Archive by Author

Jul 15

The IRS refers to it as the “responsible person” penalty.  It applies to failure to remit withheld federal payroll taxes.  You can think of federal withholding taxes as having five pieces, as follows:

  • Federal income tax withheld
  • Social security withheld
  • Medicare withheld
  • Employer match of social security
  • Employer match of Medicare

Here is the concept: the IRS considers the first three to be the employees’ money, which the employer holds in trust. When the employer fails to remit these, it is not only tax noncompliance but also theft. The IRS is very harsh on this issue and will impose one of its harshest penalties: the “responsible person” penalty. This penalty is 100%. Yes, you read that correctly.

You never want to be “responsible” for this purpose. The IRS can chase to ground anyone it considers responsible and assess the penalty. It doesn’t matter whether you own the company, or are an officer, or even still work there

Think about the math for a moment. The company falls behind on its payroll taxes. The IRS will proceed against the company for the taxes. If it then chooses to assess penalties, it does so against the responsible person. That penalty is 100%. The company pays. The responsible person pays. The IRS is paid twice.

Let’ go over a quick example: Let’s say that the amounts are as follows:

  • Federal income tax                 $1,800
  • Social security withheld          $  336
  • Medicare withheld                   $  116
  • Employer social security         $  496
  • Employer Medicare                 $  116

When the IRS goes against the company, it will want a check for $2,864 ($1,800 + 336 + 116 + 496 + 116).

NOTE: The employer social security is higher than the employee withholding because of the 2-point reduction in employee social security for 2012.  The employer percentage remained at 6.2% whereas the employee share was reduced to 4.2%.  This was part of the effort to stimulate (or at least not de-stimulate) the economy. It is also slated to expire at the end of 2012.

If the IRS assesses the responsible person, that penalty will be $2,252 ($ 1,800 + 336 + 116). Notice that the employer share doesn’t count for purposes of this penalty. Small consolation.

There are two major tests that the IRS will consider to determine if someone will be charged with the “responsible person” penalty:

(1)   Did the person have a responsibility to collect, account for and pay the trust fund taxes; and

(2)   Did the person willfully fail to perform this duty?

Let’s break down the first test. What if you are a payroll manager, responsible for running payroll and correctly accounting for withholding taxes? Are you responsible? No, not by itself, because you do not have authority to pay bills and write checks. What if you are the treasurer, with authority to write checks? Are you responsible? You will have the IRS’ attention, but the technical answer is no, not by itself. In our next blog we will discuss a taxpayer who wrote over 1,800 checks but argued that he was not a responsible person. The IRS did not believe him, of course, so off they went to court.

On to the second test. We are presently representing a responsible person client on the issue of willfulness. Willful means that one voluntarily and intentionally paid, or continued to pay, other creditors while knowing that the company failed to pay over withheld funds to the government. The IRS in the past has argued that payments to a creditor – mind you, any payments to any creditor – could be sufficient to show willfulness.

Fortunately the courts have slowed down the IRS. Let’s say the check writer was unaware of the lapsed payroll deposits, for example. How? One way is lack of financial sophistication. What if the bookkeeper “took care of it,” and the bookkeeper suddenly took ill, became disabled or left town? The business owner or manager could well need time to ramp-up, whether that means payroll, using QuickBooks or any other duty previously performed by the bookkeeper. Can one say there is “willful” intent while the owner or manager is struggling through the learning curve? Let’s swing the other way and say the check writer was financially sophisticated. What is your opinion if told that the check writer wrote checks only infrequently, and that when the primary signor was on vacation or otherwise unavailable? What if the check writer was unaware of any payroll problems? What if the check writer is authorized to pay vendor payables but excluded from any payroll responsibilities? What if the check writer was intimidated by his/her boss?

This area is of concern because of the poor economy in the last several years. There is great temptation to consider payroll taxes as yet another funding source, reasoning that the IRS can wait like any other creditor. That is not true. The IRS is not just any other creditor. The IRS can assess and collect tax for 10 years past the assessment date, and longer than that if it reduces the assessment to a judgment. And do not assume this is automatically dischargeable in bankruptcy court.  This is called “expensive money.”

Next blog: we will talk about Tarpoff and his responsible person penalty.

Jul 10

An easy way to reinstate nonprofit status will expire at the end of 2012.

You may recall that the IRS recently required nonprofits to file annually. This was a sea change from prior practice, where the smallest nonprofits were not required to file at all. Under the new rules, everyone has to file. To make it less burdensome, the smallest can file Form 990-N, also called the “postcard.” Nonprofits were alerted that three successive years of nonfiling would now result in revocation of nonprofit status. The IRS held true to its word and revoked the status of numerous nonprofits.

