Why Is IRS Appeals So Busy?

Sheldon Kay, deputy chief of IRS Appeals, stated during a February webcast that the case inventory for IRS Appeals reached 148, 000 for fiscal 2011. This is the highest it has ever been. To be fair, Appeals case closures were also at a record level, but not enough to gain ground.

A tax CPA working representation will be quite familiar with Appeals. The normal process is that a taxpayer is selected for examination, i.e. the “audit.” The audit can be through the mail, which is called a correspondence audit. The audit can be at the IRS offices, in which case you go to them. A third type is when they come to you, also called the “field” audit. You are working with a revenue agent. If you disagree you can appeal the agent’s adjustments to the agent’s supervisor, also called the “group manager.”

If you have no settlement there, you are bound for Appeals.

The cases in Appeals fall into two types: collection and exam. What we described above is exam. A collections case has normally gone through exam, and now the IRS is pressing for money. Congress gave taxpayers more protection from IRS collections in 1998 with the IRS Reform and Restructuring Act. Collections have now become half or more of the cases in Appeals.

Back to Sheldon Kay. He explained that the situation has been aggravated by IRS budget constraints. We have seen that here in Cincinnati, as the Appeals office is becoming a ghost town. It is not just the budget, though. Some long-term IRS careerists have also been retiring, reflecting incentives to retire as well as the demographic march of the Baby Boom generation.

There is also another reason. Practitioners comment among themselves that exam is experiencing a brain drain. I agree that a new hire cannot replace the experience and judgment of a career examiner. In the past, the group manager provided some continuity and savvy, but today it is possible that group manager has been there only slightly longer than the examiner.  The “system” is – too often – just not working.

Whether responding to examination or collection frustrations, practitioners are taking their clients to Appeals. The frustration may be because of IRS budgetary constraints, inexperienced personnel, excessive automated collection practices, unrealistic Congressional demands or other reasons. Practitioners are seeking the more experienced personnel available in Appeals.

IRS Offers Penalty Relief for 2011

The IRS last week expanded its relief provisions for financially distressed taxpayers. Effective immediately, the IRS will abate its failure- to-pay penalties for 2011 taxpayers, as long as all taxes are paid by October 15, 2015. To qualify for this relief, you have to be:

·        A W-2 employee and unemployed for at least 30 consecutive days in 2011 or during the 3 ½ months ending April 15,2012, or

·        Self-employed and experiencing a contraction of at least 25% in 2011 business income.

The IRS was very quick to point out that this abatement is for the failure- to-pay penalty only. You still have to file a return by April 15, 2012.

NOTE: There are two “big” penalties when you do not file a return. The first is the failure-to-file penalty. The second is the failure-to-pay. Most tax advisors will counsel you to always file, even if you cannot pay. The failure-to-file penalty is 5% a month, ten times the failure-to-pay penalty of 1/2% a month.

There is a new form to request the abatement (Form 1127-A). The relief is also limited to incomes of $100,000 if you are single and $200,000 if you are married.

The other thing the IRS did is to double the income limitation for a streamlined installment agreement. The streamlined is a payment plan with the IRS. You now qualify if your assessed taxes are $50,000 or less. This is an increase from $25,000, which itself had recently been raised from $10,000. The advantage to the streamlined is that you do not have to provide financial information to the IRS.

The payment term for the streamlined was also increased – from five years to six.

Mandatory FBAR e-Filing Postponed

This is a bit specialized, but if you have a foreign bank account it applies to you.

You may recall that you are required to file Form 90-22.1 “Report of Foreign Bank and Financial Accounts” (more commonly called the “F-Bar”) if you keep over $10,000 in a foreign bank account. It doesn’t have to be a secret Swiss account. A Canadian account will do it, for example. We have clients with Mexican real estate that also have bank accounts requiring FBARs.

You were previously required to file that form electronically starting in 2012. Chances are that meant you were going to use a tax preparer, if you were not using one already.

That electronic filing requirement has been delayed one year – until June 30, 2013.

New Annuities Allowed Inside a Retirement Plan

On February 2, 2012 the IRS published proposed Regulations concerning QLACs – qualified longevity annuity contracts. These contracts would be purchased by and held within your 401(k), 403(b), 457 and IRA accounts.

NOTE: Roths however are not permitted to own a QLAC. Can you guess why? (The answer is below).

Longevity annuities provide life annuity payments, typically starting at age 80 or 85. In many cases, the life annuity is the only benefit the contract provides. As such, these are specialized contracts to aid against outliving your savings. The IRS requires certain bells and whistles before deeming them “qualified” to be owned inside your retirement account.

Why would someone put an annuity inside a retirement account? The IRS has given us at least one very good reason.

You can delay the minimum distribution rules (MRD) on a QLAC. Yes, you read that correctly. Normally, you have to begin taking distributions in the year you reach age 70 ½. A QLAC allows you to defer distributions until and no later than the month following your 85th birthday.   

How will the minimum distribution rules work with a QLAC? You may remember that the normal rule for an MRD is to divide the retirement account balance by an IRS-provided factor for your age. The IRS is allowing you to exclude the QLAC from the balance in the retirement account.

EXAMPLE: If your account is worth $850,000, of which $95, 0000 is a QLAC, you will compute your MRD on $755,000 ($850,000 - $95,000).

The proposed regulations provide that the only QLAC benefit permitted after death is a life annuity. If the contract provides an annuity for a term certain or for a refund of premiums, it will not qualify as a QLAC.

