Taxable Talk

You get what you pay for, or so the cliche goes. The Tax Court today looked at a case where a husband and wife had two “businesses” and used tax software to prepare their returns. As Joe Kristan of Roth Tax Updates reported, the businesses were probably just methods of spending their own money. The Tax Court didn’t like that. The Cost of Good Sold that they claimed were for mainly personal expenses. That didn’t sit well either. So they lost their case.

But the IRS also asked for a negligence penalty. As the Tax Court noted, “‘Negligence’ includes any failure to make a reasonable attempt to comply with the provisions…[of the Internal Revenue Code], and the term ‘disregard’ includes any careless, reckless, or intentional disregard.” So the taxpayers blamed the software they used. The negligence penalty stood up.

There’s a lesson here. Tax software does a great job putting what you enter on the correct lines. If you have a simple tax return, say just a W-2, a 1099-INT from your bank, and no other deductions, software will do a great job.

But software doesn’t do some things. It doesn’t ask you if the deductions you’re entering in are reasonable. It doesn’t ask you if that medical insurance premium you’re entering in as an Insurance expense for your S-Corporation should be entered in on that line. It probably won’t tell you where the best place is (on your return) to take a certain deduction, or why it might be better not to take that deduction. As Roth Tax Updates said, garbage in, garbage out.

Case: Maxfield v. Commissioner, T.C. Summary 2006-27

When the first lines of a Tax Court decision read,

Tax records are the ancient Egyptians of the modern age–plagued not by boils, frogs, flies, and lice but by fire, flood, mold, and theft. The cursed tax records in this case belonged to Raleigh Cox, who owned a business that fixed used cars and then resold them.

You know you must peruse the entire case. And, indeed, it’s a great decision well worth reading. Mr. Cox operated a business, but his records were stolen by an ex-employee. His accountant managed to mangle his cost of goods sold three times. Then there was the issue of cash payments made to his largest supplier (Concord) (by writing checks out to himself or his wife and then using the cash to pay his supplier). As the Court noted, “It’s easy to see why the Commissioner questioned Cox’s claim that he routinely made cash purchases….”

Normally the absence of documentation dooms a case. Here, however, Mr. Cox was able to (at trial) credibly explain that a former prisoner he hired likely stole the records. Adding to the problems, his accountant died in the middle of the audit by the IRS.

But Mr. Cox was lucky. The Court stated,

“And what written evidence exists supports Cox’s story. He had kept the general ledger for Washington Car upstairs at his shop, and [his new accountant] and he got copies from the bank of the statements that had been stolen. Our close side-by-side scrutiny of those statements and the general ledger shows that the ledger reasonably matches the statements for those purchases Cox made from Concord by check…Cox also insisted the owners of Concord give him receipts, and he kept them too–fortunately not stuffing them into the missing duffel bag. Those receipts also match–not perfectly, but in more than enough instances for us to believe that the ledger and remaining records are legitimate.”

There’s much more in this decision about an unfortunate taxpayer. A warning, though, for those who dispute the need for documentation: If you have all the documentation, and can prove the numbers on your tax return, you’re very unlikely to have to go to Tax Court (or lose in an audit situation).

Case: Cox v. Commissioner, T.C. Memo 2005-288

The joy of frivolity. Having fun at the expense of others (playing practical jokes, for example) can give yourself a good laugh. However, it is not a good idea to do it in Tax Court.

As noted in Roth Tax Updates, Glen Silver filed a petition in Tax Court in regards to his 2001 and 2002 returns (which he did not file). In Tax Court, he “…did not raise any bona fide dispute….” This was his third try in Tax Court, and he had been fined $3,000 for his frivolous arguments on his last attempt. He had also been warned, “[The Court] urge[s] him to reconsider any positions he takes that may result in an increase in penalties for making similar arguments in that case when it’s called next year about this time.”

He didn’t reconsider his positions. No surprise, he was fined $25,000.

And the Court noted that he is trying a fourth time in Tax Court, in a petition likely to be heard in 2006. The Court warned Mr. Silver, “…if he pursues the same arguments in that case, he may expect an additional penalty under section 6673.”

Case: Silver v. Commissioner, T.C. Memo 2005-281

We’ve said it before, and we’ll continue to say it: Save your paperwork, receipts, etc. If you’re ever audited by the IRS, you need documentation. If you have it, things (usually) will go well; if not, expect a battle.

Yesterday the Tax Court decided a basis case regarding an inherited portion of a home. The taxpayers became owners of 1/3 of a house after the 1/3 owner left the home. The owners then sold the home. The only question for the court to decide was the basis of the home for tax purposes.