To recover tax-exempt status, the nonprofit must (again) file an application (Form 1023). A key issue here is that the nonprofit also has to present “reasonable cause” why it did not previously comply with IRS requirements.  The IRS can be harsh on what it considers to be “reasonable cause.” For example, let’s say that your CPA takes ill and, as a consequence, your tax returns are filed late. Many if not most people would consider that to constitute “reasonable cause” for late filing. The IRS disagrees. They argue that you could have hired another tax professional to prepare the return on time.

If you are small nonprofit (defined as gross receipts of $50,000 or less) the IRS will automatically deem you to have “reasonable cause.” You still have to file Form 1023, be careful to include certain prescribed language and attach a $100 check.

What is very, very important is that you do this by December 31, 2012. Starting in 2013 all nonprofits, whether large or small, must present reasonable cause when resubmitting for tax-exempt status.

Jul 07

It came to our attention that the IRS is sending erroneous notices on 2010 Roth conversions. If this is you, you may remember that you were allowed to spread the tax cost of converting your regular IRA to a Roth IRA over two years.  The notice states that you owe tax for 2010, which you would had you not spread the tax over two years.

You do need to respond to the notice. The IRS is aware of the software glitch, however, so we expect these notices to be resolved expeditiously.

Jul 06

We are beginning over here to re-review the tax aspects of ObamaCare after the Supreme Court’s decision last week. There are several tax changes, but today we will revisit the new investment income tax and the new earned income tax. These will happen in 2013, so let’s go over them.

Investment Income

If you are single, you will owe a new investment tax if your adjusted gross income (AGI) is over $200,000. If you are married, you will owe the new tax if your AGI is over $250,000. (I know, twice $200,000 is considerably more than $250,000. I did not write the law). If this is you, will owe a brand-new 3.8% tax on your investment income.

Let’s be clear: it is not necessarily ALL your investment income. Rather it will be on investment income over $200,000 or $250,000, as the case may be. If you are married and retired and your entire adjusted gross income of $250,000 is interest and dividends, you will owe no NEW tax. You will owe plenty of OLD tax, though.

What is investment income? Let’s go with the easy examples: dividends, interest, capital gains (short-term and long-term), royalties and annuities outside retirement plans

NOTE:  Net investment income is also defined to include income from a passive activity. This concerns me, as the rental of a duplex is a passive activity, as is passthrough income to a “passive” member in an LLC. Under Section 469, these activities were considered “trades or businesses,” although the activity could be further tagged as “passive” or “nonpassive.” They were not however tagged as “investment.” This new tax appears to use the language differently from Section 469 and equates “passive” with “investment.” The IRS unfortunately has yet to issue formal guidance in this area.

How can this tax surprise you? Here are a few ways:

(1)   You sell your business.

(2)   You get married.

(3)   You sell your principal residence, and the gain exceeds the $250,000/$500,000 exclusion.

(4)   You inherit and sell stock from a parent’s estate.

Earned Income

If you are single, you will pay an extra 0.9% Medicare tax on your earned income over $200,000. If married, that threshold changes to $250,000.

What is earned income? The easiest way is to ask whether you paid or will pay social security or self-employment tax on the income. If the answer is “yes”, you have earned income. Note that this definition excludes your pension, 401(k) and IRA distributions.

Let’s go over a few examples.

EXAMPLE 1: A married couple filing jointly has $360,000 of adjusted gross income—$240,000 of wages plus $120,000 of interest, dividends and capital gains. They have $110,000 of investment income` over the $250,000 threshold. They will owe an extra 3.8% of that $110,000, or $4,180, in tax.

EXAMPLE 2: In the following year, the same couple has $400,000 of income, the difference being a $40,000 bonus. All their investment income is now above the threshold amount. Their new investment income tax will be $4,560. In addition, since their earned income is now above $250,000 they will owe the new earned income tax of $270 ((280,000- 250,000) times 0.9%).

EXAMPLE 3:  After many years, you move from Purchase, New York. You sell your house for $920,000 and are single.  Your exclusion amount on the sale is $250,000 so the taxable gain is 670,000. Assuming that you earned income is over $200,000, the new investment income tax will be $25,460 ((920,000 – 250,000) times 3.8%).

We will discuss other tax changes in a future blog. Some are delayed (such as the employer penalty) and others are already in place but are somewhat esoteric (the prescription drug fee).

Jul 03

I was reading the following recently, and we will use it as a springboard for our discussion today:

In its continued assault on real estate investors, the Court held in Jafarpour and Prang v. Commissioner, …, the taxpayers were not actively involved in a real estate trade or business nor was she a real estate professional ….