There are restrictions; this is the tax code, after all. Premiums you pay for a QLAC are limited to the lesser of $100,000 or 25% of your retirement account. Bad things happen if you exceed this, so do not exceed the limit.

ANSWER: So why are Roths not permitted to own QLACs? Simple. Roths have no minimum distribution requirement.

IRS Refund Processing Delays

If you are wondering whether the IRS is taking longer to process and issue refunds, you are correct. This has been aggravated by a glitch in the “Where’s My Refund?” tool on the IRS website. The glitch occurs when you file your return electronically, wait a few days and then go to “Where’s My Refund,” which tells you that the IRS is not aware of your return. This is unnerving, of course. It is also incorrect.

What has occurred is that the IRS is tweaking its filters to counter identity fraud. Each year the IRS revises the Electronic Fraud Detection System (EFDS) to reflect fraud patterns detected the previous filing season. Last year, for example, over one million returns were flagged. The returns then go to personnel for review, and therein is the problem. There are not enough people to review the returns.  The ideal time for identity theft is early in the filing season, as the thief is trying to beat you to your refund. The IRS therefore has its fraud filters at their highest setting early in the season.

The IRS has released the customary “we are working on it” statement. It has also reinforced its commitment to getting refunds out within 21 days or less.

The President’s Budget Tax Proposals

The President delivered his proposed budget for fiscal 2013 this Monday. The budget included as one of its five tax “reform” principles the following:

• Simplify the Internal Revenue Code

Sounds good. Here are some proposed tax “simplifications”:

• Provide a temporary 10% tax credit for new jobs and wage increases
• Provide additional tax credits for investment in advanced energy manufacturing
• Provide tax credit for energy-efficient commercial building property expenditures
• Reform and extend Build America Bonds
• Provide for automatic enrollment in IRAs, including a small-employer tax credit
• Expand the earned income tax credit for larger families
• Expand the child and dependent care tax credit
• Provide tax incentives for locating jobs and business activity in the United States
• Provide new manufacturing communities tax credit
• Target the domestic production deduction to domestic manufacturing activities
• Provide a tax credit for the production of advanced technology vehicles
• Provide a tax credit for medium- and heavy-duty alternative-fuel commercial vehicles
• Modify certain energy incentives
• Eliminate capital gains taxation on investments in small business stock
• Expand the tax credit provided to qualified small employers for nonelective contributions to employee health insurance
• Extend and modify the new markets tax credit
• Designate growth zones
• Provide tax incentives for transportation infrastructure
• Modify tax-exempt bonds for Indian tribal governments
• Allow current refundings of state and local governmental bonds
• Reform and expand the low-income housing tax credit
• Defer deduction of interest expense related to deferred income of foreign subsidiaries
• Determine the foreign tax credit on a pooling basis
• Tax currently excess returns associated with transfers of intangibles offshore
• Limit shifting of income through intangible property transfers
• Disallow the deduction for nontaxed reinsurance premiums paid to affiliates
• Limit earnings stripping by expatriated entities
• Modify tax rules for dual capacity taxpayers
• Tax gain from the sale of a partnership interest on a lookthrough basis
• Prevent use of leveraged distributions from related foreign corporations to avoid dividend treatment
• Extend Sec. 338(h)(16) to certain asset acquisitions
• Remove foreign taxes from a Sec. 902 corporation’s foreign tax pool when earnings are eliminated
• Require a certified taxpayer identification number (TIN) from contractors and allow withholding if the contractor does not provide a TIN
• Require e-filing by any entity that must file Schedule M-3
• Authorize Treasury to require additional information to be included in Form 5500, Annual Return/Report of Employee Benefit Plan
• Allow the IRS to require prospective reclassification of misclassified workers
• Extend the statute of limitation where a state adjustment affects federal tax liability
• Require taxpayers who prepare their returns electronically but file their returns on paper to print a 2D bar code
• Impose a penalty on failure to comply with electronic filing requirements

Don’t worry too much about this. The Senate hasn’t passed a budget in years.

Senator Baucus Wants To End Stretch IRAs

Congress is looking to take away a planning option for IRAs as it seeks more money to fund its spending.

The proposal was snuck into the Highway Investment, Job Creation and Economic Growth Act of 2012. The bill was heard by the Senate Finance Committee, and Chairman Max Baucus (D., Mont.) recommended a provision curtailing the use of “stretch” IRAs.

What is a “stretch” IRA? Say you leave your IRA, or part of your IRA, to your son and daughter. Upon your passing, they take over (separate) IRA accounts. They cannot wait until 70 ½ to begin distributions, as these are inherited IRAs. They have to begin distributions by December 31 of the year following your death, but they are allowed to reset the distribution period to their own life expectancy. This allows the opportunity to have the IRA compound – or “stretch” – over their much longer life expectancy.

Truthfully, the numbers can be astounding. Consider a 78 year-old grandfather passing a $100,000 IRA to his granddaughter, who, upon her passing, transfers the remaining stretch IRA to her son or daughter. This wealth compounding is a reason financial planners like to work with stretch IRAs.

It is of course unpalatable to allow one to decide how to distribute the monies in his/her IRA, so Sen. Baucus has stepped-in to decide this matter for you. Under his proposal, most nonspouse inheritors would have to withdraw the entire amount from the traditional IRA over a period of five years. There would be exceptions for beneficiaries who are disabled, chronically ill, a minor, or a beneficiary no more than 10 years younger than the IRA owner.

