Taxable Talk

I can’t, but Joe Kristan of Roth Tax Updates has the story of yet another interesting case from the Tax Court today. If your business is grossing $2.5 million to $3 million each year, and you’re paying about $45,000 in federal and state taxes each year, and a new tax preparer says he can lower your taxes to almost nothing, be sure to ask how he’s going to accomplish that magical feat. And if you later discover your tax preparer is in Leavenworth, well, perhaps you’ve figured out how the magic is done. You can find all the gory details here.

A few years ago, there were two Tax Court cases resolved by closing agreements (a closing agreement is a settlement agreement of the case): God’s Helping Hands Living Estate Plan Trust, John M. & Thelma Smoll, Trustees v. Commissioner, docket No. 8468-01, and John M. & Thelma Smoll, Trustees v. Commissioner, docket No. 8489-01. These cases looked at whether the Trust should be recognized for tax purposes. The closing agreements stated, among other things, that the Trust would not be recognized for tax purposes and that the taxpayers would report their taxes for those years and all future years.

You’re way ahead of me. Of course they didn’t do that, or I wouldn’t be writing this. In 2000 and 2001 the taxpayers used the trust (after signing an agreement that said they wouldn’t do that). In 1999, 2002, and 2003 they didn’t file returns (at least they didn’t use the trust).

So not only do the taxpayers owe the tax, and interest, the IRS asserted that they committed willful fraud. As the Court noted,

“At trial and by facts deemed stipulated, respondent established by clear and convincing evidence that petitioners understated their 2000 and 2001 Federal income tax with the intent to commit fraud and that petitioner failed to file his 1999, 2002, and 2003 returns with the same intent…Petitioners have a pattern of failing to file tax returns and understating their income when they do file income tax returns. Petitioners also failed to maintain adequate records or cooperate with respondent, and they consistently provided respondent’s representatives with implausible or inconsistent explanations for their behavior.”

The Court went on, noting that the actions demonstrated that they deliberately and willfully committed fraud.

There’s a moral to this story. If you sign a closing agreement with the IRS, you had better follow it, because they’ll be watching you.

Case: Smoll v. Commissioner, T.C. Memo 2006-157

Assume that you’re going on permanent disability. You and your employer reach an agreement, with payments structured as though they were from workers compensation (nontaxable to the recipient). Suddenly, your employer backs out and threatens litigation—litigation that would likely take years to resolve. But your employer offers you a “nonindustrial disability retirement,” with payments that are based on age and length of service. Your employer and an IRS representative tell you that the payments aren’t taxable, so you decide to take the settlement.

Just one problem: You get a notice from the IRS saying that the nonindustrial disability retirement money is taxable.

That’s what brought Steven Diem to Tax Court today. He was employed as a fireman for San Francisco. He’s retired, and on his Form 1040 he deducted the payments of $16,617 (for the year in question) as “nontaxable pension in lieu of workers comp.”

Unfortunately for Mr. Diem, the law is settled in this area. As the Court noted, Section 1.104-1(b), Income Tax Regs., states, in part:

“Section 104(a)(1) excludes from gross income amounts which are received by an employee under a workmen’s compensation act * * * or under a statute in the nature of a workmen’s compensation act which provides compensation to employees for personal injuries or sickness incurred in the course of employment. * * * However, section 104(a)(1) does not apply to a retirement pension or annuity to the extent that it is determined by reference to the employee’s age or length of service, or the employee’s prior contributions, even though the employee’s retirement is occasioned by an occupational injury or sickness. * * * [Emphasis added.]”

So the law and many court decisions state that the income is taxable. But the petitioner noted that both the City of San Francisco and the IRS told him it wasn’t taxable. Unfortunately,

“Whatever advice or representation that was made to petitioner has no bearing upon the Court’s decision here. The law is well settled that the Commissioner is not estopped and cannot be bound by erroneous acts or omissions of his agents or representations by other parties such as the employer. Authoritative tax law is contained in statutes, regulations, and judicial decisions. Zimmerman v. Commissioner, 71 T.C. 367, 371 (1978), affd. without published opinion 614 F.2d 1294 (2d Cir. 1979); Green v. Commissioner, 59 T.C. 456, 458 (1972). A taxpayer cannot prevail simply because he relied on incorrect advice from his attorney regarding the tax consequences of the settlement. Coats v. Commissioner, T.C. Memo. 1977-407, affd. without published opinion 626 F.2d 865 (9th Cir. 1980). The representations that were made by the city of San Francisco and an IRS agent do not carry the weight of law.”

Yes, if you get advice from the IRS and it’s wrong, you’re out of luck, as the petitioner discovered.

Case: Diem v. Commissioner, T.C. Summary 2006-121