The IRS Overreaches

Posted on May 24, 2007 by Russ

What happens when you receive a Form 1099-MISC, but you never received the income shown on the information return? You don’t include it on your tax return—after all, you didn’t receive the income, so you don’t owe tax on it. But then the IRS sends you a notice saying you do owe tax on the money.

That’s the situation that the Tax Court faced today. A Colorado insurance agent accepted a new client, and assigned the commissions to the client. (Why he would do that is not known, but the evidence in the case showed that the checks from the insurance company were deposited into the clients’ accounts.) The IRS sent a notice to the insurance agent, and the case ended up in Tax Court.

Normally, the petitioner in Tax Court has the burden of proof. However, when the underlying issue is a dispute over an information return (such as a 1099-MISC), and the petitioner cooperates with the IRS (as was the case here), then the burden of proof shifts to the IRS.

That’s very important here, because there was no evidence of any money ending up with the insurance agent. After the IRS admitted that the commissions ended up with the client (it was hard not to admit that, given that the checks were deposited into their bank accounts), they still contended that the insurance agent must have received some income. “Respondent nevertheless determined that petitioner had unreported income, around $2,000 to $3,000, which respondent asserts was the amount petitioner received from Investments for the use of his license in selling the insurance policies that generated the commissions reported by NACOLAH.” (“Investments” is the client and “NACOLAH” is the insurance company.)

There was only one thing missing for the respondent (IRS) to prove their case: any evidence. Without any evidence, the Court ruled for the petitioner. “Accordingly, the Court finds that petitioner is not liable for the 2003 deficiency and section 6662(a) accuracy-related penalty because respondent has failed to satisfy his burden of production with respect to the deficiency and the Form 1099-MISC under section 6201(d).”

Case: Cirbo v. Commissioner, T.C. Summary Opinion 2007-85

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He Gambled and He Lost (In More Ways than One)

Posted on May 23, 2007 by Russ

I’ve repeatedly said that gamblers aren’t treated well under the Tax Code. One Michigan resident allegedly had a way around this problem: just ignore the gambling. This may turn out to be a much bigger problem, as he now faces a 22-count indictment.

Christopher Aaron, of Ortonville, Michigan, faces up to five years at ClubFed plus fines for allegedly filing false tax returns, and giving false social security numbers so currency transaction reports on his wins of over $10,000 wouldn’t be traced to him. Unfortunately for Mr. Aaron, the government got wind of his scheme. And when the unreported gambling income totals $3 million, the government pays attention.

His attorney notes that Mr. Aaron was an overall loser, so he doesn’t really owe any tax. Well, as someone who has prepared more than a few tax returns for gamblers, I can almost guarantee that his tax return would change if it had the gambling accurately stated. This is especially true if Mr. Aaron is an amateur (unable to net his wins and losses) because Michigan does not allow gambling losses on its state income tax. So while Mr. Aaron’s federal tax return numbers might not change, his state income tax return would likely change. You can read more about this case here.

There is a moral to this story (besides the bad treatment of gamblers under the Tax Code). It’s much better (and cheaper, considering the attorney fees that Mr. Aaron will likely incur) to prepare your tax returns correctly than to attempt to cheat the system.

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A Big Case for the Supreme Court Later this Year

Posted on May 21, 2007 by Russ

The Supreme Court doesn’t decide many tax cases. They’re usually not that interesting, and it’s rare to see a split among the different circuits in a tax issue. However, a very important tax case will be decided in the next Supreme Court term (beginning in October): Department of Revenue v. Davis.

In 2006 the Kentucky Court of Appeals (the Kentucky Supreme Court declined to hear the case) held that, “…[W]e find that Kentucky’s tax on the income derived from bonds issued outside Kentucky violates the Commerce Clause of the United States Constitution, we vacate and remand.”

Why is this important? If you live in a state with a state income tax, and you own municipal bonds issued by your state, you do not pay income tax on those bonds. However, if you own bonds issued by another state you almost certainly do pay income tax on those bonds. The Kentucky ruling says that’s illegal—it violates the dormant commerce clause of the U.S. Constitution.