Prang is just one more taxpayer to fall under the IRS’s aggressive assault on real estate investors.

That writer and I do not agree on Jafarpour and Prang (“Prang”).

We are talking today about the taxation of real estate activities. Ever since 1986 we have had the passive activity rules, which Congress used to address the problem of tax shelters. The overall concept is simple: if an activity is considered to be passive, then losses from the activity cannot be subtracted from income considered nonpassive. Here is an example: you will not be allowed to claim losses or tax credits from an Alpaca investment against your W-2 income and bonus.

There are exceptions for real estate activities. This is not surprising, considering how significant real estate is to the national economy. The exception that Prang wanted was the “real estate professional” exception. If she could attain that, then her real estate activities would be nonpassive. She could subtract losses to her heart’s content.

There are two basic requirements to being a real estate pro:

(1)   More than one-half of your work hours have to be real-estate related, and

(2)   You have to work more than 750 hours in real estate

We have several real estate pro clients. A builder or broker qualifies, for example. These guys work real estate full-time, so they are easy to identify. What if you mix real estate with non-real estate activities? Further, what if the total hours are close?  You had better keep good records. That gets us to Prang.

Jafarpour was the husband. He sold stock options in 2006.

Prang was the wife. She was a chiropractor. Unfortunately she got injured and sold her practice during the middle of 2006.

So Prang and her husband came into cash and were looking for something to do. They have some experience in real estate. They have rented a former residence in California for a decade, for example. She attended seminars on real estate investing, including a course at the community college. The community college instructor explained the additional depreciation available for Katrina-affected areas (referred to as the GO Zone).

Mrs. Prang liked the idea and they snapped up three properties in Louisiana and Alabama. They almost immediately signed contracts with management companies to handle the properties. After all, they live almost 2,000 miles away. They returned to California.

They claimed over $271,000 in real estate losses on their 2006 tax return. Surprisingly, this caught the IRS’ attention. They were audited.

Jafapour immediately admitted that he was not a real estate pro for 2006. Not a problem, as Mrs. Prang claimed that she was the real estate pro. The IRS said: let’s go through the math: how many hours did you work and how many hours were in real estate?

The way to prove this is to show a record or log, preferably kept contemporaneously, showing what you did and how long it took. Mrs. Prang had an appointment book at the chiropractic office, so that should establish the chiropractic hours. The IRS looked at it and had questions. Daily visits were often illegible. There were daily totals, but the IRS was unable to determine what the totals represented. The totals frequently did not coincide with the number of patients filled-in for the day or the hours Mrs. Prang was supposedly working. Prang deepened the hole by attesting that she left the practice after selling in June. However there were e-mails and notations that she was still involved.

The IRS moved over to the real estate logs. The log was divided into sections. Immediately they were curious because she wrote her activities in pen but the number of hours in pencil. Mrs. Prang explained that she did this so she could cross-reference her time with phone records and make adjustments. Flipping through, the IRS saw several times the same task recorded in multiple sections. More than once the amount of time seemed excessive for the task. For example, Prang noted that she spent one hour on November 8, 2006 reading the following e-mail:

Hi Lecia, I’m your loan processor and will be your main contact person from this point on. I received the FedEx package you sent back. I will review it and prepare the file for my underwriter to review. I will update you with the status within 3 business days.”

So she was a slow reader. The IRS pressed on. They spotted several days where she said he worked 17 or more hours, which was impressive. Problem is that she noted the same tasks on more than one day. She described doing something while she was actually on a plane back to California, which would have been a Copperfield-worthy trick. Some of the e-mails she claimed to have sent were from her husband’s e-mail account – and electronically signed by her husband.

The IRS came to the conclusion that she manufactured the logs after-the-fact, which greatly weakened their credibility. She worked the logs to get the answer she wanted. The IRS trusted none of it, denied her real estate professional status and disallowed her loss.

Prang went to Tax Court. Here is the Court:

We would have to engage in complete guesswork to determine how much time Ms. Prang spent at her chiropractic business on a particular day during 2006, let alone the entire year. We decline to engage in such dubious speculation.”

We are not convinced that Ms. Prang contemporaneously recorded her actions in the real estate log. Petitioners’ unreasonable assertions are so pervasive that the entire log is tainted with incredibility. Moreover, petitioners’ appointment book is frequently illegible and generally ambiguous. While Ms. Prang may have invested a considerable amount of time in real estate activities during 2006, petitioners’ records are simply too unreliable for us to draw any sound conclusion.”

The Tax Court found the logs unreliable. With them she couldn’t prove her real estate pro status. Without that status she could not claim losses. Without the losses she owed the IRS a lot of money. And she owed a big penalty.

