Even Iron Man can’t beat the IRS…..

Apparently, having the Avengers on your team is no deterrent to the IRS.

In a recent (July 21) decision, the IRS went up against the Avenger’s former employer – Marvel Entertainment Group (note: Disney’s owned Marvel since 2009) and came away the winner. Fortunately, the decision relates to a pre-2004 regulation, so the decision is more noteworthy for the numerous corny Avengers-related wisecracks (not found here) that are guaranteed to result (and the amount of money Marvel will have to pay) than future legal impact.

So what did Marvel do that put into the IRS’ sights? Back in 1997 and 1998, Marvel filed consolidated tax returns, then reorganized. As part of the reorg, a large amount of debt was canceled in each of four subsidiaries – Marvel, Fleer, Malibu and Heroes. How much? Try $171 million. Under Section 108(b)(2)(A) requires the reduction of “tax attributes” if you’re excluding canceled debt from income, and Marvel was, so Marvel reduced tax attributes – in this case, each subsidiary’s Net Operating Loss – accordingly.

The IRS disagreed. According to the IRS, the place to do the reduction was at the consolidated level, not the entity level, which had a significant impact on income. Without getting too technical, by reducing each subsidiary’s Net Operating Loss by an allocation of the total canceled debt, Marvel was able to carry forward $47 million in losses. Under the IRS’ method, Marvel would have only been able to carry forward $15 million. So when the Tax Court, relying on United Dominion v. United States (532 U.S. 822 (2001)) among other cases, agreed with the IRS, it impacted Marvel’s net operating loss carryforwards for 1997 and 1998 significantly, which in turn, affected Marvel’s 2003 and 2004 tax returns (obviously, the NOLs carried forward for a while). The end result? A $2.1 million and $14.45 million tax bill for 2003 and 2004, respectively.

Ouch. Looks like Jarvis won’t be getting that upgrade this year, Tony.

For more info, see Marvel v. Commissioner (145 T.C. No. 2, July 21, 2015)

Suspended corporation and tax debts – a bad combination

There are a couple of ways a Corporation can be suspended in California. Fail to file tax returns, and the FTB will suspend the corporation. Or forget to file your annual/semi-annual Statement of Information, and the Secretary of State will do the same.

Being suspended comes with a number of ills. First – and one of the most significant – is contract voidability. A suspended corporation cannot enter into a valid contract; as a result any contract entered into while the corporation is suspended is voidable at the option of the other party (note: this provision does not apply to contracts entered into before the corporation is suspended). The only option for the corporation is to a) resolve whatever caused the corporation to be suspended (file and pay past due tax returns, or file past due Statements of Information and pay the penalties) and then get something called a certificate of revivor. Unfortunately, though, that’s not all – you also need to get a “certificate of relief from contract voidabiliy.” So it’s a three-step process. And it can take months.

So what does this have to do with taxes? Find out after the jump.


Having my baby – what a lovely way to earn taxable income…

Couples who have difficulty conceiving often turn to alternate methods: in-vitro fertilization, surrogate mothers, and donated eggs or sperm. Each of these methods carries its own form of risk, and none of them come cheaply (of course, one wonders if about, oh, 13 years and any number of “I hate you,” “You suck” and “You never let me do anything I want to do” in, any of these parents will ask themselves if the cost was worth it).

In-vitro fertilzation aside, all of these options require a third person’s involvement, whether to supply the egg or sperm or the vessel for gestation. And no rational person will do this for a perfect stranger simply out of the goodness of their heart (and maybe not family, either, but we won’t go there today). Somehow, some way, money will be involved. After the jump, see how that can complicate matters.


Moving? Make sure you tell the IRS

It’s a fact of life – we move. People rarely die in the same house where they were born and raised. Even if they do, there are periods of time when they are living elsewhere – college, for example. And yet, one of the items frequently left off the ‘to do’ checklist when moving is “tell the IRS.” Why? Probably because most people don’t know how to tell the IRS they’ve moved. Most credit card and other bills have a ‘change of address’ spot on their payment slip (or a convenient button on their website). The Post Office has a card you can fill out – tell your postal person you’re moving, and more likely than not they’ll even bring it to you the next delivery day.

Not so with the IRS – there’s no “Check here if new address” box on the 1040, and no obvious button or link at www.irs.gov. Instead, you have to file Form 8822 – Change of Address, a separate form that you can’t file with your tax return. That’s right: even if you e-file, Form 8822 must be mailed in separately. Unfortunately, most people don’t even know about Form 8822 – it’s one of the least publicized forms out there, and at the same time, one of the most important. Most people who file every year assume either (a) that if you simply file the next year with your new address, the IRS will pick up on that and update their records, or (b) that filing a change-of-address card with the USPS (or some other government agency, like Social Security) will cause the IRS to update its records as well (because, of course, they’re both part of the government….).

{After the jump, find out why that may not be a good idea.}


From the mailbag, or why free advice is worth what you pay for it…

A few years back, I got an e-mail from a law Q&A website asking me to sign up, and dangling the prospect of a stream of new clients as an enticement. I signed up, but quickly realized that many of the questions I received were from people not looking to hire an attorney, but simply for some free advice. Even though I rarely answer questions, I still get them. Here’s a sample:

 I own four rental homes in California. I’m considering selling one simply because of the headaches and the fact that the market has risen so much that the profit will make it worthwhile to liquidate now. I’ve been taking depreciation on the 4 homes during tax time each year. If I sell one house, what will the tax implications be on the sale and on my future tax burden?

I’m engaging a partner in a creating an S Corp. with the purposes of the following business pillars: 1) Temporary/Contingent, Permanent, and Outsourcing Labor 2) Consulting small to medium size companies on various strategies 3) Designing, Developing, and releasing an enterprise product. Which type of partnership agreement should we look into and what state will it work best (Nevada or Delaware)?

I am an independent contractor. I give private lessons at a business. The business collects the payments from the students and pays me twice a month. However, they have bounced 2 checks in the last 3 months (I have worked for them since 2007). They have also bounced at least 7 other checks to other teachers (and two employees), including a replacement check for a bounced check. Are there any legal ramifications for multiple bounced checks? Can we require bank checks? Also, what penalties can we assess (other than bank fees) on the owner?


When it comes to payroll taxes, don’t forget the state…

All too often, the people who come to my office are focused on what they owe the IRS. What often gets overlooked – to their chagrin, usually – is that the IRS is often not the only player. Payroll taxes are a prime example.

Google “Trust Fund Penalty” and you’ll turn up dozens, if not hundreds of articles telling you that the IRS can assess payroll taxes personally against any ‘responsible person.’ And not only can they, they will.


The IRS can only really whack you for the ‘trust fund’ portion of the tax – that is, the part that you deducted from your employees paychecks. That’s the portion for which you’ll be personally assessed – the non-‘trust fund’ portion won’t be personally assessed.

On the other hand, California – like other states – is much more aggressive. Under Section 1735 of the California Unemployemnt Insurance Code, California will assess the full amount of the tax against you personally:

1735. Any officer, major stockholder, or other person, having charge of the affairs of a corporate, association, registered limited liability partnership or foreign limited liability partnership, or limited liability company employing unit, who willfully fails to pay contributions required by this division or withholdings required by Division 6 (commencing with Section 13000) on the date on which they become delinquent, shall be personally liable for the amount of the contributions, withholdings, penalties, and interest due and unpaid by such employing unit. The director may assess such officer, stockholder, or other person for the amount of such contributions, withholdings, penalties, and interest….

Notice the language that’s highlighted – it doesn’t limit personal liability to amounts withheld. It includes contributions, or, in plain English, the amount paid by the employer and not withheld from the employee. What does that include? Well, state tax is a withholding, as is state disability insurance (SDI, or VSDI or something similar – it’s in Box 14 of your W2). So what’s contributed by the employer? Unemployment (remember where we found this?). Employment training tax (though, in reality, it’s a small amount; the bigger issue is unemployment).

Lest you think that this is something that goes away at death, think again. Section 1090 of the CUIC requires administrators or executors to notify the State of their name and address, and subjects them to all the benefits – and liabilities – of the deceased’s position. Think you can get around this by not notifying the state? Yep, they thought of that too – see Section 1736. (NOTE: the Feds can also pursue executors/administrators, so if you’re an executor, don’t ignore payroll taxes!)

So while the Feds hit you for the taxes your company withholds from its employees, they don’t pursue you for the company’s contribution. California, on the other hand, does. In other words, forgetting about the state when formulating a controversy strategy can be a very costly oversight, indeed.

Have a payroll tax issue? Contact our office for help – (818) 480-3280 or (626) 708-1040.


LLCs, Corporations, and California’s Minimum Tax

This is always a hot topic:  A and B form a business in 2000 and incorporate with the state (for this discussion, it makes little difference if the business is an LLC or a corporation). From 2000 through 2006, things are great, and the business hums along. then, in 2007, their biggest client leaves, and the business plummets. At the end of 2007, they close the doors for good.

One problem: they never bother to dissolve the business.

In 2013, A gets a letter from the Franchise Tax Board:

“Dear A,

We noticed you’ve neither filed a return nor paid the $800 minimum tax for 2008, 2009, 2010, 2011 and 2012. Please send a check for (a ridiculous amount of money, including penalties and interest) to….”

Ok, so that’s a little more forthright than they’d actually be, but you get the point. So now what?

Well, talk to your CPA, and he or she is likely to tell you to just ignore the notices, and they’ll eventually stop coming. But…can you just ignore notices from the state? After all, they’re threatening to hold you personally liable if you don’t pay! Can they do that?

Maybe. You see, there’s this case, In re: Ralite Lamp Corporation (90-SBE-004), that addressed this very issue – whether or not the State of California can hold shareholders personally liable for the minimum tax. After all, it sounds plausible – the Board of Equalization (BOE) can hold individuals personally liable for sales tax, and the Education Development Department (EDD) can hold individuals personally liable for payroll ‘trust fund’ tax, so why not?

Because they can’t. There’s no statutory authority – not over shareholders, not over LLC members – for the FTB to take such an action. So why are they threatening to do it? Well….why not? Some sucker won’t know they can avoid the tax and pay it, and that’s something, right?

So…can you simply cite to Ralite (as your CPA would tell you) and move on? Not exactly.

You see, the parties in Ralite lost. That’s right – they lost. How did they lose? Because while the court found there was no statutory authority to hold them personally liable, there was authority in equity. Huh?

Equity is a legal principle beyond explaining here. To severely oversimplify, equity works to put parties back on equal footing. Fraud, for example, is an equitable action – and that was what at issue in Ralite: a fraudulent conveyance. In 1980, Ralite loaned its shareholders money, then in 1981 it gave them a distribution (without repaying the loan). No salaries were ever paid, and nothing was ever given in return for either the loan or the distribution. After the loans and distributions, the company was insolvent and couldn’t pay its tax. And that’s where the court found fault: “[B]ecause cash was distributed to the shareholders without adequate consideration and Ralite became insolvent, taxpayers are liable for Ralite’s tax.”

In other words, if there are sufficient funds in the company to pay the tax, and you transfer those funds out without adequate consideration (note: the court didn’t say compensation, it said consideration – the two are not the same), you may be held personally liable for the tax.

It should also be noted that 1990 precedes most LLCs, which means that Ralite has never been tested from an LLC perspective, only a corporate perspective. So while it may be true that the FTB won’t be able to pursue shareholders in a corporation, and it is likely thhey won’t pursue an LLC, you cannot say for sure that the FTB won’t try to pursue LLC members. But if they do, throw some Ralite on their fire and see what happens. Just make sure you’ve reviewed all the transactions and made sure nothing could be construed as a fraudulent transfer.

Making your life easier….

Recently, a client called me and asked if I could help them get a Seller’s Certificate from the Board of Equalization. It’s been a while since I’ve done that, but with everything online these days, I wasn’t too concerned.

Any concerns I had were lessened when I read the first paragraph of the BOE webpage: “The Board of Equalization (BOE) wants to make doing business in California as easy as possible.” Great. This should be smooth and easy.

