Friday, August 3, 2012

The "Don't look a gift horse in the mouth' Case

The taxpayer received a $100,000 wrongful termination settlement and elected not to include it in her income, relying on a section of the code that provides an exclusion from gross income for “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.”

The settlement didn’t specifically state it was for lost wages and was reported via a 1099 not a W-2 so the court couldn’t completely rule out the possibility that she was compensated for physical sickness arising from being terminated. The overarching rule when it comes to settlements is that gross income means all income from whatever source derived unless excluded by a specific provision of the Code. In order for damages to be excludable from gross income the taxpayer must demonstrate that:

(1) the underlying cause of action is based upon tort or tort type rights and
(2) the damages were received on account of personal injuries that are physical or a sickness that is physical.

Damages received for emotional distress are includable in gross income unless such emotional distress rises to the level of a physical sickness. Congress delineated symptoms indicative of the presence of a physical sickness in the code thereby establishing that not every physical symptom will indicate a physical sickness. Past cases provide a list of symptoms that indicate emotional distress.

Of the eight symptoms that petitioners testified to at trial, five of the symptoms were very similar to the list of emotional distress symptoms in the legislative history and not similar to the list of physical sickness symptoms provided by Congress. She also provided no evidence other than her word regarding these symptoms. The court ruled she suffered from emotional distress and not from a physical sickness.

The code does allow an exclusion from income of the amount of damages received on account of emotional distress to the extent of the amount paid for medical care, however, the taxpayer in this case did not submit into evidence and record of expenditures for medical care and therefore was not entitled to exclude any of the settlement from income.

Thursday, August 2, 2012

The 'Epic Fail!' Case

This case provides several examples of what not to do! The taxpayers deducted 30,000 miles (even) as a business expense on a schedule with no income or other deductions because they claimed that during their commute to their full time jobs they also looked at houses (from the outside only) that they might consider purchasing, fixing up, and reselling for a profit. They kept no mileage log or record of which houses they looked at and never actually made any appointments to see the interior of any house - much less any offers to buy houses or actual purchases of real estate.

The taxpayers were dead in the water and never should have pursued this in tax court. Commuting miles cannot be deducted even if you do something sort of like business along the way. Costs of investigating an idea to start a business/buy real estate are not deductible if you don’t wind up starting the business/acquiring the real estate. Beyond that, you must be able to prove the existence of a profit motive for any endeavor to rise to the level of a business thus enabling the deduction of related expenses.

Wednesday, August 1, 2012

The 'there is support and there is alimony' Case

A taxpayer was assessed due to having claimed $44,700 in payments made his spouse pursuant to temporary orders during the pre-divorce separation period. The orders did not specify the character of these payments as alimony or as not alimony, however, they did include wording close enough to running afoul of item B below to cause the tax court to deny alimony treatment of these payments. In my opinion, the divorce attorneys should have done a better job of making sure the payments would qualify as alimony. Depending on a person's tax rate, he or she may be better off paying more in support and obtaining a tax deduction. The recipient spouse may be at a much lower tax rate and therefore likewise better off because he/she will receive more after tax money than she would have if it were not treated as alimony.

Example: If the payee has a fed/state tax rate of 33% then a deductible $4000 payment would really cost $2680 after taxes. Assuming the recipient spouse has a fed/state tax rate of 21% this $4000 is worth $3160 after taxes. Both parties are better off with this arrangement than with a $3000 payment that is not deductible to the payee. Win win!

Unallocated family support payments are deductible as alimony or separate maintenance only if all four of the above conjunctive requirements are met

(A) such payment is received by (or on behalf of) a spouse under a divorce or separation instrument,

(B) the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income of the recipient and/or not allowable as a deduction to the payee,

(C) in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the recipient spouse are not members of the same household at the time such payment is made, and

(D) there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.

Wednesday, July 25, 2012

The 'Don't Tell Me, Show Me' Case

This case illustrates how important it is for business owners to:

A) Have a separate business/farm bank account

B) Make sure all business income and expenses run through this account

C) Reconcile deposits in this bank account with the gross income reported on the farm or business schedule

For partnerships and corps this process is a requirement to avoid negligence. It is an important practice even if you are a sole proprietor or single-member LLC.

The Court points out that: "A bank deposit is prima facie evidence of income and respondent (IRS is the respondent in tax court) need not prove a likely source of that income."

Deposits may exceed income for many reasons, including:

1. Line of credit draws

2. Credit card advances

3. Personal cash infusions

4. Transfers between bank accts

5. Redeposits of returned items

6. Repayments of loans/advances to others

It is the taxpayers responsibility to prove that any deposit is not income. It is best to gather this proof annually before memories fade. In this case the taxpayer told the court why his deposits were higher but provided absolutely no evidence to back up his verbal testimony.