Roth IRAs would remain unchanged. Nonspouse beneficiaries must begin distributions from the Roth by December 31 of the year after inheriting, but they can draw these out over their own expected life expectancies.

Why are people concerned? Here is a statistic: approximately 40% of the stock market is tied-up in 401(k)s, 403(b)s, IRAs and similar vehicles. It is an attractive target.

Form 1099-K Reconciliation Cancelled

The IRS has decided that businesses will not be required to reconcile their gross receipts with merchant card transactions reported on the new 1099-K form.

Steven T. Miller, IRS deputy commissioner for services and enforcement, wrote to the National Federation of Independent Business that no reconciliation will be required on 2012 or future business tax returns. Last October the IRS had earlier said that no reconciliation would be required for only the 2011 tax returns.

In the way of history, the Housing and Economic Recovery Act of 2008 required the IRS to begin collecting a new Form 1099-K from payment-settlement entities, such as credit card companies, for merchant transactions such as credit and debit card payments. The payment settlement entity is required to issue a 1099-K to a merchant if the merchant’s business for the previous year exceeded either $20,000 or 200 transactions.

Why would businesses complain? Well, for one, if the taxpayer identification number and legal name do not match with IRS’s files, there is back-up withholding of 28% of the transaction. How is the business to account for refunds or returns? For sales taxes? How is the 1099-K to be reconciled with accounting systems which are geared to track sales by product or type, not by payment type? How will one account for fiscal years, when the 1099-K’s will all be on a calendar year? And who is going to pay for the accountant to reconcile all this nonsense?

Couples Must Now File Separate Powers of Attorney

Starting March 1, 2012 married couples will have to file separate powers of attorney for their tax representative.

It used to be that both spouses could sign one power naming a representative. You may recall that you signed near the top of page 2. That has changed because of increased sensitivity to privacy and data security.

There is another change on the power, but the change applies to tax representatives. The representative must now include his/her PTIN on the power. Tax advisors may remember that the IRS has discussed increased practitioner enforcement, including automatic referral to the Office of Professional Responsibility of a practitioner associated with a substantial understatement penalty. The PTIN is a way to identify a specific return to a specific tax preparer.

The Backdoor Roth IRA

The following question came up recently:

I make too much money to contribute to a Roth. Is there another way to make an additional contribution to my retirement savings?

How much is too much money? If you are single the upper limit is $122,000. If you are married the upper limit is $179,000. We are assuming, by the way, that you are covered by a plan – say a 401(k) - at work.

So what do you do?

Fund a nondeductible IRA. What is this? It is the third “flavor” of an IRA. We all know the regular IRA, where you put away money, deduct it on your tax return and pay tax on the monies down the road when you take the money out. For a Roth, you put away money, take no deduction but pay no tax when you take out the money. Then there is the nondeductible. You get no deduction and the money is (partially) taxable when you take it out.

For example, say that you put away $50,000 in nondeductibles which are worth $250,000 when you start drawing. The withdrawal is 20% nontaxable ($50,000/$250,000). Another way to say this is that 80% will be taxable.

Nondeductibles are the stepchild of IRAs. You want to fund a Roth (if you can) before considering a nondeductible.

Say that you are single, in your 40s and make $200,000 per year. I recommend that you fund a nondeductible IRA for $5,000, because $5,000 is the best you can do. You have to fund your IRA by April 15^th under all flavors of IRA. Let April 15^th pass and convert the nondeductible to a Roth. How do you do that? It may be as easy as going on the broker’s website and moving the monies between the two IRAs. Think of it as moving monies between a savings and checking account.

It used to be that one could not do this, but the tax rules have been changed to allow it.

What is the downside? There are two, and the second one can be an insurmountable hurdle to some taxpayers.

(1)    First, any income in the nondeductible becomes immediately taxable. In our example, if the $5,000 is now worth $5,450, you will have $450 of taxable income. If you do what I recommend, chances are the income will be negligible as you did not leave the monies in the nondeductible for very long.

(2)    Second, the pro rata rule. If you have monies in other IRAs, you have to use a fraction. The numerator is the amount you have in the nondeductible. The denominator is the total you have in all IRAs. For example, if you have a $5,000 nondeductible and $95,000 in a regular IRA, your ratio will be 5% ($5,000/ ($5,000 + $95,000). If you convert in this scenario, the conversion will be 95% taxable.

How do you handle issue (2)? If you have a retirement plan at work and the plan allows you to roll-in, then you would roll-in your $95,000 regular IRA. At this point the only IRA you have is the $5,000 nondeductible. Your ratio now is $5,000/$5,000, meaning that 0% is taxable.

The nice thing about a nondeductible is that there is no income limit. If you make $1 million per year, you can still contribute to a nondeductible.

How long do you let the money cool before converting? Tax advisors disagree. Some advisors recommend at least six months, whereas others say that you can do so the next day. I would recommend more than a day and not more than December 31^st of the year of the conversion.

One more bit of advice. If you fund a nondeductible, put it in its own account, preferably titled “Nondeductible.” Do not commingle your IRAs. This is not Neapolitan ice cream.

Taxpayers Keep Leaving The United States

The number of expatriates continues to increase. The number for 2011 was 1,781 and represents more than a 15% increase from 2010.

Not all expatriates are wealthy and seeking to sidestep what they perceive as harsh and confiscatory government policies. The IRS itself estimates that up to seven million U.S. residents reside abroad. I have family overseas, for example, and they have no intention of returning. They must nonetheless file a U.S. tax return annually, file a FBAR and, assuming that they have not spent every nickel they ever earned, have to deal with FATCA reporting. Did you know that there are tax restrictions on a U.S. citizen marrying a non-U.S. spouse? Does that make sense to you?