Should be. But not, apparently.

The section for “Register Online” has no link to actually register online. If you want to do that, you have to go down a few paragraphs, in the middle of the section telling out-of-state sellers how to register online. Once you figure that out (if you haven’t done the interim step – go to a field office – and screamed at a hapless clerk, that is), you’re treated to three screens including a declaration of intent (which you’re told to print out, but as that admonition is at the end, I wonder how many people actually read that far) before you can actually start the process.


One thing the BOE doesn’t tell you – if you sign the application, you will be considered a ‘responsible person’ for purposes of personal assessment of tax in the event the entity doesn’t pay. Which is one thing if it’s your own business, and quite another if someone else is running the show, and you’re the one assigned to get the Seller’s Permit.

Protecting liability when your partnership ends

Recently, a client contacted me with a question: he – well, technically, his S-corporation -  was the member of a professional partnership that was dissolving. The partnership’s accountants were recommending that instead of a partnership – which leaves its non-corporate members exposed to general liability – it should form an S-Corporation.

And that’s a problem. Treasury Regulation 1.1361-1(b)(ii) specifically restricts S-Corporation ownership to an individual, and not all of the partnership’s partners are individuals. Some are S-Corporations. And as I mentioned, only an individual can own an S-Corporation’s shares – one S-Corporation cannot own shares in another S-Corporation (the only way this could possibly occur is a Q-Sub election (but see Treas. Reg. 1.1361-4 for the effect of that – generally, it means the parent S absorbs the sub-S)).

So what can be done? Well, if the parent level company’s goal is liability limitation, then there are two potential answers: an LLC or a standard, “C”, corporation. An S-Corporation can be a shareholder in either one of those entities*, and the top-level entity would have liability protection.

But…what happens if this is a professional partnership, say, doctors? They can’t form an LLC – it’s prohibited by California law (anyone with a state license must form a professional corporation instead). That leaves one alternative – the C corporation. An S-Corporation can be a shareholder in a C-corporation (heck, it can be more than ‘a’ shareholder – it can be the 100% shareholder), so the shareholders who were already S-corporations wouldn’t have to change their form, and the parent can get some liability protection.

Now, about the dissolution….well, that’s a different day.


* – for the purposes of this post, we assume a single member S-corporation. The strategy doesn’t work for multi-member S-corps.

Recently published articles

Recently, two of my articles were published – one in State Tax Notes magazine, the other in Tax Notes Today. Both are published by Tax Analysts, Inc.

Here’s the executive summary of the first, entitled Collecting the Minimum: A proposal for changes to the Minimum Tax collection rules (State Tax Notes, July 15, 2013:


Currently, any business – corporation, LLC or partnership – which is formed in California is liable for a minimum tax of $800.00 per year. Failure to pay the tax can result in penalties and interest being assessed.

There are, however, situations in which the minimum tax liability acts as a disincentive to the proper winding down of a company. Moreover, under current law, there is no way for the FTB to collect the minimum tax from a non-operating company absent a fraudulent transfer. Despite this, the FTB will continue to attempt to collect the minimum tax from a company long after it has ceased doing business, and long after any real hope of collection has vanished.

To encourage companies to properly wind down, and allow individuals to form corporations which never do business without the fear of draconian penalties and interest, the legislature needs to provide clear directions to all. Currently, most businesses rely upon dicta from one case to guide their decision-making, putting them at risk of a different interpretation by a different court. Legislative action would give clear guidance to business owners and their advisors, while at the same time allowing the FTB to focus its collection efforts on more fruitful endeavors.

This paper examines the current situation, and offers reasonable proposals to give business owners and the FTB alike clear guidance, rather than the uncertain ground that exists today.

And here’s the summary for the second, entitled Streamlining the late ‘S’ election process (Tax Notes Today, July 10, 2013):


 ‘S’ corporations have existed since 1958.  The purpose of the S Corporation was simple: to allow small businesses the ability to retain the liability protection of a corporation while still having a single layer of tax, as found in a sole proprietorship or partnership.

 Initially, the statutory deadline for filing an ‘S’ election was inflexible and the IRS believed it lacked the authority to grant relief from late ‘S’ elections, which were routinely denied.  The Small Business Jobs Protection Act of 1996 gave the IRS the authority to treat certain late elections as timely filed. Since then, the IRS has issued many revenue procedures – in addition to the many court cases and letter rulings – intended to provide uniform criteria for relief from an untimely election. Currently, there are four revenue procedures – three for corporations, and another for other entities, such as LLCs, that must first elect to be treated as a corporation.

 While the existence of multiple options is a vast improvement over the hard-and-fast rule of the past, the current structure is still not taxpayer-friendly, and could be improved. This paper examines the status of the law and argues for the adoption of a form that eliminates much of the ‘clutter’ in the current system, which should make taxpayer relief simpler and more flexible

Prop 8, DOMA, taxes and…you

Now that Prop 8 has (essentially) been shot down, and DOMA found unconstitutional, all is right in the world for gay couples, right?

Eh…not so fast.

You see, there are 31 or so states out there who have what are known as ‘mini-DOMA’ acts on their books. About a dozen states recognize gay marriage, and a handful (such as Illinois) recognize civil unions, but not gay marriage.

So, you ask?

Well, that’s a great question..

So….if you happen to live, and earn all of your income in one state, it’s pretty straightforward. Here is a little chart that explains the various scenarios:


If your state… Your FEDERAL filing status is: Your STATE filing status is:
…recognizes gay marriage Married Filing Jointly Married Filing Jointly
…recognizes civil unions Married Filing Jointly Single
…recognizes RDPs Married Filing Jointly Married Filing Jointly
…does not recognize gay marriage, RDPs or civil unions Single(1) Single

But….what about those couples who earn income in more than one state? Well….that’s where things get complicated.

For example, let’s take Adam and Steve (I thought of using other names, but I’d rather be provocative. Makes tax law much more interesting). Adam is from Boston, a state which recognizes gay marriage, but now lives in California with his spouse, Steve. Steve is originally from Arizona. Both have family back in their respective home states. Adam & Steve are consultants, and travel extensively in Arizona, Massachusetts, Illinois and California, earning W-2 income (to make it a bit simpler) in all states.

So far, so good? Great. Let’s talk about their return.

As the chart above shows, if all of their income were in California, this would be straightforward – they’d file Married Filing Jointly and be done.

But Illinois doesn’t recognize gay marriage; it recognizes civil unions only (as of now). Arizona doesn’t recognize gay marriage (it’s a mini-DOMA state, and it’s a community property state, like California. And Massachusetts recognizes gay marriage.

For FEDERAL purposes, Adam & Steve file Married Filing Jointly (MFJ). They also file MFJ for California, and Massachusetts. But for Illinois and Arizona, Adam & Steve would have to file as single – each reporting his own income and being taxed accordingly. For joint income, the two would have to split the income equally. This only gets more complex if the community property state has rules (similar to the old federal rule) that require each partner to pick up half of community income. Thus, Adam & Steve wind up being treated differently by different states.

This, of course, makes withholding a pain in the you-know-what for employers, as they will definitely have to track two different methods of withholding for gay couples. And gay couples will still have a difficult time planning (what do you do about community property rules in a state that doesn’t recognize gay marriage?) if their financial interests cross borders.

So while the LGBT community can celebrate a victory today, there are still a lot of hurdles to go.


(1) This assumes that you were not married in a state that recognizes gay marriage, then moved to one that doesn”t. For people who DO marry in a state that recognizes and then move to one that doesn’t, the issue is much more clouded, with some practitioners pointing to Article 2 of DOMA, and saying you’ll have to file as Single, while others say that you should still be able to file jointly. Stay tuned.

Finally – overhaul of corporate tax in sight

After months – years? – of carping, the corporate tax haters may finally get their wish: a corporate tax overhaul. Tim Geithner told a Congressional panel on Tuesday that the Obama Administration would soon release a framework for a corporate tax overhaul.

Of course, it’s only a ‘framework’ not a plan, but it’s a start.

I would propose wider brackets. Currently, the lowest bracket, 15% ends at $50,000.00. Make $100,000.00, and you’re paying the highest rate: 39%. That’s right at $100,000.00, you’re in the highest corporate tax bracket. Made $15.0 million? That gets you into the second highest bracket. Sound nuts? See for yourself (source:smallbiz.com):

Taxable income over Not over Tax rate
                                –          50,000.00 15%
                    50,000.00          75,000.00 25%
                    75,000.00        100,000.00 34%
                  100,000.00        335,000.00 39%
                  335,000.00   10,000,000.00 34%
             10,000,000.00   15,000,000.00 35%
             15,000,000.00   18,333,333.00 35%
             18,333,333.00 35%


So what should we do? Spread the brackets to start, and make the jump from 15% to 39% more gradual. This schedule is almost as bad as the estate tax schedule!

Logic dictates that the highest bracket should be at the end of the list, not the middle. Someone at $150,000.00 of income should only pay 15%, as should someone at $500,000.00.  It makes no sense that someone who has made $350,000 in profit pays tax on their last dollar earned at a higher rate than someone who has made $5,000,000.00.

What if the brackets looked like this:

Taxable income over Not over Tax rate
                                –          100,000.00 10%
                    100,000.00          250,000.00 15%
                    250,000.00          500,000.00 20%
                    500,000.00       1,000,000.00 25%
                 1,000,000.00       5,000,000.00 30%
                 5,000,000.00     25,000,000.00 35%
               25,000,000.00   100,000,000.00 38%
             100,000,000.00 39%


This would make much more sense, though high-income companies such as Amazon would likely protest the tax increase. But given the propensity of companies in the $100.0M range to take advantage of NOLs and other loopholes (Dutch sandwich, anyone?) in order to reduce their tax to zero, such arguments are disingenuous.

IRS goes after CA property transfers – CA property owners may face big tax

One of the benefits of living in California is Proposition 13, the 1975 law which reduced property taxes from 2% of value to 1%, and limited tax increases to 2% of the 1975 value with limited Cost of Living Adjustments. To top it off, you can pass the low tax rate down to succeeding generations – without limit. It is, arguably, how Californians are able to ‘cash out’ and get big paydays when they sell and move to greener pastures (a/k/a Oregon or Washington). There is no limit to the value of a personal residence transferred from parent to child (or, if the intervening generation is dead, grandparent to grandchild), though non-personal residence property is limited to a sum value of $1.0 million (amounts above that are taxed).

Now, however, that may be coming to a crashing halt. In a recent, low-key lawsuit mentioned in this article, the IRS is attempting to get at the Board of Equalization’s (BOE) records of property transfers. See, to get the ‘rate’ you need to file a form (BOE-502), which gets sent to the BOE for recordkeeping. The BOE has pushed back, citing privacy laws, but the IRS insists its entitled to the records.

If successful with the admitted ‘fishing expedition,’ look for the IRS to start going after taxpayers who have filed a BOE-502, but not an estate or gift tax return. Granted, many of the BOE-502s that we do are for estates that do not need a tax return, so the IRS may find a whole lot of nothing. But the guess is that there are a fair amount of noncompliant transfers, and that enough money is at stake to make it worthwhile.

Stay tuned. And if you’re a California property owner who received property in such a transfer, you’ve been warned. If you’re not sure if you should be concerned, contact our office to schedule a consultation.

It seemed like a good idea at the time…

There are a myriad of ways that you can cause more headaches than you solve in an audit. A case released today by the Appellate Court for the Second District of Illinois shows how easy it is to dig yourself a hole.

The Byrds were audited by the Illinois Department of Revenue (IDOR), which disallowed their claims of gambling losses. The IDOR found that, despite the Byrd’s claims, they were not professional gamblers. The Byrds asserted they were, and pursued the issue.

