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.

Thursday, May 31, 2012

Returning soon...

We'll be back from our tax season hiatus very soon. Until then, please enjoy this apropos Monty Python video re: Accountancy!

Tuesday, February 14, 2012

The ‘Have a Heart’ Case

A taxpayer successfully made a case that the IRS collections agent had abused her discretion in not adequately factoring into her assessment of his offer in compromise request that the taxpayer: was diagnosed with a brain tumor; his doctors had urged that the tumor be surgically removed and he had no health insurance; he had no significant assets and had been denied charity care, and that he continued to have health problems which limited his ability to earn money.

Take aways:

• The court stated that: “The settlement officer’s approach is difficult to square with the applicable administrative guidelines” which specifically permit officers to make allowances for special circumstances such as serious health conditions.

• The IRS agent did not dispute the existence of the health problems. Her log indicates that in calculating petitioner’s ability to pay, she took his health condition into account by allowing him a $200 monthly allowance for health insurance (even though he had none) “due to his medical condition.” (If only! $200/mon won’t cover health insurance, much less brain surgery!)

• The Court remanded the case to the Appeals Office for further consideration and clarification and instructed them to consider any new collection alternative that petitioner may wish to propose.

Friday, February 10, 2012

The ‘The I in IRA Stands for Individual’ Case

Taxpayer was denied an AGI adjustment for a $5000 contribution to his IRA. he was phased out for a deductible IRA contribution due to their AGI and the fact that he participated in a work sponsored retirement plan. Taxpayer thought an IRA in his name naming his spouse as the beneficiary was the same thing as a spousal IRA – an IRA in the name of the spouse (who did not participate at work). He argued the IRS was partially to blame because they did not issue the deficiency notice in time for him to correct his error. He was told that ignorance of the law is no excuse for not complying.

Take aways:

• That would have to have been one lightening fast deficiency notice because IRA contributions but be made by the due date of the return NOT including extensions.

• Losing an adjustment to arrive at AGI can have an impact on your itemized deductions and eligibility for various credits thereby costing you far more than just the disallowed deduction times your tax rate.

Thursday, February 9, 2012

The 'Oops - My Bad' Case

Taxpayer was denied the dependency exemption, head of household status, EIC, and CTC for her son. The boys father had also (appropriately) claimed him as a dependent in this year. A new custody agreement gave the father primary custody, she acknowledged he lived with his father all year, and the support agreement required her to provide only 20% of her son’s support in this year making it amply clear that she did not provide 50% of his support. Apparently, she had just prepared her tax return in the same manner she had prior to relinquishing custody. I am not sure how she got all the way to take court before realizing she did not have a leg to stand on.

Take aways:

• In cases such as this, the custodial parent may execute a Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents to allow the other parent the dependency exemption if so desired.

• If all the requirements are met, a child may qualify you for HOH status even if you are allowing the other parent the dependency exemption.

Wednesday, February 8, 2012

The ‘Mi Casa no es Su Casa’ Case

Taxpayers were denied a first time homebuyer credit because they had an ownership interest in a principal residence within 3 years of the date they acquired the new house. (This preceded the long term homeowner credit.) They sold their former residence on 6/6/07 and purchased their new residence on 7/28/09/ They listed the former residence for sale in February of 2006 and claimed that at that point they began to reside with Mrs. Foster’s parents ergo the former residence ceased being their principal residence as of that point.

Take aways:

• Whether or not a dwelling is the principal residence of a TP is relevant for a number of tax laws and the IRS considers all facts and circumstances to make these determinations. Whatever they determine, it will be 100% one way or the other. In other words, nothing is pro-rated – you either totally win or totally lose.

• In this case, between February 2006 and June of 2007: Mrs. Foster renewed her State-issued driver’s license which set forth the old house address; provided the former home address on their joint Federal income tax return; maintained utility services at the house; frequently stayed overnight and hosted family holiday gatherings at the house; kept all their personal belongings at the house; accessed the Internet at the house; and received bills and correspondence at the house. Additionally they did not pay rent or contribute toward household expenses at the alternate purported dwelling. All factors that weighed against them.

Tuesday, February 7, 2012

The ‘Less Indignation and More Substantiation’ Case

Taxpayer unsuccessfully fought the disallowance of considerable per diem payments/expenditures. Taxpayers operated a trucking co and paid drivers per diem for meals, motels, and other expenses. Sioux calculated per diem amounts on the basis of the number of travel days. Those amounts were recorded in payroll books that indicated travel dates but not destinations.