The most recent assault by Treasury on non-U.S. financial institutions, such as UBS, has had the perverse effect of these institutions dropping U.S. clients – and certainly not accepting new ones. I am not condoning the uber-wealthy hiding their income and assets from the U.S., but it is a far reach to argue back that a U.K. bank should report electronically on the bank activity and balances of my family.

Here is a chart on the number of expatriates over recent years. Kudos to Andrew Mitchel for the graph. Draw your own conclusion, if a conclusion is there to be drawn.

               

Paying a Fair Share Act

U.S. Senator Whitehouse (D-R.I.) has introduced a tax bill named the Paying a Fair Share Act.

This is the Buffett Rule. It would apply only to taxpayers with income over $1 million. At income levels over $2 million, there would be a flat 30% tax. At income between $1 million and $2 million there would be a phase-in to get the effective tax rate to 30%.

The bill is co-sponsored by the following:

·         Sen Daniel Akaka, D-Hawaii

·         Sen Mark Begich, D-Alaska

·         Sen Richard Blumenthal, D-Conn.

·         Sen Tom Harkin, D-Iowa

·         Sen Patrick Leahy, D-Vt.

·         Sen Bernie Sanders, I-Vt.

·         Sen Chuck Schumer, D-N.Y.

It is very doubtful that this bill is going anywhere.

Here is another proposal. We can call it the Biden Rule:

         Politicians who stay in Washington more than 10 years pay a 100% tax rate.

IRS Modifies Streamlined Installment Payment Program

The IRS issued a memorandum on January 20, 2012 liberalizing streamlined installment agreements. I am happy with this change.

As a refresher, the advantage of the “streamlined” is that one does not have to provide financial information to the IRS. If you have gone through this effort, you may remember IRS Form 433 – the financial information form. This is where you provide financial detail such as monthly deposits and expenses. You will also attach documentation, including copies of bank statements as well as copies of your mortgage or rent advice and certain other expenses. 

The IRS has standards for broad household expenses, such as mortgage and utilities, clothing and personal effects, medical expenses and vehicle payment and operating expenses. The IRS is inclined to use their numbers, although they will allow you to document higher or additional expenses. You then have to persuade them that your numbers are better than theirs and do not reflect a “lavish” lifestyle or incorporate”excessive” expenses. To give you an idea, the IRS does not allow for payments on your credit cards. I am not sure if they consider credit card payments to be “lavish” or “excessive.”

The “streamlined” allows you to fast-forward through this.

The liberalized streamlined rules apply only to an individual taxpayer. They do not apply to corporations and other types of businesses. You can now enter streamlined if your assessed balance (taxes, interest and penalties) is less than $50,000, an increase from the previous $25,000. In addition, you now have 72 months to pay, an increase of one year from the previous 60 months.

The IRS does charge a small fee (either $104 or $52, depending on whether you permit direct deposit) for the payment plan. Any streamlined over $25,000 must be on direct deposit.

To clarify, you do not have to enter streamlined, even if your assessed balance is less than $50,000. You can go the normal route, provide information and pursue a more favorable payment plan.  You would do that if you are pursuing a partial pay, for example. You would certainly have to go that route if you are pressing for an offer in compromise. For many people, however, the increase from $25,000 to $50,000 and an additional year to pay may make all the difference.

Why would someone hesitate to provide a 433? For one, it can be a pain to assemble and complete. Also, you have to disclose your bank accounts, including bank account numbers, on the 433. Some people believe this makes it easier for the IRS to levy your bank account. Whether correct or not, you have provided the IRS a roadmap to your finances.

A Sad Tax Story

I recently read a tax case I did not like. The IRS was pursuing action against a woman in Tennessee. My daughter presently goes to the University of Tennessee in Knoxville, so perhaps it was that geographical connection that made me look at the case.

The IRS wanted to garnish her paycheck and levy her car. The woman resisted and represented herself. She eventually took her case pro se before the Tax Court.  Read the following letter she wrote the Court and tell me that you do not feel some anger against the IRS.

To Whom It May Concern,

I don’t know what you want to know cause I don’t understand all the legal stuff you sent me. I can’t afford a lawyer. And the closest legal aid is in Knoxville 30 miles away. My poor car will not go that far. So I will start at the beginning of my story and see if you can help me.

I was in an unhealthy relationship for many years. During a great deal of that time my husband was doing alcohol and drugs. I had 2 children plus his 3 to take care of. I had been doing janitorial work at a strip mall * * *. It was the only place that I could work that I could take my [then] 3 year old daughter with me. I could not support my family and pay day care. * * * My husband took care of bills and such cause he demanded that I turn over my money. We even got a divorce during that time cause I was not obeying him.

Now I am not looking for sympathy just understanding. Do you know how hard it is to be a single parent? * * * I have a high school education and nothing else.

It was nearly five years before I was notified of a problem by the I.R.S. Danny [petitioner’s former spouse] was suppose to be doing taxes. He even made me sign a form that because he made more money he could claim my kids on his taxes cause we were no longer legally married.

I got all the W-2’s from the I.R.S. except 2005 that they still have not sent me. That is why they are not done. I did all those taxes and forfeited the refunds. I do not remember what that total came to.

But it was enough to pay I would say most of back taxes. The 2007 taxes were late and I don’t know why they didn’t arrive. I sent a second copy in as soon as my son gave me my copy. He had my copy for college financial aid and he lost them for a bit of time.