To no one’s surprise, the National Association of State Treasurers doesn’t like this ruling; they will be filing an amicus brief on the case. The Kentucky Department of Revenue doesn’t like the ruling; it will cost the state money. Indeed, high tax states (and Kentucky is not one of those) like this ruling even less. If the Court of Appeals ruling is upheld, bonds issued by high tax states (such as California) will need to pay a higher interest rate, costing the states money.

The case will be heard late this year; a decision isn’t likely to be announced until early 2008. If you own municipal bonds from a state other than your own, pay attention to the decision. If you paid enough tax from these bonds and the ruling is upheld by the Supreme Court, you may be able to amend your state tax return seeking a refund of tax.

The TaxProfBlog has more on this case, and you can find news stories at Bloomberg and elsewhere.

Hat Tip: TaxProfBlog

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A Dose of Fraud to End the Week

Posted on May 17, 2007 by Russ

The fraudsters have been active in the tax realm this week. We’ve got stories from across the country.

We’ll start in Youngstown, Ohio, where Ronald Wells had an idea of how to increase his $1/hour pay as a prisoner at the Trumbell County (Ohio) prison—he’d have friends file 35 phony tax returns with the IRS. This cost us taxpayers over $236,000 in refunds that the IRS paid out. Wells, no matter how long he’s sentenced for, won’t be going anywhere soon; he’s now serving a sentence for aggravated murder in the Grafton (Ohio) Correctional Institution.

Heading just east, from Pittsburgh comes the story of the family that’s accused of committing fraud together. James Lloyd is serving time at the Fayette County (Pennsylvania) Prison, his wife Elizabeth, and their daughter Naomi Malone are all accused of filing a false tax return, and getting $14,700. These first two stories are not the first time we’ve seen inmates accused of committing tax fraud.

Yet another Gentleman’s Club owner has found himself in trouble. Ronald Heidel, of Sanibel, Florida, will find himself at ClubFed for 18 months after underreporting income at his Gentleman’s Gold Club by $1.3 million. He also must make restitution of $130,000 and pay a $30,000 fine. I almost forgot to mention that Heidel is a former IRS agent.

The owners of a casino boat-to-nowhere will no longer be heading to sea but, instead, will be heading up the river to ClubFed. Samuel Gray and his wife Marilyn were each convicted on 18 counts of tax fraud and 4 counts of mail fraud. Samuel Gray was also found guilty of six counts of money laundering and receiving embezzled funds. We first wrote about this story in 2005 when the owner of a bank who was embezzling money managed to invest with another individual committing fraud. Samuel Gray faces a decade at ClubFed; his wife is looking at about 4 years.

Heading further south to Miami, we find a businessman who had an almost-perfect method to having his personal expenses paid by his business. David Traina set up a consulting firm. No problem with that. He was the only employee. That’s fine. He paid personal expenses out of his business and took deductions for them. That’s not good, and it’s worse when the IRS finds out. And when you avoid $70,000 in taxes, that’s a lot of veterinary bills. Mr. Traina has agreed to make restitution but may also find himself at ClubFed for a short stay.

We’ve written about the La Shish restaurants on two occasions. Elfat El Aouar received 18 months at ClubFed in her part of the tax fraud that cost the government $6.9 million in taxes. Her husband, Talal Chahine, is still a fugitive from justice and is believed to be in Lebanon. The IRS may end up owning the La Shish restaurants—liens have been filed to protect the government’s claims.

Heading to the Northwest, Laura Cook, the wife of convicted “tax guru” Wade Cook, pleaded guilty to obstruction of justice. Ms. Cook admitted that she created phony documents to evade $9.4 million in taxes. Under the plea agreement, the government will recommend 15 months at ClubFed.

That’s a lot of fraud, but somehow I figure to be able to bring up another list of cases next week.

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What If a Casino Decides to Ignore the Rules?

Posted on May 17, 2007 by Russ

Suppose you’re a poker player, and you are backed (sponsored) by a friend. You’ve agreed with your friend that for the money that he has given you, you will give him 50% of your winnings. You complete the IRS Form that has been created for this exact situation (Form 5754), enter a poker tournament, play well and win a prize. As you are ready to receive your prize, the casino asks for your social security number so that they can issue you a Form W-2G). You give them the Form 5754 and the casino tells you, “Sorry, we only issue the W-2Gs to the recipient. You are responsible for the tax situation for your win.”

