generated IRS notices (not copies of originals) proposing $1,1113,000 in penalties for failure to send Forms 1094-C to the IRS and an additional $1,113,000 for failure to provide the same 1094-C to employees.

COMMENT: Finally, we learn the mystery form.

Arlington (really, its attorneys) learned that the IRS had listed a “Lang Street” address for correspondence. Lang Street was never Arlington’s address and was only one of the middle schools in the district. It was, however, the middle school which the RO had liened earlier in our story.

While talking to the AO on June 30, 2023, the attorneys requested additional time to submit a penalty abatement request.  The AO allowed 14 days.

COMMENT: Really? This is the school’s summer recess, no one is there, and you expect people to dig up years-old paperwork in 14 days?

Once again, the AO refused to answer numerous calls and faxes.

The attorneys – frustrated – contacted the AO’s manager. The manager gave them additional time.

On August 21, 2023, Arlington received a mysterious IRS letter about a claim filed on or about February 23, 2023. Problem: Arlington had not filed any such thing.

The attorneys sent a copy of the mystery notice to the AO.

On September 13, 2023, the AO told the attorneys that he had closed the case and issued a Notice of Determination.

COMMENT: This is the “90-day letter” and one’s entrance ticket to the Tax Court.

The attorneys asked why the NOD. The AO explained that he could not provide a penalty abatement while the underlying Obamacare forms remained unfiled.

Uh huh.

By the way, while the AO verbally communicated that a NOD had been issued, Arlington never received it. It appears - best I can tell – that the NOD is stuck at a processing facility.

COMMENT: Fits the rest of the story.

So, what happened with those forms?

It turns out that Arlington sent employees their copies of the Obamacare forms on or about February 28, 2020.

COMMENT: Well, there goes one of the two penalties.

Arlington was going to send the IRS copies on March 16, 2020.

What happened at this point in 2020?

The Governor of Virginia closed all schools for two weeks over COVID-19.

He then closed the schools through the rest of the school year.

On March 30, 2020, Arlington requested an extension of time to file those Obamacare forms with the IRS.

Virtually no one was at the school. People were working remotely, if possible. The school was trying to figure out how to even pay its employees when everyone was remote.

Yeah, I suspect those forms were never sent.

Heck of a reasonable cause, I would say.

And fire the guy.

Sonny Corleone’s IRA

I remember him as Sonny Corleone in The Godfather. He is James Caan, and he passed away in July 2022.

I am reading a Tax Court case involving his (more correctly: his estate’s) IRA.

There is a hedge fund involved.

For the most part, we are comfortable with “traditional” investments: money markets, CDs, stocks, bonds, mutual funds holding stocks and bonds and the mutual fund’s updated sibling: an ETF holding stocks and bonds.

Well, there are also nontraditional investments: gold, real estate, cryptocurrency, private equity, hedge funds. I get it: one is seeking additional diversification, low correlation to existing investments, enhanced protection against inflation and so forth.

For the most part, I consider nontraditional investments as more appropriate for wealthier individuals. Most people I know have not accumulated sufficient wealth to need nontraditional assets.

There are also tax traps with nontraditional assets in an IRA. We’ve talked before about gold. This time let’s talk about hedge funds.

James Caan had his cousin (Paul Caan) manage two IRAs at Credit Suisse. Paul wanted to take his career in a different direction, and he transferred management of the IRAs to Michael Margiotta. Margiotta left Credit Suisse in 2004, eventually winding up at UBS.

The wealthy are not like us. Caan, for example, utilized Philpott, Bills, Stoll and Meeks (PBSM) as his business manager. PBSM would:

·       Receive all Caan’s mail

·       Pay his bills

·       Send correspondence

·       Prepare his tax returns

·       Act as liaison with his financial advisors, attorneys, and accountants

I wish.

Caan had 2 IRAs at UBS. One was a regular, traditional, Mayberry-style IRA.

The second one owned a hedge fund.

The tax Code requires the IRA trustee or custodian to file reports every year. You probably have seen them: how much you contributed over the last year, or the balance in the IRA at year-end. Innocuous enough, except possibly for that year-end thing. Think nontraditional asset. How do you put a value on it? It depends, I suppose. It is easy enough to look up the price of gold. What if the asset is trickier: undeveloped land outside Huntsville, Alabama – or a hedge fund?

UBS had Caan sign an agreement for the IRA and its hedge fund.

The Client must furnish to the Custodian in writing the fair market value of each Investment annually by the 15th day of each January, valued as of the preceding December 31st, and within twenty days of any other written request from the Custodian, valued as of the date specified in such request. The Client acknowledges, understands and agrees that a statement that the fair market value is undeterminable, or that cost basis should be used is not acceptable and the Client agrees that the fair market value furnished to the Custodian will be obtained from the issuer of the Investment (which includes the general partner or managing member thereof). The Client acknowledges, understands and agrees that if the issuer is unable or unwilling to provide a fair market value, the Client shall obtain the fair market value from an independent, qualified appraiser and the valuation shall be furnished on the letterhead of the person providing the valuation.