The court's response: "We found his testimony about the deposits into petitioner’s bank accounts that remain at issue to be general, conclusory, uncorroborated, and self-serving. We are not required to, and we shall not, rely on that testimony. Petitioner (taxpayer is the petitioner in tax court) has failed to carry his burden."

Wednesday, July 18, 2012

The 'Form over Substance' case

In this case we see the IRS proactively disallowing exemptions and other child related credits/deductions for the noncustodial parent due to his failure to attach form 8832.

In my personal experience this has only occurred in situations where both (divorced) parents claimed the same children in one year but perhaps this case is an omen of things to come. The taxpayer might have done a number on himself by unwisely and unnecessarily attaching a copy of his divorce decree to his tax return. The decree stated he was not the custodial parent (ergo: should have attached an 8832), something the IRS would otherwise have had no way of knowing. Self-preparing can be costly!

The internal revenue code states in a nutshell that the custodial parent is entitled to the exemption unless such person relinquishes the exemption in writing via form 8832, or a statement in the divorce decree with VERY specific wording. In cases of joint custody, the custodial parent is the person who the children stayed with for one more day of the year – not the person named as the custodial parent in the divorce decree. (Keep a detailed calendar!)

Yes, I am saying that the divorce decree drafted by your $300+/hour atty which states you get to ‘take the kids’ on your tax return in odd years is likely not worth the paper it is written on, for this purpose. I have almost never seen a decree that would hold up to IRS scrutiny. This is why a consult with a CPA is very important as a part of any divorce. Your best bet is to demand a signed 8832 form as a condition of the divorce. It can specify multiple years. Alternatively the statement in your decree:

Must be an unconditional release of the custodial parent’s claim to the child as a dependent for the year or years for which the declaration is effective. A declaration is not unconditional if the custodial parent’s release of the right to claim the child as a dependent requires the satisfaction of any condition, including the noncustodial parent’s meeting of an obligation such as the payment of support. A written declaration must name the noncustodial parent to whom the exemption is released. A written declaration must specify the year or years for which it is effective. A written declaration that specifies all future years is treated as specifying the first taxable year after the taxable year of execution and all subsequent taxable years.

Tuesday, July 17, 2012

The 'An employee by any other name...' Case

The IRS correctly reclassified a farm owner's 'subcontractors' as employees. Worker misclassification is supposedly a new focus of both the IRS and many states but their strong words still ring as more of an idle threat due to seemingly little enforcement. Since more misclassification is expected with the onset of new health insurance mandates in 2013 for employers with 50+ full-time employees, perhaps there will be more follow through.

In this case the taxpayer was placed on the hook for the not only the employment taxes but also for failure to file penalties for not having filed employment tax related forms. This additional, significant level of penalties would not apply as long as a taxpayer had him/herself as an employee (in the case of a corp) or had at least one employee so that forms were filed.

The workers in question worked solely for the taxpayer, for a lengthy period of time, for a fixed rate of pay using tools/equipment that she provided. The work they did was integral to the taxpayer's daily business and there was nothing in place to impede her ability to either control their work or to discharge them.

Summarized below are some of the key factors which come to bear on these cases. The IRS/court considers all of the facts and circumstances of each case, and no single factor is determinative.

(1) the degree of control exercised by the principal; the degree of control necessary to find employment status varies with the nature of the services provided by the worker. the principal need not actually direct or control the manner in which the services are performed; it is sufficient if the principal has the right to do so;

(2) which party invests in the work facilities used by the worker;

(3) the opportunity of the individual for profit or loss; a salary-like nature of pay and lack of entrepreneurial risk or opportunity would indicate employment;

(4) whether the principal can discharge the individual; employers typically have the right to terminate employees at will; lack of evidence of any limitation on this right indicates employment;

(5) whether the work is part of the principal’s regular business;

(6) the permanency of the relationship; and

(7) the relationship the parties believed they were creating.

Monday, July 16, 2012

The 'Cheaper to keep her?' Case

The taxpayer in this case was denied a deduction for a $20,000 lump sum of 'alimony' paid in settlement of all future alimony obligations. Unfortunately, when he drafted the settlement contract he neither referenced the appropriate clauses of the original agreement nor included a clause that the $20,000 would not need to be paid if his former spouse died within the short period of time between the signing of the settlement agreement and the paying of the $20,000. In order to be considered alimony, payments must cease at the death of the recipient. That is the way the law is written and the tax court had no alternative but to rule against the taxpayer in this instance. I find that attorneys working divorce cases often fail to consider what is necessary to preserve the most advantageous tax situation for their clients when drafting various agreements. It is worth consulting with a CPA as a part of the divorce.

The taxpayer's bad luck with attorneys continued in that his attorney at tax court did not even offer a reasonable cause defense in response to the additional accuracy related penalty the IRS had assessed. This penalty comes in to play when your income is significantly understated. It is based on percentages so if your income is not that high it doesn't take that large of an error to incur this penalty.