I am not a rich person. I work in a job so I can be home with my daughter. I left my husband in July after he threatened to beat my daughter with a baseball bat. Beating me is one thing but I could not have him beating my girl. So I am a single parent again. Right now we have not had much work in nearly a year. I have rent of 600 a mo. Utilities of 150 and get food stamps or I wouldn’t eat. I make about 700-800 [per] month. There are no better jobs in our town. My daughter is only 11 so its not like I can leave her alone at night or on weekends. D.H.S. says it’s not even legal. She is too young. There is no child care and I have no family here. I have pulmonary fibrosis that makes me sick all the time and the diagnosis says I have about 10 yrs to live. Right now I can work thank God.

I did my taxes this year [for 2008] and you are getting a little over $4,700. I’m not asking for much just a break. You can have my tax returns [refunds ?] I don’t care. Well I do that is a tremendous loss but oh well. I don’t have any money to send you on a monthly basis. Can we stop all the penalties. They are killing me. I will never be able to pay it off. * * * I let a relationship screw me up. I am truly sorry for that and am begging for a lifeline here. You can come to my home and see for yourself. I don’t have fancy t.v.’s or even cable except for internet. I can’t afford a phone. My clothes have holes in them. I even cut my own hair. If I could pay this off faster I would just to stop the nightmares it gives me.

The Tax Court told the IRS to stop it. I am not going to go through the tax back-and-forth, because this situation should never have gotten this far. The IRS was upset because this poor woman did not do everything perfectly, and rather than exercise common sense some government-idiot-with-a-pension had to press the point.

Were it up to me, I would find and fire that idiot.

Terrance Clem Wright v Commissioner

I have a question for you: if you wanted to convince the IRS that you are unable to pay back taxes because of financial hardship, would you hesitate to send them copies of your bank statements?

Let’s take a look at another pro se case before the Tax Court: Terrance Clem Wright v Commissioner. This is also a good opportunity to review the sequence of possible IRS Collections actions against a taxpayer.

Terrance Wright (TCW) fell behind on his taxes for 1999, 2000, 2001, 2003, 2004, 2005, 2006, 2007, and 2008.

On March 18, 2010 the IRS sent him a notice advising him that a notice of federal tax lien (NFTL) had been filed because of his back taxes and that he could request a hearing with the Appeals Office.

On April 25, 2010 TCW filed a request for a Due Process Hearing. The intent of a CDP is to delay a hasty IRS collection action and allow the taxpayer to propose an alternative. He did not contest the tax liabilities but instead requested an installment agreement.

On November 19, 2010, the IRS sent TCW a letter scheduling a telephone conference on January 18, 2011.  The IRS requested TCW to provide financial information and a payment proposal. This would help the IRS Appeals Officer make a decision.

On January 18, 2011, TCW and the Appeals Officer had their telephone conference. TCW told the Appeals Officer that he could not currently afford to make any payments. The Appeals Officer told TCW that - while he had provided some financial information – he unfortunately had not provided bank statements. She needed the bank statements to review his situation and make her decision. Until then she did not have enough information to determine whether TCW should be placed in currently not collectible (CNC) status. She encouraged TCW to pursue CNC status when he obtained all of the necessary financial documents.

NOTE: CNC status means that the IRS will not pursue action for a period of time, very often a year. It does not mean that the tax debt is gone, only that the IRS is granting time for you to get your financial affairs back in order.

Once informed by the Appeals Officer of the alternative, TCW liked the idea of CNC. This does not appear to have occurred to him previously, which indicates – at least to me – that he was not represented by a tax professional.

On February 2, 2011, the IRS issued a notice telling TCW that he would not receive an installment agreement or CNC.

OBSERVATION: Notice the dates: January 18 and February 2. This is not a lot of time, especially by IRS standards. Remember that it took him seven months to get to Appeals. TCW needed to have burnished his case by or before the hearing, as time is short once you are in Appeals.

The Appeals Office, at least in Cincinnati and this part of the country, is undermanned and overworked. I was told recently, for example, that Chicago Appeals are being heard in Wisconsin. My general experience with Appeals has been satisfactory, but one has to be aware and sensitive that these people are pressed for time. I am certain that TCW’s Appeals Officer was frustrated with his lack of cooperation.  

TCW, in a pique, filed a petition with the Tax Court on March 1, 2011.  TCW did not contest the underlying tax debt or the denial of an installment agreement. Instead, TCW’s only argument was that he could not afford to pay. He wanted the IRS to suspend collection action on the basis of his economic hardship. He wanted a CNC, and he wanted the Tax Court to tell the IRS to let him have one.

Here is the Tax Court:

Suspension of collection activity is a “collection alternative” that the taxpayer may propose and that the Office of Appeals must take into consideration. The Internal Revenue Manual (IRM) makes provision for a taxpayer's account to be declared “currently not collectible” in cases of “hardship.” To justify suspension of collection on the ground that the account should be deemed CNC, petitioner must show that he cannot afford to pay the liabilities; and to do so he must show his financial circumstances, including the money that is available to him and the expenses that he bears.

The Appeals officer requested that petitioner submit bank statements and other financial information so that collection alternatives could be considered. Petitioner submitted some of the requested information but failed to submit bank statements. Because petitioner failed to submit the requested bank statement information, the Appeals officer was unable to accurately ascertain petitioner's financial circumstances and, consequently, determined that she could not calculate the appropriate installment agreement terms or grant petitioner CNC status. In the absence of the requested information, respondent's Appeals officer did not abuse her discretion in denying petitioner's request for collection alternatives.