 My Take:  I have had a real estate pro audit before, and the IRS challenged the logs directly. I was younger and working under a partner at another firm. In that case, I felt that the examining agent and supervisor were being unreasonable. The client had maintained but had not assembled the data into a usable, calendar form.  The agent felt that fact impugned the log, whereas my argument was that the log was little more than an administrative compilation of existing data. The agent disallowed pro status, the group manager sided with the agent, we appealed and won in Appeals. Quite a hassle – and we had better facts than Prang. For all that the client fired us. It did not go as smoothly as he would have liked. I wasn’t too thrilled about it either.

I try to be blunter with clients these days about the hazards of tax representation. Lose the examiner’s trust, for example, and you may not convince him/her that the sun came up this morning. Catch the examiner on a pet peeve and he/she may raise the body more often than a Living Dead episode. You may have an examiner too green to realize that classroom examples rarely occur outside the classroom. You may run into a coordinated exam, in which a specialized group – not necessarily the examiner – is calling the shots.  A lot can go wrong.

Was Prang an “aggressive assault” on real estate investors? I do not see it. What I do see is someone gaming the system. They got caught. That’s all.

Jun 27

Would you be aggressive on your taxes if your job was on the line?

I am reading Agbaniyaka v Commissioner. Benjamin Agbaniyaka (Ben) started with the IRS in 1986. He received excellent evaluations, several promotions and a Master’s Degree in taxation from Long Island University. Between the years 1988 and 2006 Ben engaged in a side business selling African arts and crafts.  Here are the business results for selected years;

            2001    no sales and a loss of $5,661

            2002    sales of $3,216 and a loss of $15,232

            2003    sales of $1,372 and a loss of $7,624

            2004    sales of $200 and a loss of $6,383

He also claimed itemized deductions, including annual expenses for “Union Dues” and “Accounting Journals.”

He gets audited for 2001.

Let’s go over what the IRS expects when it sees that Schedule C on your return. It expects you to maintain records so that you can compile a tax return at the end of the year. Records can be as simple as a checkbook with a year-sheet recapping everything by category. The IRS also wants you to keep invoices and receipts, to allow a third party to trace a check to something. There are some expenses where Congress itself tells the IRS what documentation to review. Meals and car expenses are two of the most common examples. With those two, the IRS is somewhat limited in its flexibility because Congress called the tune.

Then we have the hobby loss rules. The idea here is that a business activity is expected to show a profit every so often. If the activity has always shown losses, it is difficult to buy-into the argument that it is a business. An actual business would eventually shut down and not throw good money after bad. There are exceptions, of course, but it is a good starting point.

The third point is that a revenue agent is going to be held to a higher standard. There is the education and training involved, as well as that whole working for the IRS thing.

The IRS audits 2001. It finds the following:

(1)   Ben deducted expenses for a course on trust and estates. He cannot provide any documentation, however. He also has other unsubstantiated education expenses, including his journals.

 (2)   Ben claimed a deduction for union expenses. He cannot present any proof he paid the union.

 (3)   Ben is hard-pressed to persuade the IRS that there was any profit intent to his arts and crafts activity. The problem is that Ben never reported a profit – ever. The IRS simply disallowed the loss.

 (4)  The IRS is now miffed at Ben, especially since Ben is one of their own. They argue that the Ben’s failure to make any reasonable attempt to comply with the tax code is negligence. In fact, failure to keep records shows not only negligence but also Ben’s intentional disregard of the regulations. The IRS slapped Ben with a substantial understatement penalty.

The IRS expands the audit to 2002, 2003 and 2004, with similar results.

Can this get worse? You bet. The 1998 IRS Restructuring and Reform Act requires termination of an IRS employee found to have willfully understated his federal tax liability, unless such understatement is due to reasonable cause and not willful neglect.

Let’s go back to the substantial understatement penalty. One of the exceptions to the penalty is reasonable cause. Ben goes to Tax Court. He pretty much has to. He has to win, at least on the penalty issue. If he can get the court to see reasonable cause, he might be able to save his job.  

The Tax Court is unimpressed. Here are some comments:

We found Mr. Agbaniyaka’s testimony to be general, vague, conclusory, uncorroborated, self-serving and/or questionable in all material respects.”

During the years at issue, Mr [] was a trained revenue agent and was fully aware of the requirements imposed by …. Nonetheless, petitioners failed to maintain sufficient records for each of their taxable years 2001 through 2004 to establish their position with respect to any of the issues presented.”

On the record before us, we find that petitioners have failed to carry their burden of showing that they were not negligent and did not disregard rules and regulations, or otherwise did what a reasonable person would do, with respect to the underpayment for each of the years at issue.”