Basis questions can be quite complex. In general, your basis in your home is the price you paid for the home, plus costs involved in purchasing the home, plus costs for selling the home and related legal expenses (including defending the title), and plus any capital improvements you made in the home. Capital improvements are major repairs such as a new roof or new carpeting; replacing one shingle is a minor repair. And, as always, you must document the improvements.

Unfortunately, the petitioners had no paperwork documenting any of the improvements (which were done by the prior 1/3 owner). Because one of the petitioners is a CPA, the Tax Court stated, “…should have known that such improvements should have been documented if, as petitioners contend, the expenditures constituted capital expenditures….” The petitioners, as a consolation prize, were allowed to deduct $5,000 in legal expenses that the court inferred were expended.

Case: Bettencourt v. Commissioner, T.C. Summary 2005-175

Is a “Contract for Deed” deductible when used to satisfy alimony obligations? The Tax Court today said no.

Contract for Deed’s are financing arrangements that allow buyers to purchase property from sellers by borrowing the money from the sellers. The Tax Code only allows deductions for alimony for cash or cash equivalents (e.g. checks). The court ruled that a Contract for Deed is a debt instrument and cannot be deducted as alimony.

In the same case, the petitioner also lost his arguments for deducting Bed & Breakfast expenses and writing expenses because of lack of books and documentation. We cannot emphasize enough that you need to keep your backup paperwork. Have good books (or hire a good bookkeeper).

Case: Lofstrom v. Commissioner, 125 T.C. No. 13

What happens if you receive your W-2 and your company made a mistake on your social security number and it’s off by one digit? Being an unscrupulous individual, you sense opportunity! “I don’t have to report my wages from my employer! The IRS won’t be able to match up the wages!”

Of course, when the IRS receives the wage information (forwarded by the Social Security Administration), they’ll notice the mistake and send a letter to the employer. The employer will then check their records, and fix the error (or let the IRS know that their records match the data sent).

So what happens to the employee who doesn’t file? Problems, of course.

First, you did receive the W-2. Second, whether or not you receive a W-2, you are required to file your tax return each year. In fact, there’s even a form for you to use if you don’t get a W-2, Form 4852. And third, if you don’t file, sooner or later the IRS will catch up with you. There is no statute of limitations if you don’t file.

Today the Tax Court decided a case where the petitioner claimed he filed, but the IRS couldn’t find a record of his filing under his social security number, the incorrect SSN used by his employer, or his spouse’s SSN. The numbers didn’t make sense, either. And there was no record of him filing a state tax return. The Tax Court didn’t believe him. And he didn’t spend the $4.42 on certified mail, return receipt requested to prove he mailed his returns.

The court found him liable for his taxes, penalties for failure to file, and failure to make timely estimated payments. In the future, he might just let his employer know about the error and file his returns.

Case: Zakhem v. Commissioner, T.C. Summary 2005-171

Sometimes all you can do is laugh. And most likely Judge Powell, who decided today’s case, was laughing quite a bit.

The case involved taxpayers disputing the assessment of a penalty for the untimely filing of their tax return. Just one problem: the return was timely filed and the IRS did not assess such a penalty. Rather, the IRS assessed penalties for failure to pay estimated taxes and for failure to pay tax. As the judge noted, “It is sufficient to say that these are separate additions to tax for different actions.”

Case: Goldman v. Commissioner, T.C. Summary 2005-165

The Tax Court delivered a trick on Halloween to these taxpayers. They operated a timber operation (perhaps), accounting services (although the husband was “…suspended from practice before the Internal Revenue Service since 1981”), real estate (although the wife asked, “[please] don’t issue me a 1099”), and they sort of used leased employees. It was ugly….

The taxpayers formed an S Corporation, or tried to. They filed the paperwork, but they specified that their “natural business year” ended in January. The IRS didn’t approve, so the S Corporation was never really formed. Although I’m only slightly cynical, might the taxpayers involved tried January so that they could defer tax payments for eleven months? But I digress.

As the Tax Court noted, “An election of a corporation to be an S corporation under sections 1361(a) and 1362(a)(1) must be complete, properly filed, and made in accordance with regulations….” The taxpayers took flow-through losses which the IRS challenged. They didn’t substantiate them in court. Strike one.

The taxpayers claimed they weren’t subject to the self-employment tax. But they weren’t employees and received payments for services. Strike two.

Finally, they claimed that they paid out about $18,000 for “leased employees.” But the Tax Court noted that the money came from the taxpayers personal services. That doesn’t sound like leased employees to me, and it didn’t to the Tax Court. Strike three.

We could throw in strike four and more for labor expenses that paperwork shows happened in 2000 but were deducted in 2001, and interest expenses without backup, and repair expenses without backup. The Tax Court threw in accuracy related penalties for the taxpayers’ strike-out. (“Petitioners make no argument and offered no evidence to show that they had reasonable cause.”)

Case: Arnold, et. al., v. Commissioner