Got it. You have to provide a number by January 15 following year-end. If it is a hassle, you have to obtain (and you pay for) an appraisal.

What if you don’t?

The Client acknowledges, understands and agrees that the Custodian shall rely upon the Client’s continuing attention, and timely performance, of this responsibility. The Client acknowledges, understands and agrees that if the Custodian does not receive a fair market value as of the preceding December 31, the Custodian shall distribute the Investment to the Client and issue an IRS Form 1099–R for the last available value of the Investment.

Isn’t that a peach? Hassle UBS and they will distribute the IRA and send you a 1099-R. Unless that IRA is rolled over correctly, that “distribution” is going to cost you “taxes.”

Let’s start the calendar.

March 2015		UBS contacted the hedge fund for a value.
June 2015		Margiotta left UBS for Merrill Lynch.
August 2015		Striking out, UBS contacted PBSM for a value.
October 2015		Hearing nothing, UBS sent PBSM a letter saying UBS was going to resign as IRA custodian in November.
October 2015		Margiotta had Caan sign paperwork to transfer the IRAs from UBS to Merrill Lynch.
		There was a problem: all the assets were transferred except for the hedge fund.
December 2015		UBS sent PBSM a letter saying that it had distributed the hedge fund to Caan.
January 2016		UBS sent a 1099-R.
March 2016		Caan’s accountant at PBSM sent an e-mail to Merrill Lynch asking why the hedge fund still showed UBS as custodian.
December 2016		Margiotta requested the hedge fund liquidate the investment and send the cash to Merrill Lynch.
November 2017		The IRS sent the computer matching letter wanting tax on the IRA distribution. How did the IRS know about it? Because UBS sent that 1099-R.

The IRS wanted taxes of almost $780 grand, with penalties over $155 grand.

That caught everyone’s attention.

July 2018

Caan requested a private letter ruling from the IRS.

Caan wanted mitigation from an IRA rollover that went awry. This would be a moment for PBSM (or Merrill) to throw itself under the bus: taxpayer relied on us as experts to execute the transaction and was materially injured by our error or negligence….

That is not wanted they requested, though. They requested a waiver of the 60-day requirement for rollover of an IRA distribution.

I get it: accept that UBS correctly issued a 1099 for the distribution but argue that fairness required additional time to transfer the money to Merrill Lynch.

There is a gigantic technical issue, though.

Before that, I have a question: where was PBSM during this timeline? Caan was paying them to open and respond to his mail, including hiring and coordinating experts as needed. Somebody did a lousy job.

The Court wondered the same thing.

Both Margiotta and the PBSM accountant argued they never saw the letters from UBS until litigation started. Neither had known about UBS making a distribution.

Here is the Court:

            We do not find that portion of either witness’ testimony credible.

Explain, please.

We find it highly unlikely that PBSM received all mail from UBS— statements, the Form 1099–R, and other correspondence—except for the key letters (which were addressed to PBSM). Additionally, the March 2016 email between Ms. Cohn and Mr. Margiotta suggests that both of them knew of UBS’s representations that it had distributed the P&A Interest. It seems far more likely that there was simply a lack of communication and coordination between the professionals overseeing Mr. Caan’s affairs, especially given the timing of UBS’s letters, Mr. Margiotta’s move from UBS to Merrill Lynch, and the emails between Mr. Margiotta and Ms. Cohn. If all parties believed that UBS was still the P&A Interest’s custodian, why did no one follow up with UBS when it ceased to mail account statements for the IRAs? And why, if everyone was indeed blindsided by the Form 1099–R, did no one promptly follow up with UBS regarding it? (That followup did not occur until after the IRS issued its Form CP2000.) The Estate has offered no satisfactory explanation to fill these holes in its theory.

I agree with the Court.

I think that PBSM and/or Merrill Lynch should have thrown themselves under the bus.

But I would probably still have lost. Why? Look at this word salad:

        408(d) Tax treatment of distributions.

         (3)  Rollover contribution.

An amount is described in this paragraph as a rollover contribution if it meets the requirements of subparagraphs (A) and (B).

(A)  In general. Paragraph (1) does not apply to any amount paid or distributed out of an individual retirement account or individual retirement annuity to the individual for whose benefit the account or annuity is maintained if-

(i)  the entire amount received (including money and any other property) is paid into an individual retirement account or individual retirement annuity (other than an endowment contract) for the benefit of such individual not later than the 60th day after the day on which he receives the payment or distribution; or

(ii)  the entire amount received (including money and any other property) is paid into an eligible retirement plan for the benefit of such individual not later than the 60th day after the date on which the payment or distribution is received, except that the maximum amount which may be paid into such plan may not exceed the portion of the amount received which is includible in gross income (determined without regard to this paragraph).