Take aways:

• The per diem method is an allowed method for calculating these types of deductible reimbursements. The rates are set by the IRS annually and vary by destination. There is a standard and high cost of living allowance. Recording the location of the travel would be important. The TP must still retain records substantiating that expenses were incurred.

• Taxpayer first stated that they failed to provide the records because there would be hundreds of thousands of them but then changed the story and testified that the records had been destroyed in a flood caused by a broken pipe in the storage unit. (They waited nearly 6 years to raise the issue of the destroyed records.)

• When records are destroyed or lost due to circumstances beyond TP control, TP is generally allowed to substantiate his deductions by reasonable reconstruction of his expenditures. A taxpayer is required to try to salvage or reconstruct what he can.

• TP presented no credible evidence, for example, of how many drivers they had, how long on average they were away from home, or what per diem amount was used. Based on the type of business one would imagine the expenses were legit but TP was completely fixated on proving they shouldn’t have to substantiate the costs.

Monday, February 6, 2012

The ‘Wrong on SO Many Levels’ Case

Taxpayer was found ineligible for: dependency exemptions, head of household status, earned income credit, AND additional child tax credit. Children claimed were the grandchild and nephew of TP’s wife. On the bright side, he did prevail in reducing the assessment for unreported unemployment benefits by showing he did not actually receive the amount reported on the 1099-G. The state recouped some money he defrauded them out of in a past year by garnishing his benefits in the questioned year but they never adjusted the amount reported on his 1099-G for those debits.

Take aways:

• If a taxpayer asserts a reasonable dispute with respect to any item of income reported on a third-party information return and he has fully cooperated with the IRS, the IRS will have the burden of persuasion.

• TP provided documents from the state that showed what he actually received. There is no legal basis for including in income for 2009 amounts that were “denied” to petitioner in 2009 because of overpayments in at least 1 year before.

• Taxpayer might have been entitled to at least the dependency exemption if the children lived with him all year, they were not dependents of someone else, and he provided over one-half of their support but he offered no evidence to that effect.

• The first test for determining if you are eligible for head of household status is that you can’t be married as of the close of the tax year. Taxpayer was married.

• In order to be eligible for EIC you must file a joint tax return. In this case, the combined income on a joint return would have been too high to qualify for EIC.

• In some cases a TP would qualify for regular child tax credit but be unable to benefit from it due to a lack of tax liability. To mitigate this situation, the nonrefundable portion of the CTC may be replaced with the refundable ACTC for TPs within a certain income bracket. As you might guess, this TP was eligible for neither regular CTC nor additional CTC.

Thursday, February 2, 2012

The 'Interest-ed Broker' Case


Taxpayer received a $500k sum of money from his employer, in 1998. The employer deemed this a loan which would be forgiven if taxpayer stayed employed with the company for five years. Taxpayer included the forgiven loan and accrued interest on his tax return in the year forgiven (since it was in his W2) however sought to exclude the accrued interest portion from income upon being audited and assessed taxes related to other, unrelated tax positions he had adopted on his return.

Take aways:

• The courts noted that the facts agreed to by both the taxpayer and the IRSwere in just plain wrong with respect to the law because payments such as this (forgiveness taking place in part for each year of services as an employee) have been deemed to be recognizable each year and not all at the end, however, since the IRS didn’t try to make that case they let it slide.

• The court took administrative notice that the taxpayer and his employer executed a legal agreement but didn’t follow it’s provisions. The agreement didn’t weigh for or against taxpayer but if it had supported his argument that would have been nullified by the fact that TP himself had disregarded it.

• The law does not require realization in income of discharge from indebtedness to the extent such liability would give rise to a tax deduction so if the TP could prove that he would have been able to deduct the interest he would not have to recognize it.

• TP was a stockbroker and argued that the loan was to allow him to acquire a securities portfolio with which he could showcase his skills. He claimed that the money was used for this purpose and therefore should be deductible as an ordinary and necessary cost incurred in the production of income. Unfortunately all he did was point to all the stocks he purchased right after receiving the money and did not enter into evidence any bank statments or other proof that they were purchased with the loan money specifically.

• The court found that even if TP had offered proof that the money was used for the purchase of the portfolio, such interest would be deemed investment interest and therefore only deductible to the extent of invest income. As luck would have it, TP had no investment income in that year. (It does carry forward for deduction in future years but the court did not seem to think that caused the interest to be called deductible. I would tend to disagree but the TP did not argue this point.)