Notice what the issue is here: can gambling losses be claimed on an Illinois return? Yes, if you’re a professional (via Schedule C), and no if you’re not. In their haste to show how much they lost (note: this is why you hire a lawyer), they produced the casinos’ slot machine tally sheets, which showed all of their wagers – winning and losing – and included….wait for it…..winnings of less than $1,200.00, the threshold in for requiring a W2-G form be filed. Predictably, the IDOR increased the Notice of Deficiency that it had issued the taxpayers. Luckily, through an administrative snafu, the amended Notice was canceled, and the court declined to reinstate it (though it could have).

This is frequently what happens when a taxpayer tries to be too helpful, and thinks that they can represent themselves in an audit. More often than not, the taxpayer inadvertently provides ammunition for the IRS (or in this case, the IDOR) to ‘pile on’ even more tax liability or to dig deeper into their financial records. It’s the kind of attention you don’t want.

The sad part is, had the Byrds hired a lawyer, they might not have wasted valuable time pursuing a losing strategy. Don’t be the Byrds. If your return is selected for an audit, do yourself a favor. Call a lawyer, and get help from someone trained to know what to do.

Happy New Year!

Welcome to 2011 – may it be the best year yet!

Wanna Rapid Refund? Not this year

Most people are familiar with payday loan stores, the much-reviled practice in which cash-strapped consumers can get an advance on their next paycheck. Financial professionals hate these stores, as they claim they trap low-income individuals in a never-ending spiral of debt, often at ridiculously high interest rates (when calculated on an annual basis).

Tax professionals have had their version of the payday loan since long before Check Into Cash and its brethren became players on the national (or regional) stage. Known formally as ‘Refund Anticipation Loans,’ or RALs, they got the catchy nickname of ‘Rapid Refund’ from their biggest purveyor, H&R Block. For years tax professionals have faced the decision of whether or not to offer RALs, and for a time, a number of non-H&R preparers who did offer the product often did so (quietly) through H&R itself. Those preparers who did offer RALs soon came to find that it appealed to a certain demographic, which was ill-suited for the other services a preparer might offer, such as tax planning. Several of my colleagues offered RALs for only a year or two before abandoning the concept, while others, seeing where the trend was leading, never offered them at all.

Then came semi-mandatory e-filing, and the IRS’ own ability to turn around a refund on an e-filed return in weeks instead of months. As e-filing increased, the need for a third party to provide a loan against a refund seemed less and less necessary.

Here’s how the whole RAL system worked:

  1. Taxpayer goes to tax preparer to have return prepared.
  2. Tax preparer prepares return, tells taxpayer he/she is entitled to refund, offers RAL.
  3. Taxpayer accepts RAL, completes bank paperwork.
  4. Tax preparer submits RAL paperwork to bank.
  5. In more recent years, bank would verify with IRS that taxpayer had no liens, orders, etc. against refund and was entitled to receive full refund.
  6. IRS would confirm ‘clean’ status.
  7. Bank would approve loan, deduct all fees (including prep fee) and remit balance to taxpayer via check or deposit.

Tax preparers did love one aspect of the RAL – they could get their fee out of the RAL, meaning that they were less likely to deal with a bounced check. Of course, they had to take a haircut on the fee (in the form of fees from the bank), but hey, they got paid.

Now, however, that’s all by the wayside. A few months ago, the IRS announced they would no longer provide verification for RALs to banks, and today HSBC, H&R Block’s bank, announced that it has been prohibited by the Comptroller of the Currency from funding RALs, meaning that the nation’s largest tax service won’t be offering the product this year. Jackson Hewitt and Liberty Tax, apparently, are not impacted by today’s announcement, though it’s hard to see them offering the product as broadly as in years past without IRS participation, unless they jack up the rates. According to Block, nearly 45 percent of H&R’s clients apparently take advantage of the program, though if you look at the rates & fees and what’s left for the taxpayer, one wonders who’s getting taken advantage of here, particularly when it is entirely possible for a taxpayer entitled to a $400 refund to walk out with just $150 or less.

A breakdown of HR4853 – Part II

As promised, a look at Titles IV, V and VI…

Title IV – Bonus Depreciation Extension and 100 Percent Expensing of Certain Assets

Title IV is the first portion of the new act related to business, and kicks off by extending the bonus depreciation through 2013. Most importantly, this section creates a special class of property – bought after September 8, 2010 and before January 1, 2013 – which qualifies for 100% expense treatment. In lieu of expense treatment, the business can elect to accelerate AMT credits.

For property which is Round 2 extension property, that is, for property bought in the 2010-2012 period, businesses can elect whether or not to apply the accelerated AMT credit treatment to the ‘Round 2’ property. If no election is made, the acceleration provision applies.

This title also extends the benefit periods for Qualified Disaster Assistance (168(n)(2)), NY Liberty Zone (1400L), and Gulf Opportunity Zone (14ooN) credits through 2012.

The other major provision of this Title is the extension of elevated Section 179 rates. The rates, which were scheduled to return to investment-discouragingly low $25,000 is kept at $125,000, with a phaseout starting at $500,000 of qualified property purchases in a year. Given that most small businesses would struggle to get to $125,000, let alone $500,000, this is pretty much another ‘100% expense’ section. The extended increase lasts through 2012 (after which the $25,000/$200,000 limits return), and now also includes an inflation adjustment clause for out years.

Finally, the deduction for computer software (179(d)(1)(a)(ii)) is extended through 2013.

Title V – Temporary Extension of Unemployment Insurance and Related Matters

Simply put, this title extends Federal Unemployment Insurance payments scheduled to end on December 1, 2010. They are now scheduled to end on January 3, 2012 – so party hard on January 1, 2012, because it’ll be the last time!

Title VI –

This section reduces the employee side of the Social Security tax from 6.20 percent to 4.20 percent. Medicare remains unchanged at 1.45 percent. The employer side is unchanged at 6.20 and 1.45 percent, respectively. This change runs for all of 2011.

For employers, this incentive comes on top of the original payroll tax credits enacted under the HIRE act, which became law earlier this year. In that act, employers who hired staff off of unemployment were due tax credits in 2012 (when the 2011 return was filed) for those staff members who were kept on for the entire period from February 4, 2010 through December 31, 2010. Employers also got relief on their portion of Social Security tax for those workers during 2010.

This title also applies to self-employed individuals, who will be taxed at 13.30 percent (10.4 percent Social Security plus 2.90 percent Medicare), and who will be able to deduct the full”’employer’s” portion – 6.2 percent Social Security and 1.45 percent Medicare – on the front page of the 1040.

Part III, focusing on Title VII, in a bit.

Obama’s New Tax Bill – A Breakdown Of HR4853: Part I

With the passage of HR 4853 – officially, the ‘Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010’ – the Bush Tax cuts which were set to expire in two weeks get a new lease on life. As Steven Colbert said, “I can’t wait to have my taxes be exactly the same as they were.” Of course, not everything got extended, and some new provisions snuck in, so it’s worth breaking the bill down, and taking a look at its parts.

In Part I, we’ll take a look at Titles I, II and III, dealing with the Bush Tax Cuts, AMT exemptions and the new Estate Tax rules. In Part II, we’ll look at Titles IV, V and VI, which deal with the extension of investment incentives, the extension of unemployment benefits, and the Payroll tax cuts. Then, in Part III, we’ll cover Title VII, by far the largest portion of the bill. So, without further adieu….here we go:

Title I – Temporary Extension of Tax Relief

This title does three things:

First, it extends, through 2012, the tax cuts made in the Economic Growth and Tax Relief Reconciliation act of 2001 (EGTRRA), better known as the Original Bush Tax Cuts. Furthermore, it extends the Adoption Credit, which had been extended through 2011 by the Patient Protection and Affordable Care Act (i.e., the recently enacted “Healthcare Bill” that the Republicans want to quash), through 2012.

Second, it extends the cuts under the Job Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) through 2012.

Finally, it extends some – but not all – of the cuts in the American Recovery and Reinvestment Act of 2009. Surviving are the American Opportunity Tax credit (which replaced the Hope Credit), the increased ($3,000) Child Tax Credit, and the increase in the Earned Income Tax Credit, all of which are kept through 2012. Not so lucky – the First Time Home Buyer Credit, the Making Work Pay Credit (an Obama favorite), the allowance of computers as a qualified 529 plan expense (sorry, kid, no laptop for school!), the suspension of tax on the first $2,400 of unemployment compensation, and the additional deduction for state sales tax on car purchases.

Title II – Extension of AMT relief

This title, among the shortest in the bill, does two things:

First, it increases the AMT exemption for joint filers and surviving spouses from $70,950 to $72,450 in 2010,  and for singles from $46,700 to$47,450. Beginning in 2011, those amounts climb to $74,450 in 2011, and $48,450, respectively. The sunset provision which had ended the higher rates after 2009, is repealed.

Second, it extends the special provision AMT relief for nonrefundable credits, which was scheduled to end in 2009, through 2011.

This brings us to one of the most hotly contested parts – Title III.

Title III – Estate Tax Relief

(or, what to do about George Steinbrenner and other billionaires)

Two of this Title’s provisions – the reinstatement of a tax on estates over $5.0 million, and a cap on the tax rate at 35% – are well known. But that’s not the biggest surprise – not by a long shot.

One of the biggest questions asked by estate planners during the year has been “if there’s action on the estate tax, will it be retroactive?” As the year has dragged on, it appeared that the answer would be ‘no’. In fact, it’s a resounding YES! That’s right – the bill is retroactive to 12/31/2009, which means that, for estate tax purposes, 2010 is the tax version of Season 8 of ‘Dallas’ – you remember, the one that turned out to be nothing more than a dream.

Except this isn’t a dream, it’s reality, and a number of millionaires and billionaires have already died this year. So the big question becomes: what about their estates? Glad you asked. They get an option (actually, everyone does): they can take advantage of the 2010 law as originally written – no estate tax, carryover basis with step ups limited to $1.0 million – or they can take what’s behind door #2: automatic step up in basis, a $5.0 million exemption and a top rate of 35%.

Actually, it’s not really a choice – unless the Bush version is elected on a timely filed (including extensions) return, the estate is automatically covered under the new exemption & tax. The deadline for filing is 9 months after enactment (or around mid-September), so there is plenty of time to determine which plan is better, in the long run. But be warned – if you file late, you lose the opportunity to choose. And once elected, it cannot be revoked without permission from the IRS.

Some other provisions:

The gift tax rate is now reunited with the estate tax rate. EGTRRA had de-coupled these, but they are now reunited. The downside? Because they were not in lockstep for several years, any eligible gift made in a year which differs from the current rates needs to be re-evaluated at current rates in order to calculate the unified credit. Yikes.

On the upside, trust transfers that were once taxable are no longer included, and there is no Generation Skipping Transfer Tax for 2010.

Finally, the much desired portability rule – which allows one spouse to use the unused portion of their deceased spouse’s credit – is here, allowing a surviving spouse to shield up to $10.0 million of assets. In fact, the bill appears to allow a surviving spouse of a surviving spouse (still with me here?) to use the original spouse’s credit, though it appears unlikely to actually happen. Most important, though, is the requirement of a timely filed estate return in order to take advantage of the rule. File a late return, lose the option of portability – a stiff penalty, indeed.

Be warned, though: In order to enforce the provision, the IRS can audit the estate tax returns of deceased spouses, even if the statute of limitations for assessments has passed. So, for estate tax returns, at least, the ‘six year rule’ no longer applies.

Ok, that’s enough to digest for now. More on the bill later.

Will the House vote on the Obama plan??

Yesterday, the Senate voted 81-19 to pass the Obama Tax Plan, and the early line was that the House would vote on the plan today. Early on there were reports that the voting had hit snags, as House Democrats tried to add various provisions to the bill, but pundits still held out hope that a vote would happen today. Now, as the day grows late, the last report out of Washington hinted that the vote might actually not take place until tomorrow, since the house is still debating the bill.

The pundits expect that the House Democrats will attempt to add various provisions, and some think that they may hold up the bill until next week, since the Senate is not scheduled to adjourn before then. In the end, though, the expectation is that the Dems will approve the bill as is (threats to reduce the estate tax exemption to $3.5 million be damned) and then claim that they fought long and hard against it, but didn’t want to delay unemployed taxpayer’s benefits right before Christmas.