After the Tax Court’s decision, the IRS ended Ben’s employment effective April 15, 2008.

Ben appeals to the Federal Court of Appeals. That too fell on deaf ears:

“… he was undoubtedly aware that he had to substantiate his efforts to conduct a business in 2001 and beyond. Being an experienced and knowledgeable Agency employee, he had to have been aware that he could not substantiate his alleged business activities. By claiming deductions on Schedule C, he knowingly and willfully submitted tax filings to which he was not entitled.”

Ben next tried other channels. In the end, he lost and stayed fired.

How much money are we talking about? The court does not come out and specifically give a dollar amount, but there is enough to approximate the taxes as little more than $10,000.

I question the lack of documentation for some of these claimed expenses. The bank can provide cancelled checks for the subscriptions or seminars, and the union will provide a letter of membership and dues activity.  The court doesn’t elaborate, but it is clear that Ben wasn’t trying too hard.

Would you gamble your job for $10,000? Ben did.

I wouldn’t.

Jun 20

Have you heard of cost segregation studies? This is an engineering-based study, usually conducted in tandem with an accounting firm, to break-out the cost of real estate and improvements into more tax-advantaged asset categories. For example, a sidewalk can be depreciated faster than a building. It would therefore be tax-advantageous to separate the cost of the sidewalk from that of the building and claim the faster depreciation. A virtual cottage industry has sprung up in the profession to do these cost segregation studies.

What if you buy a business and simultaneously do a cost segregation study? Sounds like the perfect time to do one. What if you buy a business and do the study later?

Let’s talk about Peco Foods Inc (Peco).

Peco is the parent of a consolidated group engaged in poultry processing. Through subsidiaries, Peco acquired its Sebastopol, Mississippi plant in 1995.  Peco and the seller agreed to allocate a $27,150,000 purchase price among 26 asset categories, including:

  • Processing plant building
  • Hatchery real property
  • Waste water treatment plant
  • Furniture and equipment
  • Machinery and equipment

Peco obtained an appraisal in connection with this acquisition. The appraisal listed more than 750 separate assets.

Peco acquired a second plant in Canton, Mississippi for $10,500,000 in 1998. This time Peco and the seller allocated the purchase price across only three asset categories:

  • Land
  • Land improvements
  • Machinery, equipment, furniture and fixtures

Peco obtained an appraisal on Canton after-the-fact. The appraisal included more than 300 separate assets. 

In 1999 Peco hired Moore Stephens Frost (MSF) for a cost segregation study of the two plants.  According to the study, Peco was entitled to additional depreciation expense of $5,258,754 from 1998 through 2002.

            NOTE: I will pass on saying that $5.2 million is not chicken feed.

Peco was now required to alert the IRS that it was changing its depreciation. It was changing what it earlier called a “building” to “machinery” or “equipment” or whatever. It had to attach a form – Form 3115 – to its tax return. Peco explained that it was breaking-out the Sebastopol and Canton depreciation schedules into more categories.

The IRS nixed the whole thing.

Why? There are special rules when someone acquires enough assets of another business to constitute the purchase of that business. This is referred to as an “applicable” asset acquisition, and the seller and buyer have to alert the IRS of how the purchase price is to be allocated. Here is Code Section 1060:

If in connection with an applicable asset acquisition, the transferee and transferor agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, such agreement shall be binding on both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate.

Each party’s argument is straightforward:

IRS:              Taxpayer has to allocate according to the acquisition agreement.

Peco:            No, I don’t because the wording is vague.          

The Court pointed out that the Sebastopol agreement used the phrase “processing plant building.” The inclusion of the word “building” was important. The Court even read the description of “building” from the Merriam Webster College Dictionary.  Equipment inside a building is not the same as the building. Why would Peco use the word “building” if it did not in fact mean a building?

The Court went through the same exercise with the Canton property.

The Court pointed out that – for it to set aside the written agreement – it would have to hold that the language was vague and ambiguous. Problem is, the Court did not think the language was vague or ambiguous at all. The Court observed that Peco had an appraisal prior to entering into one of the contracts, but it saw no need to further detail or reword its asset acquisition schedule. The second schedule was even more restrained, having only three categories. The Court observed that Peco did not seem to have any trouble with its schedules and categories until after it met Moore Stephens Frost (MSF), who clued them in on the advantages of cost segregation. The Court hinted its disapproval over retroactive tax planning, and it decided that it could not determine that the allocation was inappropriate. That meant that Peco was bound by the documents it signed. 