• Investment interest is interest on monies use to acquire property held for investment. Property is held for investment if it produces income in the form of interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business (i.e., portfolio income).

• I wonder if the IRS would have questioned it if he had reported the interest as investment interest to begin with, enabling its use in future years? Taxpayers may elect to offset dividends and capital gains with investment interest expense carry-forwards even though those types of income are currently taxes at lower rates. He would likely have obtained the benefits at some point, given his large stock portfolio and career.

Tuesday, January 31, 2012

The 'On...and Off the Road Again' Case


The code allows for a credit of highway taxes on fuel purchased for off road business use. Taxpayer used highway-legal vehicles that had been modified to become more heavy duty to haul belly-dump trailers for off-road work in the course of their business. The vehicles would travel from job to job around the country on highways, however, taxpayers did keep meticulous records regarding which mileage was on and which was off highway. In cases of mixed use they claimed no credit for any fuel taxes, just to be safe.

Take aways:

• The taxpayers asked the court to consider the truck and trailer together as one vehicle, however, each could still perform their function if attached to another so they were deemed separate. Only the truck part could be evaluated since the trailers on their own can’t consume fuel.

• The code does not consider as off-highway fuel used in a “highway vehicle” that’s registered, or that should be registered, for highway use with an exception for vehicles that has been redesigned for the primary function of transporting a particular load off-highway or which redesigned features substantially limit or impair the transport of such over the public highways.

• When considering the design, only the physical characteristics of the vehicle may be considered – how the vehicle was actually used is immaterial. The fact that a vehicle may be incredibly inefficient on the highway vs. off does not rise to the level of substantial impairment. That would require a vehicle to be too heavy, too high, or too wide for regular use. Also considered are whether such vehicle is subject to the licensing, safety, and other requirements applicable to highway vehicles, and whether such vehicle can transport a load at a sustained speed of at least 25 miles per hour

• The court found that while the vehicles had indeed been customized to be more heavy-duty they were not customized for use to haul one particular material and that while they were modified to be used off-highway, they were not modified to such an extent that they were not still able to be used on-highway.

Friday, January 27, 2012

The 'I wouldn't know what I was looking at' Case


A complicated case with very little that would be relevant to our clients. I did like that the court noted that taxpayer should not blame the preparer when ‘a cursory review of the return should have revealed errors. Even if all data is furnished to the preparer, the taxpayer still has a duty to read the return.’ TP’s regularly comment that they would not know what they were looking at when we ask them to look over a return before we finalize it, however, if you know your salary is around $100k and the wages box reads $30k then please question it! This is the type of thing we are asking you to look for.

It is common for clients to accumulate all tax forms they receive in an envelope which they eventually drop off to us, often without ever looking inside! I recommend first going through the paperwork and comparing it with the organizer we send out to make sure that you did receive everything. This is especially important if you have recently changed addresses. Commonly missing forms are: first year/last year mortgage forms when a refi or HELOC occurred, interest/dividends earned on new bank accounts/investments, 1099-R forms in first year of pension/distribution or for an early withdraw form an IRA/QRP, SS in the first year, W-2/1099, one-off individual stock sales forms for short-term or temp work.

Thursday, January 26, 2012

The 'Guilt by Association' Case


The IRS was able to assess a company’s in-house accountant who was NOT an owner for the unpaid payroll taxes of the company because he; (1) had signature authority on the bank account, (2) signed payroll checks, (3) signed the employment tax returns, and (4) signed checks in payment to other creditors while the employment taxes for those periods remained unpaid. The owner of the company maintained a lavish lifestyle for some period of time but eventually faces bankruptcy and prison and therefore seemed permanently incapable of paying the taxes. The accountant met the definition of a responsible party and therefore could be required to pay them even though he did NOT personally financially benefit and the IRS believed that he was only following the instructions of his employer in order to preserve his job.

Take aways

• The law is clear that any responsible party may be held liable for unpaid payroll taxes. Whenever possible, refuse to be a signed on payroll checks and/or reports for entities you do not own.

• The trust fund penalty amounts to the FICA taxes withheld from employee pay plus related fines. These monies are considered held in trust.

• This is why, even though it may seem cold-hearted, we disengage from clients who we know are not paying their payroll taxes unless they are pursuing/adhering to a payment plan and paying their current patrol taxes in a timely manner.