Of course, that just smacks of pure politics for the sake of politics – Democrats making life rough because it’s a predominately Republican proposal, and not on philosophical grounds – but what it really is is the fruits of two or more years of delay. If the Democrats really had such a priority on the issue of tax cut extension, a deal could have been ramrodded through like the health care bill long ago. Truth is, until the elections in November gave the Democrats a severe wake-up call (which they knew was coming, but did nothing legislatively to prevent), this wasn’t a priority issue.

As a member of the ISBA Federal Taxation Section, I traveled to Washington D.C. in 2006 – yes, 2006 – where we discussed the issue of the estate tax repeal in 2010 with various members of Congress (including the now-ousted Melissa Bean, who appeared clueless on anything tax-related), Senators, and their respective staffers. We were assured that the estate tax would still continue to exist in 2010, but there was an election before then, and that it would be taken up once the Dems controlled Congress and the Senate (this was May, before the mid-terms).

In 2007, the assurance was repeated. In 2008, it was hedged, saying that the upcoming presidential election was a priority, but when/if Obama won, it would be settled. In 2009…eh, you get the idea.

So why cry now? I doubt if the provision will change. Congress has had this issue in front of them for four years, if not longer. It simply isn’t a priority, because, in all honesty, the estate tax only brings in around 2.0% of federal revenue. It only seems bigger, but that’s arguably because of the efforts of estate planners, who need certainty in the estate laws to do their jobs.

As always, stay tuned.

News: Senate passes Obama Tax Plan 81-19

According to MSNBC and other sources, the Senate has, after rejecting several late amendments, voted to accept Obama’s Tax Plan 81-19. The bill now moves on to the house.

Recent additions to the bill include various energy provisions, and House Dems are still threatening to change the estate provisions of the bill, which is currently scheduled for a house vote on Thursday, but probably won’t see a vote until next week.

The latest on the Obama Tax Plan

It’s been a week since President Obama announced that he’d reached a deal with the Republicans to extend the so-called Bush tax cuts (see H.R. 4853).

Here’s the latest:

On Monday, the Senate voted 85-13 in a cloture motion (don’t ask) to send the bill as amended. As of now, the bill has largely passed (and, upon official vote,  is expected to pass) the Senate in pretty much the form that Obama had negotiated. House Dems, however, haven’t given up, and are discussing moving forward on estate tax changes, even though Senate Republicans have said that such revisions could kill the deal.

One largely unreported upside to the bill is a further expansion of the AMT exemption amounts, up to $72,450/47,450 from the previous $70,950/46,700.

And remember the discussion over the 100% writeoff of investments? Here’s the text, which shows that Obama really did mean deduct it all – provided you got it after September 8, 2010.

(5) SPECIAL RULE FOR PROPERTY ACQUIRED DURING CERTAIN PRE-2012 PERIODS.–In the case of qualified property acquired by the taxpayer (under rules similar to the rules of clauses (ii) and (iii) of paragraph (2)(A)) after September 8, 2010, and before January 1, 2012, and which is placed in service by the taxpayer before January 1, 2012 (January 1, 2013, in the case of property described in subparagraph (2)(B) or (2)(C)), paragraph (1)(A) shall be applied by substituting `100 percent’ for `50 percent’.”.

There are also extensions of the Earned Income Tax Credit, the Child Tax Credit, and the Adoption Credit in the bill.  View all of the Senate changes thus far here.

The Senate vote happens tomorrow. No word yet on when the House vote will happen. Sign up for updates in the box at the bottom right-hand corner of this screen.

Rah! Rah! Obama cheers for his new deal…

Perhaps sensing that he faces a tough fight in  Congress, President Obama called his new plan ‘the right thing to do’ and pointed to revised economic forecasts to support his statement.

Is it though? There is plenty to annoy everyone, particularly Dems.

One group who might be happy, though are estate planners (provided such things as portability – where one spouse can use the other’s unused exclusion – and bypass trusts remain), even if it does mean that 99% of the population (and almost everyone in Congress) is not subject to estate tax. At the very least, it’s better than what they’ve had to deal with in the last year.

To deal with the uncertainty of whether or not a  deal was going to happen, estate planning attorneys in recent months have been gaming the system, drafting contingent gift plans which had wealthy taxpayers gifting out large portions of their estates on December 31, 2010 (assuming they lived that long), in anticipation of the return of 2001-era exemptions ($1.0 million) and tax rates (up to 55%) in 2011.

The thought there was that a straight up 35% gift tax on part of the estate was better than a tax of 55% on all but $1.0 million of the estate. To give it perspective, consider that for a taxpayer worth $20.0 million, gifting $10.0 million in 2010 meant paying a total of $8.45 million in tax ($3.5 million in gift tax, plus $4.95 million in estate taxes) versus $10.45 million if no gift was made and the full $20.0 million estate was taxed.

Now, with Obama’s estate deal, that same plan costs $5.25 million – an additional $3.25 million savings. Huzzah!

Granted, most of us don’t have $20.0 million lying around, but depending on where you live, it might not be too difficult to hit $1.0 million. So the additional $4.0 million exemption comes in handy. That is, if Congress ups the exemption to $5.0 million immediately…

Isn’t this fun?

Fleshing out Obama’s tax deal

As the buzz surrounding President Obama’s announcement yesterday of a deal on the Bush tax cuts continues to churn, some numbers have started to fly about (see a version of the White House Fact Sheet here):

  • Social Security. The deal reduces the employee portion of Social Security from the current 6.29% down to 4.29%, which is projected to cost $120,000,000,000 next year alone. On the upside, if you make $60,000 a year, you just got a $1,200 pay raise, or about an extra $100 a month.
  • Unemployment benefits. The deal extends them until early 2012, adding $56,000,000,000 to the deficit.
  • Business credits. Businesses benefit, too, under the deal. Here’s how:
    • Full write-off of investments. Companies would be allowed to write off the full value of investments in 2011. What constitutes an ‘investment’ wasn’t defined, though much of the talk this morning was around the fact that companies would not have to depreciate assets. So the logical assumption is a credit similar to Section 179, if not an increase in Section 179 itself. The White House estimates that this will generate $50,000,000,000 of business-related spending in 2011. Caveat: in the past when the government has allowed for ‘bonus depreciation’ in a given year, many states have ‘decoupled’ and kept the old rates and schedules. This creates headaches for accountants, who have to keep two sets of numbers for assets. It also leads them to discourage investments by focusing on the negatives.
    • A two year extension of the R&D credit.
  • Other cuts and benefits. These are estimated to cost around $40,000,000,000 as such benefits as the American Opportunity tax credit get extended (that credit replaced the Hope Credit), an expansion of the Earned Income  Tax Credit and an extension of the $1,000 child tax credit.

Some things are more notable for NOT being in the bill. For example, the Making Work Pay Credit had to be abandoned. Ironically, Senator Hatch (R-UT) complained that that credit allowed too many middle class taxpayers to avoid having to pay taxes. Is Senator Hatch actually suggesting that the middle class – already the most squeezed class in the current recession, and often thought of as disappearing – doesn’t pay enough taxes and should pay more? Interesting.

While an estate tax provision IS in the deal, what the White House hasn’t said is how much revenue it could bring in – though Nancy Pelosi, in her statement opposing Republican parts of the deal, pegged the number at $25,000,000,000. Unfortunately, that won’t even cover one of the above provisions.

There are some other

Did the Dems blink in the Bush Tax Cut game of ‘chicken’?

MSNBC, NPR and others are reporting that a deal has been reached to extend the Bush Tax Cuts for another two years – maybe.

Under the terms of the deal, the Republicans get what was arguably their biggest election-season wish granted: the Bush (or Bush-era, depending on what you’re reading) tax cuts get extended for everyone for another two years.

Obama gets a much-wanted extension of jobless benefits for another 13 months, plus a 2 percent, employee-side reduction in Social Security Taxes. According to reports, the average family would see a $1,000 increase in income.

The American Public gets a few minor league prospects and a player to be named later. Or not. Actually, what they get is an even bigger deficit, as the cuts do nothing to pay it down, and extending the jobless benefits will only and another outflow of cash without an offsetting inflow.

Speculation says that Obama gave in for a couple of reasons. First, because the Repubs were going to hold jobless benefits hostage, and the Dems didn’t want to have millions of unemployed taxpayers (a/k/a voters) losing income right before Christmas. This argument is bolstered by the fact that the latest extension runs 13 months, or until January 2012, right after next Christmas.

The second reason is strictly political – in six weeks, the Repubs will be able to wreak even more havoc as they take control of the House. Obama, the argument goes, wanted to make the move while he still had the votes to do so.

Of course, here’s where the ‘maybe’ comes in: on inheritances over $5.0 million would be subject to an estate tax of 35%. And, according to at least one report, Pelosi informed the President that a number of Congresspeople do not support the deal.

So, as has been said, there’s a deal – but not necessarily a done deal. Stay tuned.

The first cut is the deepest – which will survive??

As President Obama tours Asia, and Democrats lick their wounds and contemplate the next two years, all eyes are watching Washington to see which of the so-called ‘Bush Tax Cuts’ will survive their December 31 sunsets.

The President has repeatedly come out against extending the tax cuts on the richest Americans, those making over $250,000 per year. Republicans have objected, saying that the effect on small business owners will harm the economy. Earlier this week, the President’s deficit-cutting commission released a report that raised some eyebrows.

Among their suggestions:

  1. Eliminate all deductions for individuals. That includes the mortgage interest deduction, long thought to be an untouchable option. In fact, I have had clients take out a mortgage simply for the tax write off (not that that makes any sense – paying $1 in interest to save 28 – or even 39 – cents is a bad idea. If you want to throw good money away, go to a casino. At least there you can have fun while doing it).
  2. Cut out business deductions, such as R&D credits. This would allow the corporate tax rate to drop to 26%. But when company such as Google pays only 2.5% in taxes, does the actual tax rate matter? Even better, this plan would, ostensibly, represent a tax increase for the larger corporations, while being a tax cut for smaller businesses.
  3. Shrink the tax brackets. Under the plan, the current personal tax brackets would shrink, since no deductions would be allowed. The lowest bracket would drop to 8% from 10%, and the upper bracket would be in the 25% range.
  4. Develop a territorial tax system. Under a territorial tax, foreign income would not be taxed on repatriation – so companies could bring profits ‘home’ without a penalty. In theory, they would then spend those profits in the U.S. -  though it may also encourage multinationals to invest more abroad.

The plans, obviously, are rather complex, and incomplete. But two things are obvious: First, that it is fairly likely that there will be some movement on corporate tax; second, that the movement is likely to benefit large corporations with significant market presence abroad, and either have no impact on, or negatively impact, smaller businesses.

Stay tuned.

9 Rules to help you decide whether or not to go to Tax Court

In the U.S., you have two options for fighting the IRS. The first is to pay the tax, and apply for a refund. If denied, you file suit in Federal District court. Option two is to proceed directly to Tax Court, without paying the tax at all. Which should you choose? Well, here’s 9 rules to help you decide if you should pick what’s behind Door #1 (Federal Court) or Door #2 (Tax Court).