What is the moral of the story? The first of course is the importance of words in tax practice. Sometimes there is no room for “you know what I mean.” This is one of those areas.

The second moral is cynical. Had there been no written allocation of the assets, or even an incomplete allocation, then Peco might have won the case. Why? Because both sides would not have named every dollar in the deal. This would have left unclaimed ground, and Peco could have claimed that ground.

To be fair, the IRS is not keen on cost segregation. It is aware of the cottage industry that has sprung up after Hospital Corporation of America. It is one thing to be tracking the cost breakout as a building is being constructed or renovated. It is another to have an engineer come in and submit “what-if” numbers on an existing building or land improvement. Notice that the IRS did not contest the validity or credibility of MSF’s cost segregation study. All it did was hold Peco to its own (and) earlier cost allocation when it purchased the two businesses. That was enough.

Jun 15

Last Friday I had a meeting with an IRS Appeals officer downtown. Her name is Fran and I like her. I understand that she and I sit on opposite sides of the table, but she does and has done – in my opinion – a fair job balancing the interests of the government and taxpayers.

Fran is retiring this year. Presently there are two people in Cincinnati Appeals. This means that soon there will be one. There are a number of reasons for this, and one is the IRS budget.

I saw this morning that the Senate Appropriations Subcommittee on Financial Services and General Government has marked up an appropriations bill that would increase IRS funding by 6%.

Perhaps I have been at this too long, but I take this as good news. Doing this every day, I have seen the decline of IRS administration. We have talked previously of IRS brain drain and the difficulty of working with their green and inexperienced replacements. We have also pointed out the blizzard of CP notices, which process often doesn’t work well and results in large amounts of wasted taxpayer (and my) time. Trying to settle an issue with ACS sometimes feels like the search for a starting New York Jets quarterback.

IDEA: Don’t issue these notices unless there is enough money to justify the time.

Collections can also do a better job. We have clients who have been laid-off and are now working where they can, perhaps as independent contractors. This creates the problem of making less money but owing more tax. Many times what they do earn is unpredictable. They are uncomfortable agreeing to a fixed monthly payment plan because they do not have reliable cash flow. Collections has a difficult time with a variable payment plan – one fluctuating as one’s income fluctuates. We presently have two of these clients in CDP Appeals.

OBSERVATION: This further increases the workload of Appeals, which will soon be down to one person in Cincinnati.

One of my non-profits received an $8,000 penalty notice for filing their Form 990 untimely. They have reasonable cause, as their bookkeeper became very ill and passed away. The Board did not know what to do, and by the time it came to us the return was late. I feel comfortable that the penalty will be abated. However, does $8,000 – for a small charity – seem reasonable to you?

OBSERVATION: If the penalty is not abated, we will go to Appeals, which again will soon be down to one person in Cincinnati.

On the other hand, I recognize the downside of increased IRS funding. This means they can look at more taxpayers, and I pay taxes too. Hopefully some of it will go to improved staffing and more experienced personnel.

I wish you the best, Fran. Enjoy your retirement.

Jun 12

Here is one of my favorite tax quotes thus far in 2012:

That an accounting firm should so screw up its taxes is the most remarkable feature of the case.”

You can be sure that language isn’t going to make it to the firm’s brochure.

What happened? It started with compensation. There is a CPA firm in Illinois with three senior partners. These partners were making pretty good jack, enough so that they did not want the other partners to know the actual amounts. Considering that they are – you know, a CPA firm – that could be a tall order. So the three senior partners in turn started three other companies.

EXAMPLE: Let’s say you, me, and the guy in the elevator form three companies to hide our good fortunes from our partners. Let’s say company 1 paints and wallpapers CPA offices, company 2 shreds CPA firm files and company 3 provides door-to-door transportation to CPAs during busy season.  We will have our firm “pay” these companies for services and then we will split it up – behind the scenes, of course. Brilliant! What could go wrong?

The firm and tax case is Mulcahy, Pauritsch, Salvador & Co. They had approximately 40 employees and revenues between $5 and $7 million during the years at issue. The firm was organized as a C corporation. This technically made the partners “shareholders,” and the existence of a C corporation allowed for the possibility of dividends. The three shareholders had the following ownership:

                Edward Mulcahy                              26%

                Michael Pauritsch                            26%

                Philip Salvador                                 26%

For the years at issue they received W-2s as follows:                       

                                                              2001                       2002                       2003  

                Mulcahy                           106,175                 103,156                 102,662                    

                Pauritsch                            99,074                   96,376                   95,048                                    

                Salvador                           117,824                 106,376                 112,086

The firm paid consulting fees to the three companies of:  

                2001                                   911,570                

                2002                                   866,143

                2003                                   994,028  

The three companies then paid the three shareholders according to the hours each worked during the year.