Wednesday, January 25, 2012

The 'Renter of my Rental is Me' Case


Taxpayer’s income from a commercial rental was recharacterized as active and was not available to be offset by passive losses. This recharacterization was upheld under the self-rent exception to the rule that rental activities are by definition passive activities. (Taxpayer rented the property to his wholly owned corp.)

Take aways:

• Taxpayer had a generic lease but the rents did not correlate to this lease and in some years the rent deducted on the corp did not match the gross rental income reported on the TP’s personal return.

• Because petitioner materially participated in the business activity of the tenant, the self-rental rule would appear to apply. It is a pretty cut and dry case.

• TP relied on the advice and counsel of a paid preparer with a suitable level of knowledge for determining how to characterize the income and therefore were able to avoid the accuracy-related penalty.

Tuesday, January 24, 2012

The 'Just Horsing Around'' Case


Anyone running a business that is something others may list as a hobby can learn a lot from this case! An endeavor (breeding Welch ponies and cobs) that taxpayer’s treated as a business was found to be a ‘an activity not engaged in for profit’ (a.k.a a hobby) and therefore 5 years of losses were disallowed. The court ruled that they were enthusiasts not bona-fide breeders. Taxpayer’s lone sale of a horse in this 5 year period was to a not-for-profit for $500 and they took a charitable contribution of $5000 which they claimed was the remaining value. Expenses were substantial. Over a 10 year time period they claimed almost $840k in losses.

Take aways:

• To prove profit motive, “the goal must be to realize a profit on the entire operation, which presupposes not only future net earnings but also sufficient net earnings to recoup the losses which have meanwhile been sustained.” This throws cold water on the theory that a couple of profitable years will evidence a profit motive in spite of a number of loss years.

• Taxpayers conceded that their research showed that in order to become profitable as horse breeders, given the high boarding costs, they would need to own a facility. Yet, they continued to acquire more horses while incurring very substantial annual losses, suggesting “an indifference to those losses that we are unable to reconcile with an actual and honest objective of making a profit.”

• Activities that have a clear recreational aspect are likely to draw IRS attention when reported as businesses with repeated losses.

• Taxpayers listed a dog on the depreciation schedule and $1100+ in dog expenses. This was cited as evidence of how loosey-goosey the taxpayers were in relation to keeping their personal and business expenditures segregated. They also used a standard pro-ration of 80/20 for everything indicating that everything was estimated.

• The court pointed out that the purpose of keeping business records is not only to “memorialize transactions for tax reporting purposes.” Rather, bona fide business people use these records to help them improve the performance of the business over time. This is part of what is considered when determining whether or not a profit motive exists.

• Someone who is really in the business of breeding horses would keep records about each horse and these taxpayer’s did not. Additionally, although some appreciation of horses was possible, it is inconceivable that they might be enough to recoup the cumulative losses since the start of the business.

• There have been cases where horse ownership was deemed a hobby even when the horses were boarded by the taxpayers.

• Although taxpayers utilized a paid preparer, the court noted that there was no evidence that they either sought or relied on his advice in relation to the appropriateness of their treatment of this activity as a business. (Both seeking and relying on advice of a competent professional are required for any hope of avoiding the accuracy-related penalty on these grounds.)

• Taxpayers depreciated the horses, further negating their claim that they were held for sale. Inventory/stock in trade is not depreciable.

Monday, January 23, 2012

The 'who killed your chances to deduct these losses' Case


Taxpayers were denied six-figure losses from a ranch they owned because they were not active participants in the business venture. They had spent some minimal time on phone calls and had visited the ranch a number of times throughout the year. These visits were deemed to be recreational in nature.(I.e bringing the children, hosting clients/employees of his primary business, etc.) The ranch was in Colorado and they lived in Minnesota. The ranching operation employed a full-time, onsite ranch manager and the court had a copy of the job description which stated he was in charge of all ranch operations.

Take aways:

• Taxpayers needed to establish through meeting one of several tests to prove that they were actively involved in the business in order for the loss to be an ordinary loss which could be used to offset ordinary income. Passive losses can only offset passive income. Passive activities would include rentals and businesses in which the taxpayer does not participate.

• Taxpayer failed to prove that they had spent 500 hours on Stirrup Ranch activities, they engaged in regular, continuous, and substantial activities relating to Stirrup Ranch, or that they materially participated in the activities of Stirrup Ranch.