Tax Court is a good option (i.e., consider it) if:

  1. You’re represented by counsel. Of all the Tax Court cases I’ve read, one thing has become abundantly clear – those taxpayers who come to the court pro se lose. Often. Sure one or two might win, but those are the really well-organized taxpayers. Most taxpayers aren’t so lucky. Spring for a lawyer – even the Tax Court suggests they may be beneficial.
  2. You have support for your case. You’d think this is a no-brainer, but you’d be wrong. Most taxpayers who come to court, do so with little to no evidence to support their assertions. “I should get the deductions because I’m very honest, your honor, and I swear I’m not lying on my tax return” is no way to persuade a judge to take your side. In fact, it often has the opposite effect – it persuades him that the government is right. Remember, it’s a pretty low bar for the government – all they have to do is a) send you a bill, and b) bring a copy of the bill to court (for the most part), and they’re done. To paraphrase the late Johnny Cochran, “If you have no support, don’t go to court.”
  3. You’re fighting over significant dollars. And no, $1,500.00 is not significant. Sure, it may seem like a lot of money, but going to Tax Court means you’re not paying the tax. If you lose, you’ll owe even more – lots more. If the balance is under $25,000.00, the IRS is obligated to accept an installment plan from you. Take advantage of it. What is significant? Well, that depends – and a good lawyer can help you determine if you should fight back, or take your beating and move on.
  4. You’re arguing a new area of law, or some esoteric deduction that’s not directly addressed. Got nailed on vehicle mileage? Take your pill and move on. Same with Unreimbursed Business Expenses, or any business-related deduction. They’ve been litigated to death, and unless you meet criteria #2 above, you’re not likely to come up with a viable enough excuse to persuade the court to rule in your favor. So don’t try. And don’t pin your hopes on the ‘Cohan Rule,’ either – the court requires sufficient evidence in the record to support the assumption. Which means it’s rarely beneficial to the taxpayer.
  5. You used a tax preparer. Certain penalties can be abated if you hired someone else to prepare your return, and you relied upon their advice. But be careful here – if you have financial knowledge, you won’t be so lucky. The court will assume you could have discerned that the advice you got was bad, and you shouldn’t have followed it.

Tax Court is a bad option (i.e., don’t go) if:

  1. You can’t pay what you already owe. Filing in Tax Court does not require that you pay the tax assessed. The upside is obvious – you’re not out any money. The downside is too often ignored – penalties and interest are still accruing while the case is pending. Tax Court cases can take a year or more to be heard, and a month or more before a decision is made, which means that the amount that you owe is rising daily, and if you lose, you could pay double or triple what you would have paid if you’d just settled. As I mentioned above, if the amount you owe is less than $25,000.00 you really should consider an installment agreement.
  2. You’re trying to advance a frivolous/creative argument. You’re not a person, as defined in the tax code? Or maybe you think that you’re exempt from tax because you’re a corporation sole? Or….well, there’s a lot of creative arguments that people have tried (16th Amendment not properly ratified, tax forms don’t bear OMB numbers, blah, blah, blah). None of them have worked. Think you’re different? Well, think twice – you can be subject to a $25,000 penalty. So if you thought your tax bill was high before….
  3. You did your own taxes. Don’t think that just because you sprang for Tax Cut or Turbo Tax or something similar, your tax return will automatically be correct. Remember the old computer rule – garbage in, garbage out. In a recent case, a couple used Tax Cut, and somehow managed to deduct gambling losses without having any winnings. Trouble is, the code doesn’t permit that. Needless to say, they got hit with additional taxes, penalties and interest. They also violated rule #3 – the amount of tax assessed was $5, 783 plus a penalty of $1,156. Now they’ll owe that, plus interest. And, lest you think that a few hundred dollars in interest is worth the risk (even though the tax code is pretty clear, and makes this case in particular an obvious loser), don’t forget about all the personal time, effort, and stress that went into this matter. How much is that worth?
  4. You’re representing yourself. NOT a good idea. Most self-represented taxpayers lose because they make bad arguments, say things or admit things that are bad for their case, or simply present themselves poorly. If you hate speaking in front of a group, you’ll really hate being in court – it’s just like being in front of a group, with additional stress to make you feel worse.

Going to court is risky, and can be expensive. Don’t make it more expensive by being brash.  Use the above rules as a guideline to help you make the right – and reasoned – choice for you. And if you need a lawyer, you know where to find one.

Out with the old….three changes to expect out of the election

Proposition 24, which would have repealed several pro-business tax measures passed in recent years, looks to be a failure. Which brings up an interesting point: what will tonight’s results mean for your taxes?

  1. The Bush Tax Cuts are likely to stick around. Three weeks ago, the debate was if any of the cuts would remain, or they would all be allowed to expire. It was the second most frequently asked question of me this fall (first: what is the future of the estate tax?), and in all honesty, it’s hard to know what Congress will do until an election is over. Now, with the Republicans in power in the House, look for  a number of new bills to start hitting the floor in the ensuing weeks. Given the Tea Party’s tilt toward fiscal conservatism, keeping the cuts looks to be a sure thing. The Dems may be able to reduce the amount of the credits, but it’s a good bet that many will survive largely as they exist today.
  2. There will be movement on the estate tax. Financial planners and estate planners have been wringing their hands looking for some direction from Congress in order to advise clients. I went to Washington in 2007 with the Illinois State Bar Association, and it was a topic of our discussions with Congressional and Senate staffs. Then, the prevailing opinion was that the tax would end up near the levels they were at in 2006-07, and not the 2009 or 2001 levels. A year later, and the theme was ‘wait until after the election.’ Everyone agreed that something would be done before 2010. As we all know, it wasn’t, so it will be interesting to see if Congress continues to wait, or if it takes action. It’s a good bet that there will be action.
  3. Look for the corporate tax rate to drop. Republicans have been trumpeting that the U.S. has one of the highest corporate tax rates in the world (if your name isn’t Google, that is, or Apple, or Oracle, or Zurich Insurance). Given the failure of Prop 24, it’s not a stretch to think that 1) Republicans will use rate cuts and other incentives to stimulate business investment, and with it, job growth, and 2) the public is ready for such a move. Expect the first bill to hit early next year, unless job loss claims begin to show significant improvement.

Check back here in a few months, and see how I did…

No sale: Small business health plans

In all of the debate over healthcare earlier this month, one of the big concerns was small businesses who had health care plans for their employees. What were they going to do when the ‘public option’ was implemented? The solution was simple: give small business owners a tax credit of up to 35 percent of their health insurance costs. Insurance brokers around the country salivated at the prospect of small business owners lining up to by credit-qualified plans.

Eh, except that it really hasn’t happened.

According to an article in last week’s Bloomberg Business Week, few employers have dialed their brokers up. Why? Ye olde phaseouts, that’s why. The credit starts to dwindle once a company hits more than 25 employees, or $25,000 in average salary, and disappears completely by the time a company gets to 50 employees or $50,000 in average salary. That leaves employers in certain states (say, oh…..California!) which BW calls ‘high cost’ states, out of luck and with little to no credit. And since it’s based on average salary, one high-dollar employee (like, the owner, maybe?) can skew the average too high and blow the whole scenario. Of course, if it is the owner, the solution is simple – take a lower salary. Eh, but then you invite the IRS to come in and say that the salary is too low, and, well….bye-bye credit. So it’s  a losing proposition, and not exactly what the government had thought it was giving the more than 4 million businesses it contacted about the program.

Read the whole article here.

The Latest ‘Foolproof’ Strategy…and why it may not be a good idea.

Prisoner: There’s a message through the grapevine, Johnny.
Johnny Dangerously: Yeah? What is it?
Prisoner: Johnny and the Mothers are playing “Stompin’ at the Savoy” in Vermont tonight.
Johnny: Vermin’s going to kill my brother at the Savoy theater tonight!
Prisoner: I didn’t say that.
Johnny: No, but I know this grapevine.

From the Edgewood/20th Century fox film Johnny Dangerously

Every month, I get asked about some unique way that someone has found to save taxes. Usually these questions start like this:

“A friend/coworker/neighbor of mine told me…”

When I hear this phrase, I immediately know that I’m going to spend the next few minutes refuting tax ‘advice’ given out by someone’s cousin’s neighbor’s best friend…eh, you know the chain.

Like the grapevine in Johnny Dangerously, the ‘advice’ usually starts out as true and practical – for the person it’s given to. But by the time it gets to the 5th person on the list, it’s become something entirely different…and often downright wrong, if not illegal.

And ‘highly questionable’ if not outright illegal can be used to describe the latest ‘tax strategy’ to cross my desk.

Here’s how it works:

Let’s say that you have a traditional IRA at a traditional third-party provider, like Fidelity, with a fair market value of $99,000. You’ve been told that a Roth IRA is the way to go (not always, but that’s not the point here), and that for this year only, you can convert a traditional IRA to a Roth IRA without regard to income limits, and pay the tax over a two year period. You want in. Your friend tells you he/she has a ‘foolproof’ way to do it, and pay less in tax, too (always a red flag, but people hear what they want to hear).

Step 1 is to change the IRA to a self-directed IRA. This is pretty simple, and permitted.

Step 2 is to have the self-directed IRA invest into an LLC. Again, a permissible event depending on a few other factors. For this example, we’ll assume the factors that would negate this aren’t present.

Step 3 is to have a non-related person invest in the LLC as well (since related parties would be one of those negating factors). The non-related person invests a small amount ($1,000) and has a tiny (1%) interest, while your IRA has a significant (99%) interest. However, your IRA does not have any voting interest or control, while the non-related party has complete control (another red flag, but what could possibly go wrong?). This is a tricky area (easy to become involved in a prohibited transaction) but isn’t outright impermissible.

So at this point, you’d have an LLC with a total capitalization of $100,000 – your $99,000 plus the non-related person’s $1,000.

Step 4 is valuation. This is where it gets tricky. Because you don’t have control, you argue that the investment isn’t worth $99,000 – it is worth less, say, $80,000. Discounted valuations are permitted for such vehicles as Family Limited Partnerships, so this isn’t unusual.

Step 5 is the Roth Conversion. You convert the investment in the LLC from a self-directed Traditional IRA to a Roth IRA, claim the discounted value of $80,000 as the taxable value, and save yourself the tax on $19,000.

I know what your first question will be – is that legal? Well, that’s why these things perpetuate: there’s no clear-cut prohibition on such a transaction, probably because Congress can’t foresee every permutation of a strategy. But…if it sounds too good to be true…

Here’s a few problems with this strategy:

  1. The non-related party just got a $19,000 boost in the value of their 1% share. If we assume that the LLC is worth $100,000, and that your share is only worth $80,000, then that must mean the other share is worth $20,000. If that share is transferable, the other investor can now sell it for $20,000, pay the tax on the gain, and walk away with over $16,000 in profit. And you? Well, you’re left with a $19,000 loss, which you can’t recognize (because it was in a traditional IRA when it ‘occurred’), and an LLC over which someone else – not you – has complete control.
  2. You have no control over the money. That’s right – you ceded control to save on tax, so you cannot direct where the funds are invested. And if the funds are invested into a vehicle which is later found to be self-dealing (and thus a prohibited transaction), you will have a nice $80,000 distribution. Better yet, what’s to stop the non-related party from investing in their grandiose scheme with your money? You could wind up with nothing.
  3. You aren’t avoiding tax at all, merely deferring it. The point of this exercise is to get the $99,000 out of the LLC while only paying tax on $80,000. But since Roth IRAs are taxed on the earnings, the additional $19,000 will be taxed when the funds are distributed. Only the corpus of the Roth will not be taxed.
  4. The IRS has rules against these kinds of transactions. Notice 2004-8 deals with abusive Roth transactions, and includes prohibitions on transferring undervalued assets into a Roth. Such transactions are considered ‘listed’ transactions, and must be reported. Failure to do so will subject the individual to additional penalties. Given that the investment in the LLC is greater than the claimed value, the transaction above is subject to challenge by the IRS as an undervalued asset, and subjecting you to those very penalties.

So the operative question then becomes: is the purported tax ‘savings’ worth the risk?

I’ll take ‘What, are you crazy?’ for $400, Alex.

Tax Court Cites Monty Python – and South Park!

The blogosphere – well, at least those of us who find tax entertaining – is alive with the news that the Tax Court cited to Monty Python in a recent decision. What everyone seems to have missed is the more entertaining cite, buried in a footnote: South Park’s Underpants Gnomes. Seriously.