The IRS comes in and asks the obvious question: what consulting services were provided?

Back to our example:                

                IRS:  Steve, how many paints and wallpapers did you do?

                Me:  Er, none.              

                IRS:  How many files did you shred?

                You: None.

                IRS:  How many transportation clients did you drive?

                Elevator guy: None.  

Truly folks, it does not require graduate school and years of study and practice in taxation to guess the IRS’ reaction. They disallowed the deduction and said that it was a disguised dividend to the three shareholders.

MPS is upset. If it is not consulting, they argue, then it is compensation.

The IRS says: please show us the W-2, the 1099, anything which indicates that this is compensation. MPS argues that it is “like” compensation. Heck, at the end-of-the-day the three companies paid the shareholders based on their hours worked. Doesn’t that sound like compensation? “Sounds like” is a childhood game, says the IRS, and is not recognized as sound tax planning. Surely MPS would know this, being a CPA firm and all.

MPS goes to Tax Court. MPS argues that its intent was to compensate, therefore the tax consequence should follow its intent. It brought in experts to prove that the shareholders were undercompensated, malnourished and in need of more sunshine. The Court listened to the argument, gave it weight and said the following:              

There is no evidence that the ‘consulting fees’ were compensation for the founding shareholders’ accounting and consulting services. If they had been that—rather than appropriations of corporate income—why the need to conceal them?”

There is an important point here. There is a long-standing tax doctrine that you may select any form and structure you wish for a transaction, but once you do you are bound by that form and structure. The CPA firm was a C corporation and was transacting with its shareholders. A C corporation transacts in one of two ways with its shareholders: as compensation or as dividends/distributions. If the compensation was disallowed, you have the possibility of a dividend.

The Court did try to work with MPS. It noted that two tests for compensation are that (1) it must be reasonable and (2) it must be for services performed. This brought in the “independent investor test” of Exacto Spring, which precedent the Tax Court had used in the past. The idea is easy: what return would you need on your investment to pay someone a certain amount of compensation?

EXAMPLE: A hedge fund manager receives 20% of the fund’s capital gains. This is referred to as the “carry.” Why would an investor agree to this? What if the manager was returning 20% to 30% to you annually – even after deducting his/her 20%? Would you agree to this? Uh, yes.

So the Court looks at MPS’ taxable income for the years at issue:

                2001                                   11,249

                2002                                  (53,271)

                2003                                       -0-

The Court observed that the firm had money invested in its offices, technology, furniture, etc. It noted that – according to normal market expectations – that invested capital required a rate of return. It did not think that taxable income of zero was a reasonable rate of return. The Court was aware that the firm was zeroing-out its taxable income by paying consulting fees. This indicated to the Court that the firm was not concerned with a reasonable return on invested capital. MPS could not meet the Exacto standard. Without meeting that standard, the Court could not weave “compensation” out of “consulting fees” whole cloth. This was an unfortunate result because the firm received no deduction for dividends but the shareholders had to pay taxes on them. That is the double taxation trap of a C corporation. It is also a significant reason why many planners – including me – do not often use C corporations.

Let’s go tax nerd for a moment. I believe that MPS would have substantially prevailed had it deducted the payments as compensation (and included on the W-2) and the IRS in turn argued unreasonable compensation. Why? Because I believe the Court might have disallowed some of the compensation but permitted the rest. MPS instead came from the other direction: it had to argue that the payments were compensation rather than something else. This changed the dynamic, and it now became an all-or-nothing argument. MPS lost the argument and got nothing.

MPS appealed the case but with the same result. It is here that the Seventh Circuit Court of Appeals gave us the quote:

That an accounting firm should so screw up its taxes is the most remarkable feature of the case.”

The taxes were almost $980,000. Remember, the personal service corporation lost its deduction (and paid taxes) and the shareholders received dividends (and paid taxes). The penalties alone exceeded $190,000.

MY TAKE: This tax strategy borders on the unforgivable. There were so many ways to sidestep this result.  One way would have been working with disregarded entities, also known as single-member LLCs. The three shareholders performed services for and received W-2s from the accounting firm. The Court however did not agree that their three companies performed services for the accounting firm. A disregarded entity would have avoided that result by having the member’s activities attributed to the SMLLC.

How could the firm pay entities that provided no services? Was nobody in that tax department paying attention? I presume they were steamrolled by the three senior shareholders.

I was brought up with the technique of draining professional service corporation profit to zero by using year-end bonuses. That technique has frayed over recent years as new doctrines – such as Exacto Spring– have appeared. It is as though these MPS guys were stuck in a time warp.