My take? Send the bank statements. It really is that simple.

Can the IRS Disallow Your Net Operating Loss Carryback?

Here is a quiz question:

            Can the IRS reopen a tax year if you file an NOL carryback?

Most tax accountants will remember the intent of IRC Section 7605(b), even if they may not remember the specific citation:

No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.

This language entered the Code in 1921, and its intent was and is to relieve taxpayers from unnecessary annoyance.

The question is whether it is the original year that is being reopened or whether it is the carryback from a later year that is being reviewed.

The IRS expounded on IRC Section 7605 in Rev Procedure 2005-32. The wording we are after is “reopening.” Section 2.04 of the Rev Procedure informs us that new section 4.02 is being added to define the “reopening” of a closed tax case.

The new section 4.02 states:

A reopening of a closed case involves an examination of a taxpayer’s liability that may result in an adjustment to liability unfavorable to the taxpayer for the same taxable period as the closed case, with exceptions, some of which are noted below. The Service’s review, including an inspection of books of account, of a taxpayer’s claim for a refund on an amended excise or income tax return, as well as the Service’s review of a Form 843, Claim for Refund and Request for Abatement, claiming a refund for an overpayment reported on a return, is not a reopening.

Someone ran face-first into this in FAA 20114701F. Here are the facts:

Taxpayer deducted a bad debt loss in Year 1. It was audited and the IRS allowed the loss. Enough time goes by that the statute of limitations for Year 1 expires. In a later year Taxpayer has an NOL, which it carries-back to Year 1. The IRS however was still churlish about that bad debt deduction in Year 1.

The FAA goes on to reason that the IRS did not pick this fight. Rather the Taxpayer did by electing to carryback its net operating loss and claiming a refund. The Taxpayer’s action allowed the IRS to “reopen” the closed year.

There was some saving grace, thankfully. The IRS decided it could deny Taxpayer’s claim for refund dollar-for-dollar – but only to the extent of the refund. The worst that could happen is that the Taxpayer would not receive any refund, resulting of course in a total waste of the net operating loss carryback. But hey, at least the Taxpayer did not have to write a check to the IRS for the audacity of claiming a tax refund.

1099s and Weatherly v Commissioner

There are two new questions on your income tax returns this year:

·         Did you make any payments in 2011 that would require you to file Form(s) 1099?

·         If “Yes,” did you file or will you file all required Forms 1099?

Several points come immediately to mind:

·         Remember that you are signing this return as being “true, correct and complete” to the best of your knowledge.

·         I, as the preparer, have to exercise due diligence by also asking you this question.

·         What are the consequences of answering “No?”

Congress will be unsatisfied until it has combed your sofa cushions for loose change. This pressure unfortunately passes down to the IRS, and we are seeing the results in OVDI, FATCA, automated collections and taxpayer liens. Obviously they believe there is money to be found here.

This brings us to Jeremiah Weatherly v. Commissioner (TC Memo 2011-206). It’s a tax case having to do with Forms 1099.

JW operated a bailiff consulting business. These are people who perform evictions and serve process, for example. He hired daily workers to help out. He must have been doing relatively well, as he reported $177,925 of Contract Labor on his 2005 return.

He got audited. The IRS wanted his Forms 1099. JW provided the IRS with 64 Forms 1099.There was a problem, however. JW had not filed the Forms with the IRS.

                OBSERVATION: Really, JW?

The IRS now had no confidence in the 64 Forms 1099, so they requested JW obtain and submit Forms 4669 from the 64 people. Form 4669 requires the payee to report the amount of the payment and where it is reported on his/her return.

OBSERVATION: This is not going to go over well.

JW’s response rate was pretty much what you would expect: he got eight replies. The IRS bounced 2 of them, as the social security numbers were invalid. With the remaining six, JW was able to document $25,115 of his Contract Labor expense. The IRS simply disallowed the remaining $152,810.

JW appealed pro se to the Tax Court. He got schooled. Tax law and long-standing tax doctrine require a taxpayer to maintain records sufficient to establish the amounts of allowable deductions and enable the Commissioner to determine the correct tax liability. This is a two-step requirement: your records have to be good enough for you to prepare a correct return AND to allow someone to double-check your work.

The Tax Court asked for JW’s books and records. Nothing. The Tax Court asked for other evidence to substantiate that these amounts were actually paid. Nothing. The Court then wanted JW to testify about his bookkeeping practices. Nothing. Frustrated, the Court held for the IRS. JW got charged with additional tax of $67,436 and penalties of $29,425.

What can we learn from JW?

Let’s admit, JW should never have represented himself. All he accomplished was to aggravate the Court. It is possible that another taxpayer – more responsive and attuned – could have obtained a different result. The Court did try to help JW, even alluding to the Cohan rule where it will allow estimates as long as the Court is convinced that there truly was an expenditure.

Nonetheless, we can see the position the IRS can and may take if one fails to file Forms 1099. Perhaps your bookkeeping practices are different from JW’s, and you could have provided the Court with substantial and satisfactory alternative documentation. However remember that you would have engaged – and paid – a tax CPA to represent you at audit and Appeals before even arriving at the Court. And you would still be at the Court’s mercy.

This process seems expensive to me. Here is another idea: issue 1099s, especially since you are now required to affirmatively respond to the new questions on your 2011 tax returns. There is now one more reason for the Court to turn you down: you lied when you answered “No” to the first question.