• Despite claiming to make all the decisions, spend countless hours on phone calls with the ranch manager, and work ‘dawn to dusk’ while at the ranch they did not enter into evidence a log, diary, calendar, or any other record.

• Activities such as (1) studying and reviewing financial statements or reports on operations; (2) preparing or compiling summaries or analysis of the finances or operations of the activity for the individual’s own use; and (3) monitoring the finances or operations of the activity in a nonmanagerial capacity would not count toward time participating in running the business. Those are activities of an investor.

• Taxpayer owned a successful company at which he earned about 6mil/yr. The case made administrative note of the fact that he used that company’s private plane to fly to the ranch. (One wonders if he properly accounted for this personal use!) This served as further evidence that while on trips to the ranch he was conducting his primary business and not ranch business.

• The tax preparer was an attorney, a CPA, and a former IRS agent. The court noted that ‘he should have known better, particularly if he was shown no more evidence and documentation than was shown to us.’ Because of their reliance on his advice they were not hit with the accuracy related penalty. (He also should have known better than to let them go to tax court with no evidence!)

Sunday, January 22, 2012

The ‘Split the Difference’ Case
Taxpayer was an established landlord who owned 6 actively rented properties. In one year he acquired 3 additional properties to rent but wound up selling them before the year was out without ever renting them. He wound up at odds with the IRS because he claimed to be real estate professional eligible to deduct passive losses against ordinary income and because the IRS asserted that the gain on the sale of the 3 never-rented properties was a capital gain not eligible to be netted against passive losses from the operation of the rented properties.

Take aways:

• Taxpayer had an unrelated full-time job which always makes it difficult to prove RE professional status since one of the points to prove is that you spent the majority of your business-related time on the rental business. For those who are rusty at math, this means if you work 2000 hours a year at something else, you need to prove 2001 hours spent on being a landlord.

• The court noted that to carry the burden of proof re: the above point “requires more than a post-event ballpark guesstimate of time committed to participation in a rental activity” and that “his subjective estimate suffers from a lack of contemporaneous verification by records or other evidence.” Really? You show up at tax court empty-handed?

• The Court ruled against the IRS deeming the purchase/sale of the 3 never-rented properties part of the same passive real estate activity as the rental properties thereby allowing the taxpayer to net the proceeds from the sales against the rental losses. TP was able to successfully convince the court that his primary intent when he acquired these properties was to rehab and rent them.

• It is interesting that the IRS tried to characterize these transactions as capital. One wonders whether they would have taken this approach had the properties been held for longer than 1 year prior to the sale, thus making the gains eligible for taxation at a reduced rate.

Saturday, January 21, 2012

The ‘Double Negative’ Case

In this case the taxpayer tried to deduct as a business loss the income he expected to receive but did not receive. His description on the return was: “Cost; Refunded + no income. Bankrupt.” Even though this description made me chuckle, I have to admit that it is not uncommon for people to believe fervently that forfeited or lost income is or should be deductible. For example, performing services (for which they normally charge a fee) for free for a charity. Sometimes the client will list the value of the service with their contributions for their personal returns. I can understand why the tax court felt compelled to explain the same rule 6 ways from Sunday because I am always left with the feeling that, no matter how I explain it, the client is still not buying into the concept.

Take aways:

• Business bad debt deductions for uncollected receivables only apply to accrual based taxpayers because they have recognized income at invoicing. Cash basis taxpayers don’t recognize income until the payment is received. If income is not received it is simply never recognized. You can’t deduct it again as a loss.

• Likewise if you perform a service for free you don’t have to report income for it – period – that’s it - the end

Friday, January 20, 2012

The ‘Any Means ANY’ Case

Taxpayers were both active participants in their employers’ retirement plans yet spouse also made a $5000 IRA contributions and deducted it on the tax return. In fairness, spouse had only contributed approx $200 to employer’s plan. Taxpayer’s income precluded the deductibility of the IRA contribution under the circumstances. Taxpayer tried to claim the $200 as taxable in order to obtain the $5k deduction.

Take aways

• If an employee makes “a voluntary or mandatory contribution to an employer pension plan such employee is an active participant in the plan for the taxable year in which such contribution is made.” Even de minimis participation is sufficient to render a taxpayer an active participant.

• This is another case where taxpayer tried to utilize his/her own rationale vs. the tax laws. The Court must enforce the laws as written and interpreted. “While the result to petitioner seems harsh, we cannot ignore the plain language of the statute and, in effect, rewrite this statute to achieve what would appear to be an equitable result.”