Well, that exact situation will be facing entrants into this year’s World Series of Poker held at the Rio Hotel & Casino in Las Vegas and run by Harrah’s. I was told yesterday by the Assistant Tournament Director that while the casino will have copies of Form 5754 at the Cashier’s Cage, they will issue the W-2Gs and prize winnings only to the actual winner of a prize.

For the professional gambler who is backed, this is only an inconvenience. His accountant can, at year-end, create W-2Gs to correctly appropriate the winnings. However, for the amateur player this could be a lot more than an inconvenience.

The amateur gambler is now on the hook for the taxes on winnings that aren’t his. It’s even possible that the gambler will have to pay taxes on “phantom” winnings. Say that the gambler won $5000, but $2500 of it belongs to someone else. During the remainder of 2007, the gambler has losses of $3000. If the gambler completes his tax return without making any adjustments, he’ll show $5000 of winnings on line 21 (Other Income) and $3000 of an itemized deduction on Schedule A—he’ll pay tax on $2000 of income that he didn’t earn! And if our “lucky” gambler happens to reside in a state that doesn’t allow gambling losses, he’ll pay state tax on the full $5000!

I received an inquiry today asking,

“We have a small group of players who put up equal shares of money to create a pool sufficient to pay for a main event entry. We give the winner of a private tourney 50% of the equity in any win (and the right to play with the group’s money) and the remainder is divided evenly between the rest of us. In the past, we have provided them with a Form 5754 that spelled out the various equity holders and received individual W-2Gs from Harrahs.

What is the correct way for us to handle this in the future? Should the winner issue 1099-MISC or W-2Gs to the stakeholders? What if the winner was a net loser in gambling for the year prior to the win at the WSOP? Can he still write off the payments to his backers or can he only do that to extent of his winnings, like a gambling loss.

Besides lobbying Harrah’s to change the rules (and perhaps complaining to Nevada gaming regulators, there’s little you will be able to do to change this policy. But I think there are ways for the amateur gambler to still appropriate his winnings, should he be lucky enough to cash at the World Series of Poker.

First, make sure your syndicate/backing agreement is in writing. It should be signed and dated by all participants before the event(s) that the gambler will play in. You may even want to get the document notarized to prove that it was signed and dated before the event.

I would still before the actual event complete Form 5754, and bring it with you to the casino. Harrah’s is supposed to obey the rules (and that includes paying people based on what’s on Form 5754). When you cash, bring the Form 5754 to the Cashier. Harrah’s will likely tell you that they won’t look at it and that it’s your responsibility to do the taxes. You have two choices at that time. You should have a witness at the cage who can swear that Harrah’s refused to honor the Form 5754.

You could at that time call the Enforcement Division of the Nevada Gaming Commission/State Control Board (their Las Vegas phone number is (702) 486-2020). Based on information I have from various gamblers, it’s very doubtful that the NGC will do anything about this problem. And since Harrah’s has the right to refuse entrance into any other tournament should you criticize the World Series of Poker, you risk not being able to play in anything else ever again at the WSOP if you choose this path. But it is available; one of the responsibilities of the Enforcement Division is to “arbitrate disputes between patrons and licensees.”

Alternatively, the winner accepts the W-2G. When he returns home, he gives his accountant the correct payout information (the Form 5754). The accountant then splits his winnings: his share remains as gambling winnings (line 21); the portion belonging to others is moved to a Schedule C as receipts (income) (and the accountant or the winner mails checks to the other participants). The accountant issues W-2Gs (or Form 1099-MISC’s) to the other participants; the total of these are listed as expenses. The net income from this “business” is zero (so there’s no self-employment tax owed).

NOTE (Added in 2013): Based on how the IRS handles W-2Gs from individuals, individuals should issue Form 1099-MISC’s, not Form W-2G’s.

The accountant should attach an explanation to the return explaining exactly what was done and why; I would file a paper return and not file electronically.