Another way, and the obvious, would be to have just paid the founding partners more compensation. Yes, that would have given away the amount of actual compensation to the senior partners. Then again, this case has also given away that information.

Jun 07

Joseph Mohamed seems a good sort. He and his wife live in Sacramento, California. He is a successful real estate professional. In 1998 they formed the Joseph Mohamed Sr. and Shirley M. Mohamed Charitable Remainder Unitrust II. Tax pros call this a “CRUT.”

QUESTION: What is a CRUT? This is a special trust involving a charity. You can guess that a purpose of the trust is to make a charitable donation. In a CRUT, an annuity goes to the donor (in this case, Joseph and Shirley) for a period of years. At the expiration of that period, the remainder goes to a charity. In the Mohamed’s case, that period is twenty years. Why would you do that in place of simply donating twenty years out? Because the CRUT allows you to claim the charitable deduction now.

In 2003 and 2004 the Mohameds donated several properties to the CRUT. The properties were worth somewhere between $18 million and $21 million. Joseph Mohamed prepared his own taxes. This means he ran into Form 8283 to report the property donations. He did not read the instructions though, as he did not think he had to. The form seemed straightforward enough.

Form 8283 has several parts. Part 1 Section B required a description of the donated property and “can be completed by the taxpayer and/or appraiser.” It also had the following text:

“If your total art contribution deduction was $20,000 or more you must attach a complete copy of the signed appraisal. See instructions.”  

Mohamed was contributing real estate, not art. He read that to mean that he did not have to attach an appraisal. He did attach all types of statements and documentation to his return, including his own valuation of the real estate.

The return gets audited (who is shocked?). The IRS was displeased that Mohamed had self-valued such a large dollar donation of property. The IRS first goes after the valuation. Makes sense. Mohamed then gets an independent appraisal which shows that the properties are worth more than he claimed.

The IRS then pulls back and realizes something. Regulation 1.170A-13(c) requires the following for donations of this nature and amount:

  1. A qualified appraisal must be made not more than 60 days before the donation and no later than the due date of the return.
  2. It must be signed by a qualified appraiser, who cannot be the donor or person claiming the deduction.
  3. The qualified appraisal must contain defined information, such as a description of the property, its basis and fair market value.

Mohamed had a problem. You see, he did not have a qualified appraisal. That requires an independent appraiser, and he obtained that after the filing of his return. There was of course no signature, as there was no qualified appraisal. While he attached numerous statements to his return, they did not completely address the litany of questions that the IRS wanted in Reg 1.170A-13(c).

The IRS disallowed the donations. Mohamed goes to Tax Court and raises three arguments:

  1. The extreme result indicates that the Regulations are invalid.
  2. The IRS-designed Form 8283 misled him.
  3. He substantially complied with the documentation requirements.

The Court quickly dismissed arguments 1 and 2. It went through an analysis (which we will skip) and concluded that the Regulations were valid and reflected Congressional intent. The IRS, for example, was ordered by Congress to issue Regulations requiring appraisals for donations of property in excess of $5,000. A Regulation that implements Congressional intent is difficult to rule invalid. The Court was sympathetic to argument 2, but it pointed out that the form is not the tax law. The Court even added that “a taxpayer relies on his private interpretation of a tax form at his own risk.”

Now we get to argument 3. What does “substantially comply” mean? There was a previous case (Bond) where the Court found substantial compliance, but succeeding cases have ever compressed the reach of that decision. The Court determined that substantial compliance meant complying with the “essential requirement” of the statute. Problem is, the “essential requirement” of the statute is the need to obtain a qualified appraisal. With that verbal loop, there was no way that Mohamed could substantially comply.

Here is the Court:

We recognize that this result is harsh – a complete denial of charitable deductions to a couple that did not overvalue, and may well have undervalued, their contributions – all reported on forms that even to the Court’s eyes seemed likely to mislead someone who did not read the instructions.”

MY TAKE: I am sympathetic to the Mohameds, but I am also confused. They must have used a tax professional in the past to establish the CRUT. They then make a near-$20 million donation but do not hire a pro to walk it through? It doesn’t make sense to me.

In both Mohamed and Durden there was no question that contributions were made; there were also no question as to the amounts. The taxpayer may have felt comfortable thinking: what are they going to do, put me in jail? No, they won’t put you in jail, but they will take away your charitable deduction. Don’t think that a court will bail you out, as there may be limits to what a court can do.

What is the answer? I would encourage the use of a tax professional if there is even a whiff of a question on your return. I know – it costs money. The problem is that you may not know you have hit a slick spot until after the IRS contacts you. As Mohamed and Durden have shown, that may be too late.