I highlighted the phrase “including money and any other property.” There is a case (Lemishow) that read a “same property” requirement into that phrase.

What does that mean in non-gibberish?

It means that if you took cash and property out of UBS, then the same cash and property must go into Merrill Lynch.

Isn’t that what happened?

No.

What came out of UBS?

Well, one thing was that hedge fund that caused this ruckus. UBS said it distributed the hedge fund to Caan. They even issued him a 1099-R for it.

What went into Merrill Lynch?

Margiotta requested the hedge fund sell the investment and send the cash to Merrill Lynch.

Cash went into Merrill Lynch.

What went out was not the same as what went in.

Caan (his estate, actually) was taxable on the hedge fund coming out of the UBS IRA.

Dumb. Unnecessary. Expensive.

Our case this time was Estate of James E. Caan v Commissioner, 161 T.C. No. 6, filed October 18, 2023.

Primer On Research Expenses And The Research Credit

[In case you were wondering what a tax CPA does during weekdays, I drafted the following for a fellow CPA as a walkthrough through the tax terrain for research expenses and the related – but different – research credit. It is not recreational reading, but hopefully it may help another tax practitioner out there – CTG].

 

The research & development tax credit has been around since the early 1980s. Initially, only the largest of corporations seemed able to meet its requirements. The passage of years introduced more realistic standards, allowing even modest companies to benefit. Its decades of changes, requirements, limitations and alternate calculations make this a challenging area for almost any tax practitioner.

Let’s take a brief dive into the research credit.

Analysis of the credit, oddly enough, does not begin with a tax credit itself. No, it begins with the deduction for research expenses.

         § 174 Amortization of research and experimental expenditures.

(a)  In general.

In the case of a taxpayer's specified research or experimental expenditures for any taxable year-

(1) except as provided in paragraph (2), no deduction shall be allowed for such expenditures, and

(2)  the taxpayer shall-

(A)  charge such expenditures to capital account, and

(B)  be allowed an amortization deduction of such expenditures ratably over the 5-year period (15-year period in the case of any specified research or experimental expenditures which are attributable to foreign research (within the meaning of section 41(d)(4)(F) )) beginning with the midpoint of the taxable year in which such expenditures are paid or incurred.

 For years – decades actually – research and experimental expenses were deductible as incurred, although the taxpayer had the option to capitalize and amortize such expenses if preferred. For taxable years beginning on or after January 1, 2022, however, that option has been eliminated. Research and experimental expenditures must now be capitalized and amortized (that is, spread out over time). The only difference is the period:

·       Domestic research is amortized over 5 years.

·       Foreign research is amortized over 15 years.

This is a sea change in the treatment of such expenses. Many practitioners – including me – have only known one option, and that was the immediate deduction of relevant expenses. Granted, amortization does not mean the deductions are lost; it means only that the deduction is spread over a period of years. If the company is unprofitable (think a start-up), the difference between immediate deduction and amortization may be minimal. Take a mature company (Pfizer, for example), and the difference could be dramatic.

What type of expenses qualify for the Section 174 deduction?

·       Wages paid to employees directly involved in R&D, and individuals who support and supervise their work. Support or supervise is defined as one level above or below.   

·       Supplies and raw materials.

o   There is an issue here about depreciable equipment. In general, the taxpayer decides the matter by capitalizing or not capitalizing the equipment. If it does, then the equipment is not considered supplies and cannot be included in the expense pool.

·       Work performed by a third party, as long as the business retains the risk of failure.

·       Patent costs

·       Certain overhead expenses (think a research lab)

Now, we know that wages may qualify for the Section 174 deduction, but obviously not all wages will qualify. There are additional “qualities” for an expense to qualify as Section 174 expenses:

·       A permitted purpose

The underlying activity in which wages are incurred must relate to a new or improved business purpose. For example,

o   Something functions (at all)

o   Something functions more reliably

o   Something functions more efficiently 

·       Technological in nature

o   Must be based on a hard science

§  Think engineering, physics, chemistry

§  Scratch sociology and the like  

·       Elimination of uncertainty

o   There must be a realistic question whether the idea will work.

§  Mind you, it does not have to work, but there must be an initial question (or oppositely, a hope) that it will.  

·       Process of experimentation

o   Think classic trial and error.

There are best-practice recordkeeping standards for these expenses. At this point (that is, deduction), such practices may or may not be critical, but the recordkeeping becomes critical as we leave Section 174 and go to the tax credit under Section 41.

             § 41 Credit for increasing research activities.

(a)  General rule.