Thursday, January 19, 2012

The ‘Getting the @#$% of the Stick’ Case

The TP definitely gets my sympathy in this case. She attempted to cancel a whole life policy by sending a letter but instead of cancelling, the insurer started loaning the TP the money to pay the premiums because the policy had cash value. After 20 years of this, the insurer seized the cash value to pay off the premium loan. Part of the surrendered cash value was a return of the taxpayer’s own money but part was accrued interest. The interest portion became taxable income when this event occurred. The TP never received the 1099 because the insurance company did not have a current address so she owed not only tax on money she never received (because it was used to pay premiums) but also owed penalties and interest.

Take aways:

• The TP was deemed to have received the interest income and then used it to pay the insurance premiums (a nondeductible personal expense). If the policy had been cancelled in 1988 she would have had taxable income in that year – but also the cash

• Perhaps we need some legislation that prohibits insurance policies from containing automatic loan clauses which enable them to start attaching the cash value as collateral for premium loans without any further paperwork. Until that day – buyer beware. The TP should have followed up and ensured the policy was indeed cancelled.

Wednesday, January 18, 2012

The ‘Relationships Count’ Case

The taxpayer claimed his cousin’s two minor children as dependents for head of household status, exemptions, child tax credit, and earned income credit even though they did not reside with him for the ENTIRE year.

Take aways:

• Unless the children bear one of the relationships to the taxpayer specified by code they must live with the taxpayer ALL year (among other criteria) in order to qualify dependents

• Note: Even when children qualify as dependents, CTC and EIC may be disallowed because the tests for these credits are different than the dependency tests

Tuesday, January 17, 2012

The ‘What is Mine is Yours’ Case

The taxpayer followed the advice of an attorney and organized his dental practice as an LLC with himself, the only generator or revenue, as a 1% owner and another LLC as 99% owner. The 2nd LLC was owned by the taxpayer’s children. In this manner the taxpayer sought to take advantage of the children’s lower tax rates and avoid self-employment taxes.

Take aways:

• Under the assignment of income doctrine, taxpayers may not shift their tax liability by merely assigning income that the taxpayer earned to someone else

• Business entities must have economic substance other than the avoidance of taxes. The 2nd LLC did nothing other than own the 1st LLC which creates a problem.

• If the children were able to perform some service for the business the taxpayer could have employed them and they would have been exempt from FICA charges so some income would have legally transferred to them – of course not hundreds of thousands of dollars of income….

Monday, January 16, 2012

The ‘It’s all Residential’ Case

This court stems from a state issue that is becoming more and more common. Normally unearned income is only taxed in the state of your primary domicile. A number of taxpayers from New York who also have homes in other states (with lower tax rates) attempt to attribute this income to the state where their second home is located. The extent of one’s presence in a state dictates whether or not one is a resident or nonresident. Taxpayers can’t just pick whichever state they prefer. NYS has become more and more aggressive about getting their pound of flesh. In this case the taxpayers reported significant capital gains on a SC return and NY successfully proved they should have been reported on a NY return. Taxpayers were within the time limit to obtain a refund from SC. The federal part of the issue was that the taxpayers did not report the approx $3500 interest the received from SC on the refunds. The taxpayer’s rationale was that they paid approx $7500 in interest to NY so the 2 should be offset.

Take aways:

• You can; apply your own logic to these situations! There has to actually be some legal support for your position.

• The tax code has always treated interest paid and interest received quite differently. All interest income is taxable unless a code section specifically excludes it. Interest paid is only deductible where the code specifies.

Sunday, January 15, 2012

The ‘Woulda, Shoulda, Coulda #1’ Case

Barely into 2012 and we already see vehicle deductions being disallowed. This is a no brainer folks – keep a log or don’t bother fighting the deficiency notice! TP who clearly drove his automobile a substantial number of miles as part of his employment (as a traveling sales person) was denied $19k of unreimbursed employee expenses deductions. Although he provided some contemporaneous records regarding his automobile expenses, they were insufficient to substantiate the number of miles driven and when and where he drove for business. He provided no documentation regarding his meals and entertainment expenses or his nonautomobile expenses and failed to establish the portion of his home which was devoted to his employment.

Take Aways:

• It is a common misconception that if you deduct actual vehicle expenses, it is not necessary to keep a mileage log. This is absolutely incorrect. Another misconception is that if you incorporate you no longer need to keep a mileage log – also incorrect. If you have vehicle use deductions you must have a log: date, business miles driven, and business purpose for the driving - every day (even if it is always the same) plus start and end odometer readings for the year to calculate total miles.