This should pass muster with the IRS because the income is being moved to the individuals who really received the income. This is what the law requires—individuals are supposed to pay tax on their income, not the income of others.

For the record, I believe that Harrah’s is required to issue W-2Gs as per a correctly submitted Form 5754. Nevertheless, I’m not surprised at all by Harrah’s new rule. In 2006, Harrah’s would only follow Form 5754 if the other recipients were physically present (this is not a requirement of Form 5754); I had to send out W-2Gs for clients impacted by that rule. Unfortunately, it will take Nevada regulators and/or the IRS complaining to Harrah’s for this bad policy to change.

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Partially Up In Smoke

Posted on May 15, 2007 by Russ

The Tax Court today looked into whether a non-profit corporation that provides help to the terminally ill and provides medical marijuana to the terminally ill is allowed to deduct its operating costs.

The non-profit, Californians Helping to Alleviate Medical Problems, Inc., was a San Francisco based corporation that helped the terminally ill. In its view, as a secondary service the provided medical marijuana to their patients; in the view of the IRS, it was intertwined with its other goal—and the non-profit only had one line of business.

A few tax facts first. If you are in an illegal occupation or you sell illegal or illicit drugs, you must report the income from your occupation; illegal income is just as taxable as legal income. Medical marijuana is in a curious category; under California law, properly prescribed medical marijuana is a legal line of business. However, for federal purposes marijuana—even marijuana legally prescribed—is considered a Schedule I controlled substance for tax purposes. And §280(E) of the Code prohibits deductions or credits for trafficking in controlled substances (Schedule I or II).

The IRS did not dispute the actual amounts of the expenses. So the Tax Court was left with two questions to answer: (1) Could the non-profit deduct expenses related to the distribution of medical marijuana; and (2) Could the non-profit deduct the expenses related to providing care for the terminally ill or were the two lines of business one?

The Court held

“…that section 280E does not preclude petitioner from deducting expenses attributable to a trade or business other than that of illegal trafficking in controlled substances simply because petitioner also is involved in the trafficking in a controlled substance…We define and apply the gerund “trafficking” by reference to the verb “traffic”, which as relevant herein denotes “to engage in commercial activity: buy and sell regularly”. Webster’s Third New International Dictionary 2423 (2002). Petitioner’s supplying of medical marijuana to its members is within that definition in that petitioner regularly bought and sold the marijuana, such sales occurring when petitioner distributed the medical marijuana to its members in exchange for part of their membership fees.”

The Court then turned to the second question: Was there one line of business or two?

“Petitioner was regularly and extensively involved in the provision of caregiving services, and those services are substantially different from petitioner’s provision of medical marijuana. By conducting its recurring discussion groups, regularly distributing food and hygiene supplies, advertising and making available the services of personal counselors, coordinating social events and field trips, hosting educational classes, and providing other social services, petitioner’s caregiving business stood on its own, separate and apart from petitioner’s provision of medical marijuana.”

The Court then held that the expenses will be allocated, and the expenses allocated to the caregiving will be allowed but the expenses allocated to medical marijuana will not be allowed.

Thus, for federal tax purposes, even if you legally supply medical marijuana, you can’t deduct related expenses. However, if you have another line of business, those expenses are deductible. Note that it is very likely that the expenses related to medical marijuana are deductible on the California tax return.

Case: Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. No. 104

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Some Good News for California…But Will the Legislature Spend the Money?

Posted on May 14, 2007 by Russ

State tax collections in April have exceeded projections, a pleasant change for California fiscal authorities. As of April 19th, the Central Valley Business Times reported that California has a $1.9 billion surplus compared to a $1 billion deficit in January. The big question: Will the Legislature and Governor reduce California’s structural deficit or will it be spend, spend, spend (as usual)?

California requires a balanced budget, and a budget passed by June 30th. The latter has rarely happened in the last few years; the former has happened through gimmicks and the movement of funds rather than fixing California’s structural deficit.

Governor Schwarzenegger has said,

“I have an obligation, which is a promise to the people of California that I will bring down this structural deficit to zero, and that we will be fiscally responsible. So there is two choices: one is to create extra revenue through all the various different means that I have proposed, or the other one is to go and start making those cuts.”