For purposes of section 38, the research credit determined under this section for the taxable year shall be an amount equal to the sum of-

(1)  20 percent of the excess (if any) of-

(A)  the qualified research expenses for the taxable year, over

 

(B)  the base amount,

(2)  20 percent of the basic research payments determined under subsection (e)(1)(A) , and

(3)  20 percent of the amounts paid or incurred by the taxpayer in carrying on any trade or business of the taxpayer during the taxable year (including as contributions) to an energy research consortium for energy research.

The research tax credit is a big deal because it gives you a second tax bang for doing something you were doing anyway. First, you get to deduct the expense of doing something (immediately under old law; over time under the new law). Second, you get a tax credit on top of the deduction.

The tax credit can be – to be diplomatic – confusing.

There are two main paths:

       

·       The regular credit

·       The alternate simplified credit

 

The Regular Credit

 

The regular credit begins with an odd question:

·       Did you have qualifying research expenses (QREs) before 1984?

If the answer is yes, you will have to accumulate information from the 1980s to calculate the credit, This requirement has been enough to break the hearts of many seeking the research credit.

If the answer no, then calculations become more doable.

The basic calculation is:

Current QREs – base amount = excess QREs         

The base amount involves a five-year period and can be any 5 years between the company’s 5th and 10th taxable year.     

Add up the 5-year QREs. [A]

Add up the 5-year gross receipts [B]

Divide [A] by [B] (called the fixed base percentage)

Let’s pause for a moment.

For its first 5 years, the company can just use 3% for its fixed base percentage.  

The fixed base percentage cannot exceed 16% (i.e., once outside the five year window).

 Back to math. 

Multiply the fixed base percentage by average annual gross revenues for the 4 preceding years (this is called the “base amount”).

Use the greater of the base amount or 50% of current QREs.

Subtract that amount from current year QREs (let’s call this the golden earring).

 Now what?

We multiply the golden earring by a percentage.

Easy: 20%, right?

Nothing is easy.

If we use 20%, then we have to add the amount of the research credit back into taxable income, meaning there is a loop-the-loop.

Fortunately, one can elect to use a reduced credit to avoid the loop-the-loop. The reduced credit is directly tied to the maximum corporate tax rate. Presently the maximum rate is 21%, so the reduced credit would be 20% times 79% = 15.8%.

The election must be claimed on an original, timely filed return and is good only for the year of election.

 Let’s look at an example. 

 

Current year QREs					164,000
Sum of 5-year QREs		[A]	250,000
Sum of 5-year gross receipts		[B]	960,000
Fixed base percentage			26%
Limit on fixed-base percentage				16%
Average gross receipts preceding 4 years				744,000
Base amount				119,040
Greater of base amount or 50% of current QREs					119,040
Subtract					44,960
Credit rate					20%
Credit					8,992

 

The Alternative Simplified Credit

This option came into the Code in 2007, offering an alternative to working with (possibly) decades-old data, There is a price for the simplification, though:     

The credit is 14% if the company has at least 3 years of QREs, otherwise … 

The credit is a flat 6% of current year QREs.  

You again have the loop-the-loop or you can elect to use the reduced credit. 

The nice part of the calculation is that you look at only the three years preceding the current year. 

Here is an example.  

Current year QRE					164,000
Average QREs previous 3 years			[A]	105,000
Multiply [A] by 50%					52,500
Subtract					111,500
Credit rate					14%
Credit					15,610

 

              

 

Here is an example with the reduced credit. 

Current year QRE					164,000
Average QREs previous 3 years			[A]	105,000
Multiply [A] by 50%					52,500
Subtract					111,500
Credit rate					11%
Credit					12,265

 

              

 

 

What if the company does not have 3 years of QREs? Then a flat 6% of current QREs applies.  

Current year QRE						164,000
Average QREs previous 3 years			[A]
Multiply [A] by 50%						0
Subtract						164,000
Credit rate						6%
Credit						9,840

              

              

 

 

The Payroll Tax Offset Option

The PATH Act of 2015 introduced yet another option to the research credit: use it instead to offset employer payroll tax.

More specifically: 

(1)  The offset applies to both the social security portion (6.2%) and Medicare portion (1.45%) of the employer FICA tax.

(2)  There is a $500,000 maximum.

(3)  Only companies with gross receipts for 5 years or less (think startups) qualify.

(4)  Only companies with gross receipts of $5 million or less in the year of the election qualify.

(5)  The election goes with the income tax return.

(6)  The offset applies to the first payroll tax quarter after the company files its income tax return.

(7)  Any unused credit carries over to the next payroll tax quarter.

(8)  Any ultimately unused credit, however, will not be refunded.

The provision was clearly directed at companies with payroll tax obligations but little or no immediate income tax liabilities to sop up that research credit.

Be cautioned, however: you would be exposing your tax filings (both income and payroll) to heightened scrutiny. R&D credits are a high priority for the IRS.