• Use of office in home is so uncommon for an employee that it is often not worth the increased scrutiny to claim this deduction. Against schedule C income, the home office saves SE as well as income tax but not so when taken on a 2106.

Saturday, January 14, 2012

The ‘I'm in Love with the Sound of My Own Theory’ Case

Taxpayer unsuccessfully fought the full inclusion of dividends in his taxable income under his self-developed “return of capital” theory. (A theory that the court deemed “without statutory basis” by the way.) TP claimed that a portion of the purchase price represented “accrued dividends” that had accumulated since the last record date. In TP’s view, these portions are treated as “returns of capital” and are not be includable in gross income.

Take Aways:

• Under TP’s theory he would have had to painstakingly reduce his basis in these shares by the part of the purchase price he recaptured through designating a portion of dividends as tax free returns of capital. This would result in higher taxable gains down the line when the shares were sold.

• What a surprise that his return was self-prepared!

• There is ample guidance on who recognizes dividends so it is sort of odd that he spent Lord knows how much time calculating accrued dividends and no time researching code. It is not as though this is a rare situation!

Friday, January 13, 2012

The ‘Close but no Cigar’ Case

The taxpayer was denied a deduction for the $19k of travel and meals expenses he claimed on a schedule C for the trade of being an author. TP had no experience working as an author, had not yet published a book, had a full-time W-2 position in a completely different field, and had no income from the trade in that year. The expenses were incurred on a 4 month worldwide trip he claimed was solely for book research. Although he had a business plan and kept a journal, all the facts and circumstances are considered and he did not meet the burden of proof. (He did dodge the accuracy penalty because he relied on the counsel of a CPA to whom had given all the information.)

Take Aways

• TP would need to prove he intended to earn a profit from the activity, that he was regularly and actively involved with the activity, and that the activity had commenced.

• Since the majority of the expenses were for travel and meals, TP was obligated to strict substantiation – no estimates allowed. A sweeping statement that ‘all’ the travel was for business would not fly. TP must establish the business purposes of EACH expenditure and substantiate it by a written statement.

• In general, any expenditures incurred before your business activity commences must be capitalized as start up expenses, although this was not mentioned in the case. Also, high expenses on a zero income schedule C create a red flag - especially T/E expenses.

• The checklist to prove profit motive for an endeavor contains many factors. It sounds as though TP had the checklist and he complied with a few line items but it was all very contrived.

Thursday, January 12, 2012

The ‘I’m from the Govt and I’m here to help’ Case

TP conveyed an easement to 501(c)3 conservation fund. Generally the difference between the value of the property with the easement vs. without the easement constitutes a charitable deduction for the conveyor. TP is permanently sacrificing that value even though they still own the property. (Note that this is an exception to the general rule that only the contribution of an enitre interest will qualify as a charitable contribution.) It is normal for the contribution deductions resulting from conservation easements to be in the hundreds of thousands of dollars and so one should expect increased IRS scrutiny. In this instance the transaction failed as a matter of law because the contract contained the following wording:

Extinguishment – If circumstances arise in the future such that render the purpose of this Conservation Easement impossible to accomplish, this Conservation Easement can be terminated or extinguished, whether in whole or in part, by judicial proceedings, or by mutual written agreement of both parties, provided no other parties will be impacted and no laws or regulations are violated by such termination.

This ran afoul of the following parts of the code which provide for the ability to obtain a charitable contribution:

“A contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.” And “interest in the property retained by the donor ** * must be subject to legally enforceable restrictions * * * that will prevent uses of the retained interest inconsistent with the conservation purposes of the donation.”

This case is a bit scary because one would assume the conservation 501(c)3 attorneys would have drafted an appropriate contract. You know the contributors were not the ones to write the contract.

Take aways:

• The court ruled that the remoteness of the likelihood of this clause ever being exercised was neither here nor there as far as the outcome of this case was concerned.

• TP argued that the gift constituted the creation of a charitable trust. The court noted that State law determines the nature of the property rights, and Federal law determines the appropriate tax treatment of those rights. There was no evidence to indicate that their State considered contributions to conservation easements to be de facto trusts. Nor was there any language in the conservation easement deeds to evidence either the creation of a trust or the intention to create a trust.