The Governator released his new budget today, and the structural deficit is still around at $1.4 billion. And that’s before the Legislature gets their hands on the budget.

The news story from the Associated Press indicates that no one is happy with the budget. Democratic Assembly Speaker Fabian Nunez (D-Los Angeles) is upset with the cuts to social programs. Assembly Minority Leader Dick Ackerman (R-Tustin) wants more cuts so that the state isn’t running a structural deficit.

The budget requires a 2/3 vote to pass meaning that Republicans must consent. I think the spending cuts in social programs are d.o.a. and we’ll see yet another year with magical movement of money so that everyone can announce that the budget is balanced…but where the structural deficit increases. I hope I’m wrong but I doubt it.

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Why I Haven’t Been Covering the Conrad Black Trial

Posted on May 14, 2007 by Russ

Because Mark Steyn is.

You haven’t hear of Mark Steyn? You haven’t read Mark Steyn? His daily column is available on his web site. His column is carried by many newspapers, including the Orange County Register. He appears weekly on Hugh Hewitt’s radio show every Wednesday. And he’s a much better writer than I am.

Macleans magazine, the Canadian newsweekly, is paying Mark Steyn to write a blog on the Conrad Black trial. It’s extremely entertaining, and quite worth reading.

So if you want a Conrad Black fix, go to Mark Steyn’s Macleans Conrad Black blog.

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Holy Housing in Los Angeles?

Posted on May 12, 2007 by Russ

Back in 2005, I reported on the Orange County Sewage District’s hiring of a spiritual counselor. The idea of spiritual sewage made me laugh…at least, I’m not in the OCSD so the tax dollars didn’t come out of my pockets. I couldn’t imagine any other government agency in California repeating the OCSD’s mistake.

I should never overestimate the intelligence of bureaucrats.

The Los Angeles Times reported today that the Los Angeles Housing Department has paid over $18,800 to a Hawaii Zen Buddhist priest. According to the story, Norma Wong has conducted management training, “…that includes teaching breathing with sphincter control, learning ‘how to stand’ and playing with wooden sticks.”

Of course private industry sometimes does things like this. I’ve seen and participated in outdoors training, team-building exercises, etc. in my career in private industry. However, I’ve never done stick exercises.

Residents of the City of Los Angeles will be happy to know that the L.A. City Council has approved a new contract with Ms. Wong for $15,000. Your tax dollars at work….

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Tax & Spend Doesn’t Have to Happen

Posted on May 12, 2007 by Russ

The Presidential election in still 18 months away, but campaigning is in full swing. I haven’t decided who I’m going to vote for, but I have decided on one candidate I won’t vote for.

Former Senator John Edwards (D-NC) is offering a lot of policy proposals. Unfortunately, when you spend money, you’ve got to get it from somewhere. Edwards’ proposals appear to cost at least $1 Trillion. Edwards is also against continuing the Bush tax cuts, and is for increasing tax rates except for the lower class. Given that most of the income tax paid in the United States comes from the middle and upper class, that means that you and I will be seeing more of our money go for a big bureaucracy should Mr. Edwards be elected President.

Meanwhile, CNN correspondent Jack Cafferty reported that, “John Edwards says he worked for a hedge fund primarily to learn more about financial markets and their relationship to poverty. Do you see any contradiction there?”

I notice that Professor Bainbridge saw the same things that I did. I don’t know if he saw the news from Illinois, though.

Governor Blagojevich proposed a huge business tax—a gross receipts tax that would have cost Illinois businesses $7.6 billion. Now, if that tax had passed who do you think would have paid it in the long-run? Consumers, of course; taxes get passed on. As Joe Kristan reported this morning, the tax didn’t pass…it was a “missed it by that much” moment: it failed 0 to 107.

If you’re a politician, you may want to look at what happened in Illinois and apply it to your next race. Taxes aren’t popular. There’s a perception that government is bloated, and, imho, there’s at least an element of truth in that. Taxpayers want lower taxes and tax simplification. Politicians who want to win elections should take this message to heart.

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