The IRS Is Now Accepting E-Files for the 2012 Tax Season

Tax season officially started yesterday, when the IRS started accepting e-filed returns. Electronic filing is expanding: approximately 100 million returns were e-filed for 2011. The IRS is certainly encouraging this momentum. Professional tax preparers – such as Kruse & Crawford – have to submit individual income tax returns electronically if they expect to prepare more than 10 returns in 2012. One does not have much of a tax practice if one does not prepare more than 10 individual tax returns in a year. The percentage of e-filed individual returns has increased from 58% in 2008 to 77% last year.

The Free File has also started, which allows one to e-file federal individual tax returns for free if one’s income is less than $57,000.

One last note: tax returns will be due Tuesday, April 17th this tear. That is because the 15th is on a weekend and the next business day (Monday) is a holiday in Washington, D.C.

The SMLLC and the Family Payroll Tax Exemption

If you are a single-member LLC (SMLLC) reporting for tax purposes as a sole proprietorship, you may be interested in a recent payroll tax change.

An SMLLC is reported for income tax purposes as either a corporation or a proprietorship. A question came up in recent years on how to treat an SMLLC for payroll tax purposes. In August, 2007 the IRS issued final regulations requiring the SMLLC to be treated as the taxpayer for employment tax purposes. This meant that it had to get an identification number separate from its sole member, for example. These regulations became effective January 1, 2009.

This in turn raised the question on what to do with the family employment tax exemption. The family tax exemption allows a proprietor who pays his/her spouse or children the following:

·         For a child under age 18, unemployment, FICA and Medicare taxes will not apply

·         For a child over 17 but under 21, unemployment taxes will not apply

·         For a spouse, unemployment taxes will not apply

By treating the SMLLC as an entity distinct from the sole member, the parent was not employing the family member, at least technically. This threw-out the family employment tax exemption.

Talk about unintended consequences.

The IRS has now reversed course and has expanded the family tax exemption to SMLLCs – and has made the exemption retroactive to January 1, 2009. This could mean that amended payroll tax returns are in order.

Example: You operate as a SMLLC. You have 7 employees, which include your spouse, a child age 16 and a child age 19. What are the federal employment tax consequences?

a.       The child age 17 is exempt from FICA, Medicare and unemployment

b.      The child age 19 is exempt from unemployment

c.       The spouse is exempt from unemployment

WSJ article "More Firms Enjoy Tax-Free Status”

I read this today on The Wall Street Journal:

Sixty-nine percent U.S. companies were organized as pass-throughs, or nontaxable organizations, in 2008, compared with 24% in 1986, according to data from the Internal Revenue Service. Members of Congress and the business community disagree on whether the exemption should change. Increasingly, traditional for-profit companies are at a competitive disadvantage against pass-throughs.

The article title is “More Firms Enjoy Tax-Free Status.”

Here is a gripe: it is misleading nonsense to refer to passthroughs as tax-free or nontaxable. Passthroughs are partnerships, LLCs and S corporations, and generally their income is allocated to and reported by their owners and partners. For Kruse & Crawford clients, this means that the passthrough income is reported on one or more individual income tax returns. It is there that tax is calculated and paid. Client tax estimates are due, and we are presently working on several estimates due on January 16^th.  I stayed here late last night working on something the Wall Street Journal says is nontaxable and apparently not “for profit.”

If passthroughs are “nontaxable” or not “for profit,” then this tax guy has missed the boat for more than two decades.

The Anschutz Company v. Commissioner

So what do you do when you own a fortune in stock but do not want to pay the tax man?

Let’s look at Philip and Nancy Anschutz and The Anschutz Company (TAC). Philip Anschutz (PA) began acquiring oil and mineral companies during the 1960s. He expanded his activities to include railroad, real estate and entertainment companies. This meant he owned large blocks of various companies’ stock, and he housed them in TAC. TAC was an S corporation, a fact which is important and to which we will return later.

Well, if you keep buying companies, eventually you wind up having a lot of money invested in those companies. In the late 1990s and early 2000s, PA and TAC began looking for ways to free up some of that invested cash.

In 2000 and 2001 TAC received approximately $375 million from a series of variable prepaid forward contracts with Donaldson, Lufkin & Jenrette (DLJ). The contracts involved shares of Union Pacific and Andarko Petroleum. DLJ later became part of Credit Suisse.

Let’s get into eye-rolling territory and talk about a “forward contract.” Here is an example:

You want to unload $250 million worth of AJ stock but delay any tax consequence. Tony Soprano (TS) wants to help you. You hire a firm (BADA BING) who proposes a business deal involving TS. You loan the stock to TS. No, instead you loan the stock to BADA BING and you grant TS a security interest in the shares. TS then sells the stock. TS sells short, though.

QUESTION: By selling short, TS is saying that he does not own the stock. This is consistent with the story so far, as you lent the stock to TS. TS has a security interest in the stock, but that interest is not the same as owning the stock. Therefore TS has to sell short. He is protected however because – if ever called upon – he can deliver your shares to close-out the trade. Remember, your shares are in his possession.

                What do you get out of this? Nothing so far.

But let’s say that TS gives you 75% the money from the short sale. Ah, now you have something – you have cash in your pocket. The transaction as described is now a “prepaid” forward contract. The “prepaid” means that you got money.

There is more. You get a 5% prepaid lending fee because, by golly, you are lending the use of your shares to TS.