The cites come in Shao v. Commissioner. Cecilia Shao was an employee of Veritas Software when she began receiving stock grants and options. Not being a financial whiz, she sought out the advice of Jovita Honor at Wade Financial. Jovita encouraged Ms. Shao to use margin loans – a very risky investment indeed, just ask the Duke Brothers – to hedge her options. All was well for a while, but when the ship started to sink, so to speak, Ms. Shao wanted protection. Enter Derivium, a company which gave 90% loans on the value of a stock. Little did Ms. Shao know that Derivium’s game was to take the stock, sell it, and use the proceeds to fund ‘dividends’ to those clients whose stock (the one they’d just sold) actually paid them, or some other purpose. According to the court,

Derivium’s asserted hedging activity apparently masked the fact that their long-term strategy, reminiscent of South Park’s Underpants Gnomes, relied on a business plan of “Step 1: Make 90% loans. Step 2: ? Step 3: Profit.”

Of course, the long and short of all this is that the IRS wanted Shao to be held responsible for accuracy-related penalties, as other taxpayers involved in Derivium-related transactions (most notablyCalloway v. Commissioner) have been. But the court refused to play along, and said Shao’s actions were consistent with that of someone who believed that the transaction was a loan, not a sale. And to reinforce the point, they cited to Monty Python:

In Shao’s case we don’t find the circumstances that led the Court to penalize Calloway–there is no evidence of a wink-wink-nudge-nudge-say-no-more arrangement with Derivium. See Monty Python’s Flying Circus: How To Recognise Different Types of Trees From Quite a Long Way Away (BBC1 television broadcast Oct. 19, 1969).

Although it is entertaining to see the Tax Court – which most people would consider to be dry and humorless – show that it is capable of a funny side, I’m waiting for the day when the Court cites to the Simpsons. I imagine there’s a wealth of material from which the court can draw (As in an entire episode, perhaps? “Mr. Simpson, this government computer can process over nine tax returns per day. Did you really think you could fool it?”).

What happens if I don’t file a return?

It’s a frequent call:

“Law Office.”

“Hi. I haven’t filed a tax return in X years. Now the IRS says I owe $Y. Can they do that? How do they know what I owe when I haven’t filed a tax return?”

Let’s look at those two questions:

1. Can they do that?

Yes, they can. It’s called a Substitute For Return, or SFR for short (hey, it gets wordy if you say it a lot). And it’s authorized by law – see 26 USC 6020(b)(1), which states:

If any person fails to make any return required by any internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise.

2. How do they know what I owe when I haven’t filed a return?

Truthfully, they don’t. What they DO know, however, is what some – not all – of your income is. And that’s enough to get started. For example, they know:

A. How much you made, if you’re an employee (from your W2);

B. How much interest you earned from your bank (from Form 1098);

C. The gross amount you made from stock sales (from Form 1098);

D. What you paid in mortgage interest (from Form 1098);

E. What non-employee income you have (from Form 1099-Misc);

F. How much your partnership or S-Corp earnings were (from K-1s);

G. How much pension (from Form 1099-R), Social Security, or Railroad Retirement Board income you had;

H. How much was withheld from your check (W2, again);

I. How much you paid in estimated taxes (from Form 1040-ES).

And that’s just for starters. The IRS has access to a lot of third-party provided information (unemployment, gambling winnings, etc.) which they can use to determine how much income you had in a given year. As bad as that seems, it’s not the worst part. It’s what they DON’T know that gets you.

For example, they don’t know:

What your filing status is – for an SFR, the IRS manual states that they are to use the filing status which results in the highest tax liability, so if you’re married, they will use Married Filing Separately (IRS agents have told me that they are not permitted to assume you’ll file a joint return). If you’re single, but qualify as Head of Household, you’ll be filed by the IRS as single.

What expenses you may be entitled to – a big problem for self-employeds, who generally gross considerably more than they net.

How many exemptions you may be entitled to – hey, it’s  not the IRS’ job to make sure you can still claim Junior, so they just assume you can’t.

What you paid for the stock or bond you sold – the general rule is that if you can’t prove basis, basis is zero. So since the IRS doesn’t know the basis, it’s zero.

As bad as that all may seem, it gets worse.

The SFR is not an official tax return. That’s right – it counts for nothing other than to provide a basis for collection efforts to begin. What does that mean for you, the taxpayer?

  1. It cannot be used to discharge taxes in bankruptcy. Only an actual, filed, tax return – which represents a ‘tax assessment’ – can qualify for discharge. In order to discharge your taxes in bankruptcy, there are a number of qualifiers which must be present, and the first of the qualifiers is that it’s been at least 3 years since the tax was assessed. So if you file your 2006 tax return in 2010, then head over to your bankruptcy lawyer hoping to get the 2003 tax discharged, you’re out of luck – it wasn’t assessed until 2010.
  2. It has no statute of limitations. The IRS has 10 years from the date of assessment to collect tax. And since the SFR doesn’t qualify as an assessment, it does not trigger the statute. The IRS can collect on this until the cows come home. Or later.
  3. It can be used for levies, liens and garnishments. The IRS can, however, levy your bank account based on the tax shown in an SFR. And since the tax calculated by an SFR is almost always higher than the actual tax due, you’ll spend more than if you just hired a competent preparer to file the return.
  4. You’ll lose out on important credits and benefits. For the most part, and SFR does not contemplate things such as Earned Income Credit, Child Tax Credit, and other benefits that you may be entitled to.

So if you haven’t filed a return, don’t think that you won’t eventually get a bill from the IRS. And it’s sure to be one that you won’t like. Before that happens, click here, and let me help you avoid a headache you don’t need.

Brown v. Deutsch – can you eliminate tax debt by watching TV?

It’s all over the internet: Jerry Brown has sued Roni Lynn Deutsch, calling her practices ‘heartless’ and saying she ‘preys’ on individual taxpayer’s ‘vulnerability’. While this is big news, she’s not the first TV tax solution huckster to be sued. And I’m certain she won’t be the last.

If you owe taxes – particularly if you owe a large sum, or have the IRS breathing down your neck, it’s easy to be drawn into these ads. In fact, you’ve probably seen the commercials, frequently on late-night TV: “Do you owe taxes? We can help! Call us now, and see how you can save thousands in taxes!!!” Frequently, they feature average, middle-class-looking actors raving about how they owed tens of thousands, but settled for only pennies (“I owed $50,000, but only paid $800!”).

That’s pretty much a ubiquitous line – every huckster on TV who’s looking for your business will pretty much use some variation of the above. Roni Lynn Deutsch, JK Harris, Tax10000, it doesn’t matter. All of them promise to reduce your taxes by thousands. Some are more entertaining to watch than others, but all of them have some fine print about how ‘results (are) not typical. You may not realize the same savings.’ Tax10000 even goes so far as to say that “[y]ou may not meet IRS eligibility requirements for this program.
Even if you do, you should not expect to reduce you taxes by this much.” Even better is another one of their disclaimers – the one that says that they do”not provide tax relief services but only refer[] you to a company that helps people negotiate with the IRS”.

Of all of these, RLD is the ‘oldest’ in terms of advertising on television (not in terms of attorneys, though. Her Managing Attorney has only been practicing for 5 years, and most of the attorneys listed on her website have been practicing 3 years or less). She’s been on numerous TV shows, radio programs, and quoted in articles several times over. But she is not without her detractors. (Neither is JK Harris). So what’s more surprising than the fact that she’s being sued is the fact that it’s taken so long for it to happen.

What all of these services are pitching – without actually saying so, for the most part – is the IRS’ Offer in Compromise (OIC) program. What they are NOT telling you, though, are the important parts:

  1. That it costs $150 plus 20% of the submitted offer to even get IRS consideration (so if you owe $100,000 and want to settle for $1,000, you’ll have to pay $350 [$150 plus 20% of $1,000] to the IRS).
  2. That most OICs that are approved settle for about 18% of the balance owed (in the hypothetical, that means you’d pay $18,000 of that $100,000, and owe $3,750 upfront).
  3. That only about 20% (depending on year, often less) of all submitted OICs are accepted. If your OIC is not accepted, you forfeit the money you’ve paid to the IRS – the IRS won’t send it back (except for the $150 fee, it gets applied to the balance outstanding).
  4. That the IRS will review your financial situation against national standards, and not necessarily against your actual payments. For example, if the national standard for a family of two in your area for housing and utilities is $1,450 per month, and your actual payments exceed $3,000, well…you’re out of luck – the IRS will say you can afford to pay, because in its eyes you have $1,500 a month to draw from. How does the IRS figure that? Because the IRS will tell you to sell the asset or live more frugally in order to pay the debt you owe. Sure, it may not be realistic, but that’s the standard, and it will likely mean your offer gets rejected.
  5. That the process can take several months to resolve and one phone call won’t do it.
  6. That you will not qualify if you are currently in a bankruptcy proceeding.

Here’s another part that rarely gets mentioned: if you owe the IRS, you probably owe the state, too. And unlike the IRS (who must collect any tax within 10 years of assessment or lose it forever), states often don’t have statutes of limitations – meaning that they can come calling with a huge tax bill years after you think you’ve solved your problems. Interestingly, not one of the TV ads mentions helping you solve your state tax problems.

So back to the question posed by the title:  if you owe thousands to the IRS, can you eliminate that by watching TV?

Not really.

If you owe taxes, and need help, click here.

All tax preparers are NOT created equal….

Prepare fraudulent returns, lose your right to practice before the IRS, right? Every accountant, enrolled agent, and attorney knows that Circular 230 promulgates the rules under which tax preparers are granted (and can lose) their right to practice before the IRS. And violations of its provisions mean you can lose your entire practice. Or so many thought.

Take, for example, Irma M. She was a tax preparer in the Chicago suburbs, whose clients enjoyed the fruits of her labor – specifically, the addition of mileage expenses to their returns. Worked fine until one client was audited and asked about his vehicle mileage. “What mileage?” he asked. “The mileage you claimed for your work on your tax return.” The response was classic: “I don’t drive my car for work.. oh, wait, that. My tax preparer told me I should do that.”

In no time, the IRS lined up 11 similar people, all ready to testify. At the last minute, Irma realized her error, and pleaded guilty. Her sentence? 15 months as a guest of the U.S. Government.

Then there’s Mr. Cruz, the defendant in U.S. v. Cruz, d/b/a Nations Business Center. He and an associate were found to have substantially inflated (large enough to get nailed on various penalties) Schedule C deductions. They closed up shop, and re-opened. The error rate dropped to zero, but the IRS still wanted to disbar him. Surprisingly, the district court disagreed, and allowed him to keep his right to practice before the IRS. But the court did remand the lower court’s denial of the IRS’ request that Mr. Cruz have to notify his clients of his conviction for ‘deceptive practices.’ Looks like he’ll still have to deal with that monster. But at least he’s taking appointments, if you’re looking for someone.

By the way, neither preparer was licensed, but both were still preparing returns as ‘professionals’. Irma claimed to be a CPA in her native country, but that holds little weight here in the U.S.

If you’re gonna fake it, do a better job…

I can’t begin to count the number of taxpayers who told me to ‘just put a number down’ or ‘oh, about X thousand miles, I guess’ when I would ask them how many business or commuting miles they drive. Many don’t bother keeping records, insisting that ‘I can prove that number if I have to.’ Translated to IRS-ese, “I’ll make up a log if and when I get audited, and not before.”

Ah, but that can be your biggest problem, as Willie & Thelma Moore found out today. You see, Willie worked for the City of Houston, and Thelma was a real estate agent (and oh, yes, they decided to 1) not use a tax preparer, and 2) represent themselves in court, both big mistakes). When the IRS audited them on their vehicle mileage, they produced a mileage log. Problem was, the log showed Willie driving to work on January 1st. Uh, Willie….January 1st was a government holiday. You were off that day. And Thelma showed daily round trips to her office – 15 miles a day. Uh, Thelma, it’s 13 miles one way to your office (never heard of Google maps, did you Thelma? Hmm. Might want to look into that). And 13 times 2 is 26, not 15. So you’re off by 11 miles a day. We won’t mention how you drove to Brazoria, Texas, and claimed 189 business miles, when the town is only 47 miles away, and a whopping 1.9 miles in size. The Tax Court surmised that you drove 95 miles around the subdivisions of Brazoria that day (seems they didn’t use Wikipedia). Let’s see…95 divided by 1.9…

The lesson: do the mileage log when you do the miles. Otherwise, you may look very, very foolish.