• Pay a CPA and a tax attorney dummy! I had a call once from a farmer seeking an appointment to discuss the tax treatment of conservation easements. He refused to come in unless the consult would be free. Really? Trust me when I tell you, screwing this up may be life changing. It is worth the money to get professional advice.

• In the future I will require that clients in this situation retain a tax attorney to review the contract and issue an opinion letter re: the legitimacy of the charitable contribution prior to preparing the return – or even better before they sign the contract so the recipient can be made to change the wording. (My opinion is that CPAs should not be interpreting contracts. That is a legal service.)

Wednesday, January 11, 2012

The ‘Columbian Laundry-ing?’ Case

Taxpayers were assessed a deficiency on the total disallowance of all $134k of cost of good sold expenses claimed against $161k of income because they did not keep adequate records. Taxpayers’ business was to buy clothing in the US and export it to Columbia.

Take Aways:

• The IRS filed the notice of deficiency about 2 years after the return was filed so just because you file a return and don’t hear anything for awhile, it is not correct to assume everything is copasetic.

• The court found TP’s receipts bad evidence because they: did not indicate which purchases of clothing were for export and which purchases were for the Gaitans’ personal use; in some cases, were illegible/did not clearly identify the purchaser, or had been deducted on their other schedule C. (If you are a retailer, it is probably best to show some withdraw of inventory for personal use vs. none at all.)

• The court would not admit credit card statement evidence because she was without the supporting receipts or other evidence corroborating that the purchases reflected on the American Express statements were purchases of business inventory. In addition, some months were missing which may have reflected credits/refunds. (We regularly advise our clients that they need to retain the actual merchant receipt – not just the statement. That is like having cancelled checks with no record of the invoices you paid.)

• The court would have been able to estimate all but vehicle expense if she had brought more to the table. She did not even have evidence of any clothes being shipped out of the US. (Husband owned a car wash by the way. Hmmm…Saul from Breaking Bad is coming to mind here…)

• The TP also lost the much smaller deduction for travel because she failed to prove that the trips were PRIMARILY for business. Many people think if they do any business on a trip it is deductible, but the burden of proof (for within the contiguous US) is the PRIMARY purpose. There can be many purposes but only one PRIMARY purpose.

Tuesday, January 10, 2012

The ‘Of All People’ Case

Was there a full moon on 1/3? Taxpayers were assessed the deficiency plus the extra penalty for drastic understatement because they failed to keep adequate records and properly substantiate the flight lesson expenses they claimed. The taxpayers were a couple that included a highly compensated CPA employed by a corporation AND a 20 year financial planner/commercial realtor with an MBA. They claimed that A) they did not know they needed to keep receipts for business deductions and B) their tax preparer told them they did not need to keep receipts. They should be ashamed of themselves! The court noted humorously that they were “skeptical” of their “alleged” lack of knowledge. Tee hee.

Take Aways:

• This is why CPA firms must now require an engagement letter in order to prepare a tax return. You’d think that a couple with these credentials would not try to dishonestly throw you under the bus to save a few thou but, sadly, this is the world we live in currently!

• To deduct education costs the course must maintain or improve your skill for your current position only. The court was not convinced that pilot skills go hand in hand with being a commercial realtor. Even though the TP did submit evidence that he used aerial photos in sales brochures he created, the court noted that he was able to obtain these in the past without actually needing to know how to pilot a plane. Doh! (They admitted he did not make an effort to persuade them so who knows what would have happened if he had?)

Monday, January 9, 2012

The ‘Not a Leg to Stand On’ Case

I cannot fathom why the taxpayer went to court. He filed three schedule C forms, one with less than $2k of income and lots of mileage, one with zero income and almost $70k of expenses including $12k of vehicle deductions. He was just asking to be audited. The court noted that he introduced “no evidence of any sales efforts that could lead to customers” and “no credible evidence to substantiate that the claimed expenditures were ordinary and necessary to his business, or showing that they even exist.” He lost and was also assessed the additional penalty for significantly understating his tax liability without reasonable cause.

Take Aways:

• TP claimed that his records were destroyed by fire. If someone is able to materially reconstruct the vast majority of their records after a bona fide tragic occurrence the court would fill in the rest but in most cases the taxpayers just arrogantly say – “Sorry I don’t have anything – it was all destroyed” Trust me, this has been tried before. You have got to pull out all the stops to reconstruct your records to the very best of your ability if they are lost in a fire.

• A schedule C with no income and lots of mileage is a big audit risk.