Somewhere down the line this story has to end, however. Say that 8 or 10 years down the road you are obligated to deliver to TS either:

·         a (variable) number of AJ shares, or

·         cash, or

·         equivalent but not identical stock 

The variable number of shares permitted to settle the contract makes this a variable prepaid forward contract.

There is also a way to do this with puts and calls and is referred to as a collar. It is interesting in a train-wreck sort of way, but let’s spare ourselves that discussion.

Let’s give TS some incentive to do the deal. We can add the following:

·         If the stock appreciates over the term of the deal, you get the first 50% in appreciation but TS gets ALL the appreciation after that.

·         TS kept 25% of the cash. He could invest it over the term of the deal and keep the earnings.

·         TS did sell the stock short, so if the stock goes down, the short sale would earn TS additional profit.

·         Upon the occurrence of certain events (bankruptcy, material change in economic position), TS could accelerate the settlement date of the deal.

How could TS lose money? TS already sold all the stock and paid you 75% of the proceeds. TS kept the remaining 25% for a period of time. Granted, TS did sell the shares short, so TS would have the risk of the stock going up in price over the term of the deal. This is how one loses money on a short sale, as it would make it more expensive for TS to close out his short position. But wait, TS has physical possession of your stock. If you do not make TS whole, he will simply take your stock to cover the short sale. What if the stock goes down? Then TS has a profit on the short sale. TS dealt a pretty good hand for himself.

How could you lose money? You really can’t. If the stock goes down, you buy it at the lower price and deliver it to TS. If the stock goes up you participate in the gain. Not all the gain, but still a gain. You lose by not making as much money as you could have by holding on to the stock. I can live with that kind of loss.

What was the underlying tax law that drove this transaction? Under long-standing tax law, a taxpayer did not have a sale - for tax purposes – of securities until the taxpayer delivered shares from his/her long position. In a forward contract, the delivery is delayed for years, possibly many years. So a forward contract, even a prepaid forward contract, of securities was not considered a "sale.” The IRS changed this in 1997 with Section 1259, which provided tax rules for constructive sales of financial positions. You may remember that you used to be able to protect an appreciated stock position at year-end by something called a “short sale against the box.” Then one day your accountant told you that you could not do that anymore because the law had changed. Tax law now requires you to have some level of risk in the position. The question is: how much risk?

Since TAC entered into these transactions in 2000 and 2001, it at least had the warning of Section 1259. TAC did not however have clarification of how far it could push the “link” between a variable contract and a stock loan. Tax law takes time to evolve. This is an innovative tax area involving financial instruments and derivatives, and tax clarification takes time. In 2006 the IRS finally gave warning that it did not like this structure. Too late for TAC to close the barn door, of course.

The IRS went after TAC.

What was the IRS position? We can hear the IRS saying:

“TAC did not keep enough risk to avoid a constructive sale of the Union Pacific and Andarko stock.”

What was TAC’s position? We can almost hear them saying:

“What are you talking about? We entered into two transactions - a prepaid variable and a stock loan, not one. The prepaid variable did not rise to the level of a constructive sale. The loan was to Wilmington Trust Company as collateral agent and trustee. Last time we checked, Donaldson, Lufkin & Jenrette was not Wilmington Trust Co.

In addition, is it fair to make tax law retroactive?”

In 2010 the Tax Court agreed with the IRS. TAC immediately appealed. The Appeals Court handed down its decision on Tuesday, December 27, 2011.

The 10^th Circuit Appeals Court noted that TAC effectively exchanged its shares for …

(1)    Upfront monies of 75% and 5%

(2)    the  potential to benefit to a limited degree if the pledged stock increased in value, and

(3)    the elimination of any risk of loss of value in the pledged stock

NOTE: Think about this for a moment. TAC transferred its shares to DLJ and DLJ relieved TAC of any risk of loss. What does this sound like?

The 10^th Circuit Appeals Court further reasoned that DLJ…

(1)    obtained all incidents of ownership in the shares, including the right to transfer them

(2)    acquired an interest in the property that it could not prudently abandon

(3)    had a present obligation to pay monies to TAC

(4)    had the right to sell or rehypothecate the shares

NOTE: DLJ had an immediate obligation to pay TAC and also had the right to sell the shares. What does that sound like?

Welcome to the new tax shelters. There was a time that shelters involved real estate or oil and gas and relied on nonrecourse loans or accelerated depreciation. Contemporary shelters use financial derivatives.

At the heart of this case is a metaphysical tax question: when is a sale a sale? The IRS did not challenge the substance of the deal. What it did challenge was this important detail: TAC lent its shares to DLJ to make the deal work. TAC argued that the stock loan and variable forwards were separate deals and that the stock was loaned to Wilmington Trust, not DLJ. The Tax Court in 2010 could not overcome the fact that, when TAC lent its shares, the shares were effectively gone and could not be recovered. A common factor of a sale is that the seller no longer has possession of the property sold.  

Why did TAC do this? TAC is an S corporation. S corporations can pay tax if they have a unique fact pattern called “built-in gains.” Sure enough, TAC had built-in gains in the Union Pacific and Andarko stock. The built-in gain had a clawback period of ten years. Sale of property with built-in gains within this period triggers the built-in gains tax. TAC was trying to avoid the double-taxation of built-in gains and then capital gains.

TAC lost big. The taxes were about $110 million. Oh, add on about another $30 million for penalties and taxes. Since TAC was an S corporation, all its income, deductions and credits flowed-through to PA and were reported on his individual income tax return. This means that PA lost big too.