Yee-haw! The Tax Court rides into town!

Yesterday, with the spurs a-jinglin’ and a-janglin’, the Tax Court rode into town and issued several opinions of note:

In Foy & Barbara Smith v. Commissioner, the Court looked at rental real estate activities, among other things. While Smith isn’t particularly instructive – it’s a pretty straightforward case – a few items stand out:

  1. The taxpayers allocated the cost of land based upon their tax preparer’s method, which he in turn based upon his experience, and the standards he used for other clients;
  2. The taxpayers claimed various expenses – replacing HVAC units, roof work and painting and carpets – instead of depreciating them, then challenged the IRS’ selected lifespans.

The first one is the most alarming, because it is a typical scenario where rental real estate is involved. You go into your tax preparer’s office, and he or she asks, “how much did you pay for it?” You tell him the price you paid, say, $250,000. You might (actually should, but many people aren’t so well-prepared) show him the HUD-1 closing statement. He then takes some portion, and calls it ‘Land,’ which he does not depreciate, and another portion and calls it ‘Building,’ which he does. This, he says, is what the code says to do (true), and he used his “knowledge of the area” in coming up with the allocation. And here’s where you could have a problem.

Some counties – Los Angeles County included – will put values on both the building and the land. If they do, watch out. In Smith, the IRS took those assessed values, and used them to establish new depreciation numbers. In the case of the Smiths, the impact was minimal (they only were looking at assessments of $966 and $3,909 for the years at issue), but for others it could be significant. Once the IRS introduced the assessor’s bill, the burden was on the Smiths to prove the bill wrong. The lesson is clear – don’t take the assessor’s valuations lightly if you own rental property. If they differ from your Schedule E valuation, you need to challenge them or be prepared to prove why your valuation is more right than theirs.

The second problem – claiming HVAC and other capital items as expenses – is a common dodge taxpayers use to avoid having to depreciate a low-cost (relative to the property value) item over a long period of time. The HVAC units (which were central air & heat) and the repairs to the roof were definitely capital improvements; no way they were going to get around the longer term depreciation. The carpeting and the painting, however, were arguably expenses. Problem was, they didn’t separate those costs from the roof repairs, and thus lost the capability of expensing them. The lesson here? Be sure to clearly identify each expense, or be able to prove them individually, lest you get burned in the same way.

The final issue in Smith was an abusive trust. Again, the taxpayers did not keep good records, and could not show exactly when they knew the investment was a total loss. The court seemed inclined to give them the loss, but chose not to do so when they couldn’t provide evidence of worthlessness, nor could they explain why an original investment of $37,000 only resulted in a $34,000 loss. Too bad.

In Linda K. Betts v. Commissioner, the Court offered yet another lesson to horse owners (and there are a lot of them in Los Angeles County) who seek to claim losses from their horses: it won’t be easy.

Betts involved a woman who worked making packaging designs for the pharmaceutical industry by day and in her free time raised horses. Well, a horse, at least. Prior to the packaging job, she’d owned a ranch on which she ran an ultimately unsuccessful horse business. The IRS had audited her then, and made no changes.

Skip forward a few years. Now she has a regular job, and decides to once again raise horses. She buys one horse, negotiating the price down from $15,000 to $1,000 from an owner who 1) did not keep the horse well and 2) just wanted to be rid of him. That second part should have been the first red flag.

Betts’ intent, which she stated at trial, was to sell this horse after training him. She had been told he could fetch upwards of $100,000, but that never occurred. Shortly after buying him, problems developed, and she eventually tried to sell the horse for $20,000, then $12,000, both a far cry from the $100,000 she claimed he was worth. Still, she stuck to the original $100,000 valuation at trial to validate the alleged profitability. In addition to this horse, she purchased another, which she sold for a $6,000 profit. Unfortunately, for the seven years under audit, she accumulated total losses of over $150,000.00.

The court disallowed all of the losses, and sustained the argument that, despite her investment of time and money, her horses were nothing more than a hobby.

Why? Let’s count the reasons:

  1. She did not have a business plan, and when she finally did come up with one, it was lame. In fact, it consisted only of a statement on the number of horse owners nationwide, and in LA County, and not much more.
  2. She admitted that horses were a risky proposition, and that she could lose money. And in fact she had lost money in her earlier attempt.
  3. She did not clearly track her costs by animal to know if she was profitable. On the one horse she did apparently sell at a profit, she admitted that she did not separate her costs by horse, so could not say for certain if she did profit on the sale.
  4. She did not take steps to reduce her losses or increase her income. In fact, she reduced some expenses – marketing, for one – which the Court thought evidenced a lack of effort to increase income.
  5. She did not have adequate business advisers. While she did seek out several prominent people in the field, the court found she did not seek their counsel on business matters, or how to run her business better.

In fact, the court ran through the 9 (non-exclusive) profit objective factors in Section 1.183-2(b) and found her wanting in almost all of them. For the uninformed here are those factors:

  1. The manner in which the taxpayer carries on the activity;
  2. The expertise of the taxpayer or his advisers;
  3. The time and effort expended by the taxpayer in carrying on the activity;
  4. The expectation that assets used in the activity may appreciate in value;
  5. The success of the taxpayer in carrying on other similar or dissimilar activities;
  6. The taxpayer’s history of income or losses with respect to the activity;
  7. The amount of occasional profits, if any, which are earned from the activity;
  8. The financial status of the taxpayer; and
  9. Elements of personal pleasure or recreation.

According to the court, “[n]o one factor is necessarily determinative in the evaluation of profit objective, nor is the number of these factors for or against the taxpayer necessarily determinative.”

Maybe not, but it should be clear to the horse owners of LA County (and elsewhere) that if you have a horse-based activity which generates tax losses, expect to be audited, and expect the IRS to look very closely at your activity.

In Wayne & Caroline Drown v. Commissioner, the taxpayers invested in Hoyt Farms, a discredited abusive tax shelter. The taxpayers – who chose, like Smith above, to represent themselves – got hit for additional taxes several years after filing. That was then. This is now – the IRS is now comin’-a-callin’ looking for penalties, specifically Section 6662 penalties. Them be the penalties fer negligence, pardner. And when you represent yourself, and prepare your returns yourself AND ignore IRS notices and claim you thought all was OK because you got what seemed to be a ‘never mind’ letter from the IRS, well … you got nuttin’ to hide behind. The best defense to a Section 6662 is to do what everyone else does – point the finger at the other guy (i.e., the taxpreparer). But…the Drowns (nice name, eh?) didn’t have that. So…the IRS got its couple.

Oh, don’t think they didn’t try to wriggle away. They cited Section 6502, the 10-year Statute of Limitations. No dice, said the court; the penalties haven’t been assessed yet, so the clock hasn’t even started, much less finished. They tried Section 6229, but the court noted that that statute had been suspended while the Final Partnership Administrative Adjustment (FPAA) proceeding was ongoing. So…that clock was still ticking, too. They were down to estoppel, which failed too, because the court found no misleading information had been provided by the IRS to justify estoppel.

The lesson here? Don’t think that tax shelter is getting you something for nothing – seek competent advice. A CPA would have likely advised them not to invest. Even if they’d ignored it, a good tax lawyer would have told them to pay the taxes, penalties and interest and cut their losses. If they wanted to fight it, do it in District Court, not Tax Court, where the meter still runs. Alas, they didn’t get that advice, and paid.

Intuit tries to rain on the free e-file parade

Back in the day when electronic tax return filing began, everyone charged a fee for electronic filing. The firm I worked at charged $30, largely because – like many smaller firms – we didn’t actually do the filing. We would send the file off to a third party provider, who charged us $25 a return. Like most electronics and software, as more players entered the market, the cost dropped, and before long we were able to do our own e-filing. While the cost still wasn’t free, it was considerably less, and by then the cost was no longer a separate line item – it had been built into the overhead (it helped when the IRS started pushing firms to e-file). Surprisingly, while many firms have followed suit and built-in the e-filing costs, some small firms (one near me comes immediately to mind) still separately charge clients to e-file returns.

Early on, states recognized how e-filing could be beneficial – it sped up processing time, allowed for intergovernmental crosschecking (now your state could see if you were telling them the same thing you were telling the IRS) and saved money be requiring less staff. So to encourage people to e-file – and to take advantage of the increasing number of people self-preparing electronically – states began offering their own e-file programs, usually limited to people of a certain type (say, singles with incomes below certain dollar amount, or people filing ‘basic’ returns (no Schedule D, etc.)). This, of course, competes with the paid service offered by firms like Intuit, which means that instead of offering programs like TurboTax at a slight loss or breakeven price (and making it up on the e-file fees), they will have to make it profitable. Of course, this will inevitably mean lost sales (because some people are price sensitive), so things could get interesting.

Or…you could do what Intuit seems to be doing. Hire lobbyists to kill the free e-file programs. That way, you force users to use your e-file program, which you offer free to certain users at first, then slowly and quietly push the ‘better’ prospects – those who could afford to pay, such as a single person making $125,000.00 – into the paid e-filing. Don’t think it will happen? Don’t bet on it. It will be interesting to see how this plays out, and if Intuit can force other states to do the same.

3 ways taxes can cause your business problems

Taxes are a fact of life, even for business. But while everyone focuses attention on how businesses pay little to no income tax, there are other areas where taxes can represent a minefield for business, no matter how big or small. Here’s three quick ways that taxes can cause your business headaches.

  1. Buying things without paying sales tax. Now, you might think that this is the sole province of the Ebay buyer, but if you did, you’d be wrong. Large companies get burned by this, too. One popular area for case law here is the purchase of an airplane. Here’s how it happens: Company X buys a plane in the name of Entity Y in State Z, and hangers it in State A (Entity Y’s HQ), where it does little business, and whose tax law is either lax or absent on the topic.

    State B, where Company X does business, comes along and assesses use tax. “Use tax?” cries Company X, “we don’t owe use tax…the plane is owned by Entity Y, headquartered in State A, and the plane rarely comes here! Even if we did owe tax, you can only charge us based upon use in your state, not on the full value! Anything else violates the Commerce Clause and interstate business!”

    State B challenges, saying no apportionment is needed and no Commerce Clause violation exists. The two wind up in court. The case law here is pretty extensive, but facts in these cases typically follow the pattern above. Occasionally, Company X has won in lower courts by challenging the assessment under Commerce Clause rules (See), getting the tax lowered to an apportioned amount, but in each case, that’s been overturned upon appeal (and you knew that would happen, right?).

    The only solution is to pay SOMEBODY the tax, because the courts have tended to find that where the tax has been paid at purchase, another state cannot come along and tax it again.

  2. Failing to properly document cash payments. It’s not only the IRS that likes cash-based businesses; states do too. Often, it’s because the business fails to properly collect and remit sales tax (see above), but another good reason is the obvious – underreporting of income.

    Whenever cash is involved, a good document trail is important. A comedy club client of mine held ‘open mike’ nights, where a small cash prize was awarded. If the contestant was particularly good, they’d be invited to stick around and perform later in the evening, earning them another payout. Fortunately, the owner was smart enough to copy the winner’s driver’s license, and get their addresses and SSNs, because while most performers earned under $600 (the IRS threshold for issuing a 1099-MISC), the aggregate total for the year was large enough to catch the IRS’ attention in audit. Although the Service initially denied the deduction for such payments, they relented after the client showed them his records. Without the records, he would have been assessed over $20,000.00 in taxes and penalties.

    A second scenario involves the short-timer. Every business has had one – the person who shows up to work on Monday, and never again. No call, no e-mail – they just drop off the end of the earth. This is particularly true for small businesses, such as restaurants, but it happens across the board. Often, the business decides that running this person through payroll is a pain, and just cuts them a check, or in the case where the employee actually does give notice, pays them out of the cash drawer. Again, record keeping is important. The IRS will look to deny the deduction unless you can show that the person was 1) real, 2) not related and 3) owed the money. Particularly with small businesses, the IRS looks to checks to individuals and cash payments as attempts by the owners to take cash out of the business tax-free. Sounds odd (particularly where the person being paid has no relationship with or to the owner), but again, I’ve had these discussions with auditors enough to know that that’s their M.O. Besides, if they deny and assess, the burden of proof shifts to you. Keep good records, and save yourself a headache.

  3. Not doing your homework. Depending on what you do, and where you’re located, you can face a number of different taxes. Trying to start your own business – or run a business – without good tax advice is a recipe for trouble.
  4. For example, picking the wrong entity can mean a bigger tax bill. You might have heard that an LLC is the way to go, but is it? It depends. Where are you doing business? What kind of business? And do you plan on expanding to other states? For example, in California, LLCs are hit with a gross receipts tax that applies no matter the business’ performance, while S Corps pay a flat $800 tax until profits get up around $40,000.00. You’d probably want to know that tidbit before you signed up to be an LLC in California.

    A good tax advisor can also warn you of pending changes, such as the proposed FICA tax on S-Corps, or the very real excise tax on tanning salons. Thus, it’s important to do your homework and pick a good tax advisor who will keep you abreast of important changes. As part of your ‘homework’, you should also schedule a time to sit down with your advisor before the end of the year to review your financial position and discuss strategy. More importantly, you should check in with them often throughout the year, not just at year end. Even if an appointment costs you $200.00, it’s better than owing $5,000.00 in March because you weren’t aware of a change in the law. And if your tax advisor is not communicating regularly with you, you need a new advisor.

Proving undocumented expenses, shifting burdens and avoiding penalties: a look at some audit issues.

Cross-posted at: Above the Line

Here’s the scene: you go to the mailbox, and inside is a letter from the IRS. They want more information about your 2008 tax return, specifically some deductions on your Schedule A. Problem is, those records got lost when you moved last month, and you’re not sure you can prove all of your expenses. Is all lost?

Some may be, but not necessarily all.

What can be saved? Well, to answer that, you need to look at some tax court cases, a section or two of code, and cross your fingers. Chocolate and/or whiskey might help, too. For you. Not the agent.

In general, once the IRS issues a notice of deficiency, that notice is presumed correct, and you’re on the hook to prove that it’s not.  (See, e.g., Rule 142(a), Welch v. Helvering, 290 U.S. 111, 115 (1933), Lang v. Commissioner, T.C. Memo 2010-152, at 4 (2010)). Often, in a tax court case, a taxpayer will attempt to circumvent this general rule by citing to Section 7491, a provision of the code which shifts the burden of proof to the IRS. Does it work? Not really.

Here’s why: in order to shift the burden of proof, you, the taxpayer, must comply with certain rules. In reality, if you do, your case is not likely to get as far as Tax (or Federal District) Court in the first place. Furthermore, the burden of proof issue is only determinative when there is an evidentiary tie (See,  Knudson v. Commissioner, 131 T.C. 185, 189 (2008), Lang v. Commissioner, T.C. Memo 2010-152 at 8). Still want to try to use 7491? Then take a look at the way Section 7491 is worded:

(a) Burden shifts where taxpayer produces credible evidence

(1) General rule

If, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by subtitle A or B, the Secretary shall have the burden of proof with respect to such issue.

(2) Limitations

Paragraph (1) shall apply with respect to an issue only if –

(A) the taxpayer has complied with the requirements under this title to substantiate any item;

(B) the taxpayer has maintained all records required under this title and has cooperated with reasonable requests by the Secretary for witnesses, information, documents, meetings, and Interviews; []

The first thing that stands out is the phrase ‘credible evidence.’ While not specifically defined, paragraph 2(B) provides a strong indication of what that might mean – producing the records required to substantiate the expense.

The second point to be made is what one colleague calls the ‘cooperate fully’ provision – you comply with all reasonable requests made by the IRS. This means that if they ask for your employer’s reimbursement policy, you provide it, or a reason why it cannot be provided (if your employer does not have a reimbursement policy, you’ll need to have them say so in a letter. Agents don’t have to, and likely won’t, rely upon your oral statements only). “Reasonable request” gives the IRS pretty wide latitude, too. As long as the IRS can provide a plausible explanation why the record is needed, you’ll need to ante up the document. You can certainly challenge it later, if needed, but that fight isn’t particularly advised at the early stages of an audit (unless you know you’re on shaky ground. If you are, damage control is your best option).

If, for some reason, you do not have proof of an expense, you can – under what is known as the Cohan rule – estimate the expense. Cohan refers to composer George M. Cohan (of “Yankee Doodle” fame) who was audited by the IRS in 1930[1]. Cohan had certain entertainment and business-related expenses that he couldn’t provide receipts for, but which he alleged were business-related. Based solely upon testimony he provided, the court (in an opinion written by the great jurist Learned Hand) agreed, and overruled the IRS’ denial of all expenses. In his opinion, Judge Hand stated,

“… the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making. But to allow nothing at all appears to us inconsistent with saying that something was spent. True, we do not know how many trips Cohan made, nor how large his entertainments were; yet there was obviously some basis for computation, if necessary by drawing upon the Board’s personal estimates of the minimum of such expenses. The amount may be trivial and unsatisfactory, but there was basis for some allowance, and it was wrong to refuse any, even though it were the travelling expenses of a single trip. It is not fatal that the result will inevitably be speculative; many important decisions must be such. We think that the Board was in error as to this and must reconsider the evidence.”

Since Cohan was decided, the law has been considerably narrowed. For example, estimation is not acceptable in regard to travel , meals and entertainment (Section 274(d) requires documentation; without documentation, no expense is permitted), and courts have made it clear that when a section of the code requires specific types of documentation, an estimate is unacceptable.  Moreover, courts routinely refuse to provide any estimation where insufficient evidence exists in the record to provide a basis for estimation. [2]

While it can be said that alternate means of proof are acceptable substitutes for receipts, that doesn’t mean that alternate means are a cure for what ails you. Again, courts require documentation: “In the absence of adequate records, a taxpayer may alternatively establish an element of an expenditure by “his own statement, whether written or oral, containing specific information in detail as to such element” and by “other corroborative evidence sufficient to establish such element.”” Lang, at 7, quoting Larson v. Commissioner. The use of the phrase ‘specific information in detail’ is vague enough that it gives the IRS latitude in deciding how specific you need to be. Suffice to say that your testimony alone is probably not even close to being enough.

Finally, to add insult to injury, the IRS can, under Section 6662, tack on an accuracy related penalty. Here again, you might be tempted to rely upon Section 7491 burden of proof requirements. Don’t . The Services burden here is ridiculously small. All the IRS has to do is show the greater of two things:  either 1) that you understated your tax by more than $5,000.00, or 2) that the amount of understatement is greater than ten percent (10%) of the tax shown on the return. If the Notice of Deficiency does that, the IRS burden of proof has been met, and you’ll be assessed the tax.

Frequently, the Code gives taxpayers and out, and here a safe harbor exists which may allow a taxpayer to avoid the penalty under Section 6662 – as the Court in Lang noted:

The accuracy-related penalty is not imposed with respect to any portion of the underpayment as to which the taxpayer acted with reasonable cause and in good faith. Sec. 6664(c)(1). The decision as to whether the taxpayer acted with reasonable cause and in good faith depends upon all of the pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Relevant factors include the taxpayer’s efforts to assess his proper tax liability, including the taxpayer’s reasonable and good faith reliance on the advice of a professional such as an accountant. Id. Furthermore, an honest misunderstanding of fact or law that is reasonable in the light of the experience, knowledge, and education of the taxpayer may indicate reasonable cause and good faith. See Remy v. Commissioner, T.C. Memo. 1997-72.

What does that mean? Well, where the taxpayer has been found to have sufficient knowledge, experience or education, or attempted to assess his or her proper tax liability, a penalty has been assessed[3], but where a taxpayer has shown that they have little financial knowledge, the penalty has been waived. So a cleaning lady whose unreimbursed expenses are disallowed will have better luck laying the blame at the tax preparer’s feet (provided it can be shown that they are a competent preparer) than, say, a law professor who teaches tax law. It is very much a fact and circumstance based test, and what works for one taxpayer may not work for another.

In short, just because you do not have, or cannot find a particular receipt does not mean you automatically lose a particular deduction. It does mean that you have a harder row to hoe, and a higher likelihood of disallowance, but don’t start writing a check just yet – hire a professional, and start pushing back.

[1] Cohan v. Commissioner, 39 F2d 540 (2nd, 1930).

[2] See, e.g., Lang, where the Court permitted the taxpayer a $96 deduction for Ross Reports magazine, because the taxpayer 1) provided two receipts showing he’d purchased the magazine for $8, and 2) testified that he bought the magazine monthly. However, the court did not allow a deduction for Backstage magazine, which the taxpayer claimed to buy weekly at $2 a pop, because he could not even produce one receipt showing a purchase.

[3] See Lang, where, in denying relief under 6664, the Court noted, “While a taxpayer’s reliance on the specific advice of a tax return preparer may constitute reasonable cause, petitioner has failed to offer testimony or evidence regarding the qualifications of his tax return preparer. Petitioner’s general statements that he relied on his tax return preparer are not sufficient to prove a reasonable basis, substantial authority, or reasonable cause for his disallowed deductions. Secs. 6662(d)(2)(B), 6664(c)(1).” Lang, at 23.

Wither the Tax Extender bill?

Harry Reid, Senate Majority Leader, has indicated that HR4213 – better known as the “Extender Bill,” but officially known as The American Jobs and Closing Tax Loopholes Act (gotta love the names bills get these days) – is dead in the water.

From CCH:

Senate Majority Leader Harry Reid, D-Nev., on June 21 declined to commit the Senate to any immediate further action on the American Jobs and Closing Tax Loopholes Bill of 2010 (HR 4213), placing the $118-billion package of tax breaks and unemployment benefits in limbo as Democrats search for a way to attract 60 votes. A spokesperson for Reid, however, said the Senate plans to move ahead with extenders and the Majority Leader held out hope that a breakthrough is still possible.

“I hope we can move forward on the legislation we tried to finish last week,” said Reid on the Senate floor.

Senate Republicans during the week of June 14 rejected the bill when it carried a $140-billion price tag, forcing Senate Finance Committee Chairman Max Baucus, D-Mont., to come up with a pared-down version, which Republicans also blocked. Another revision by Baucus is likely if the Senate turns to the bill again.

The Senate on June 18 approved by unanimous consent a measure that would allow a six-month extension of a provision that would prevent cuts in Medicare payments to doctors. The Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Bill of 2010 (HR 3962) was initially a provision in HR 4213 and its removal reduced the overall cost of the bill. Senate aides have speculated that Baucus may remove unemployment benefits and federal Medicaid funding for states from the extenders package to further reduce the cost.

Of course, that was Tuesday. On Wednesday, the Senate made multiple revisions to the bill, including further tweaks to the carried interest provisions, which taxes fees made by investment fund managers at ordinary rates, among other things.

S-Corp shareholders in services businesses should also keep an eye on this bill, which would tax not only their salaries (which already happens) but their distributions as well (which doesn’t). S-Corp advocates have objected, saying that the IRS has sufficient resources to police unequal distributions (Congress’ concern here is shareholders who take small salaries and large tax-free dividends), and that the number of ‘filching’ shareholders is small, but this provision is anticipated to raise significant sums at a time when Congress desperately needs funding sources, so expect the change to happen.

Fair, compassionate tax representation

Tax problems can be overwhelming and frightening. The IRS is a formidable adversary; when you are facing tax difficulties you want a tax attorney in your corner who understands what you are going through, and has the experience and skill to represent you expertly.