Should All Tax Preparers be Regulated?

Wait a second. Aren’t tax preparers regulated?

Well, sort of. All tax preparers fall under the aegis of Circular 230. If your tax preparer is an Enrolled Agent (EA) (what I am), a Certified Public Accountant (CPA), or an attorney, they can practice fully before the IRS. (Not all CPAs or attorneys are tax practitioners.) If you go to H&R Block, for example, it’s quite possible that the person preparing your return is someone trained by H&R Block and has what is called limited practice. In general, you get what you pay for.

Two states currently regulate professional preparers: California and Oregon. In California, any professional tax preparer who is not an EA, CPA, or an attorney must register with the California Tax Education Council (CTEC), or face fines. Preparers become “California Registered Tax Preparers” (CRTP) by taking a 60-hour course, obtaining a bond, and paying a small fee. Although this program has been in place for a few years, the California Legislature just passed legislation that puts some teeth into the program: CTEC now has funding to go after unregistered preparers and fine them.

This past year legislation was introduced in Congress that would require all professional tax preparers in the US to be registered. An exam would have to be passed, continuing education would be required, and fees would be paid. The legislation was generally supported by the National Association of Enrolled Agents (NAEA), the American Institute of Certified Public Accountants, the American Bar Association, and the National Taxpayer Advocate. The legislation is still active, but has not passed the House of Representatives.

Personally, I have mixed feelings about regulating all preparers. Some of the best advertising for professionals such as myself are the errors and frauds committed by the like of Western Tax Service. In general, you get what you pay for in life. Additionally, such a program would require either increased funding for the current Circular 230 (Office of Professional Responsibility) staff, or a new bureaucracy, just what we need in Washington.

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No Records, But A Big Heart (and a Wonderfully Written Decision)

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

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A Gambling Association

The Tax Court today looked at whether a heretofore charitable organization (a 501(c)(3)) that has a gaming operation can retain its’ charitable (501(c)(3)) status. This case gives an excellent example of some of the drawbacks of “charitable” gambling from a charity’s perspective.

The petitioner, a Middletown, Ohio association that had been granted 501(c)(3) status in 1982, began to operate bingo games and pull-tab gambling (pull-tabs are where a card or ticket is given to a customer, a symbol is revealed, and then the customer looks to see if the symbol is a “winner”) to fund their charitable activities. So far so good. Under Ohio law, such gaming for charity is allowed if a security guard is at the gaming establishment. So the association hired a security firm to provide such a guard.

The IRS then audited the association for 1992 through 1995. The association made a number of mistakes. First, it paid the staff working the bingo games/pull-tab sales “under the table.” Second, the charities receiving the funding were, according to the Tax Court, controlled by the association’s President. Third, while the association raised between $870,000 to $2,000,000 through the gambling operation, they donated to charity between $270,000 and $440,000 each year with the donations decreasing while the receipts were increasing.

Under the Tax Code, a charitable organization must be “…organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes.” The IRS claimed that the association did not “…[engage] primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3).” [Sec. 1.501(c)(3)-1(c)(1), Income Tax Regs] The IRS felt that the association engaged primarily in gaming (not charitable work), that the association served the interests of its founder (rather than charitable work), and that it was a “feeder” under §502.

The Tax Court found that the association was primarily a gaming organization, not a charitable association. First, the under-the-table payments undoubtedly started the negative thinking. Second, most (if not all) of the workers at the bingo nights were compensated, and were not performing their work for charity. Third, the Court believed the IRS’ witnesses and disbelieved the association’s witnesses.

So if you’re going to have a charitable 501(c)(3) association, make sure you don’t gamble that designation away. Scrupulously follow the Tax Code or you’ll roll craps.

Case: South Community Association v. Commissioner, T.C. Memo 2005-285

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Remember The Maine?

Do you remember the Maine?

For those of you who don’t remember history, the battleship USS Maine blew up in the harbor at Havana, Cuba. Even today, the cause of the explosion is still a mystery. But one thing is quite sure, the tragedy of the Maine led to the Spanish-American War.

That’s a nice bit of history, but you may be wondering what this has to do with a tax blog. Well, the war was funded by a tax: an excise tax of 3% on telephone service. This tax, on long-distance calls, continues today.

There’s a problem, though. Does the tax apply to wireless long-distance calls, which are charged based on time, rather than distance? As this article in USA Today notes, an appeals court in Washington, DC ruled that the tax, which has been extended to wireless service, does not apply to wireless service. Consumers are due refunds that total up to $50 billion; however, obtaining the refunds is a time-consuming process. Additionally, because cases are pending in all of the 13 Courts of Appeals, this matter will likely go up to the US Supreme Court and it is unlikely that the IRS will issue refunds until that happens.

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More on Section 199

Thanks to Joe Kristan of Roth Tax Updates, here is some more information on the Domestic Production Activities Deduction, aka the Deduction from Hell. The draft form is available online here. A much more technical introduction to the proposed regulations, written by Elizabeth Askey of Pillsbury Winthrop Shaw Pittman LLP is available here. Joe Kristan’s in-house presentation on Section 199 is here. And the proposed regulations are available here.

As an aside, I’m not in despair over this deduction. As I was telling friends over dinner this past weekend, Congress continues to mandate full employment for tax preparers. It’s a pity that Congress does this by making deductions unnecessarily complex.

Hat Tip: Joe Kristan, Roth Tax Updates

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The Deduction From Hell (Corporate Taxes)

Not many small businesses do their own tax returns. If they do, they’re likely to “enjoy” Form 8903, “Domestic Production Activities Deduction.” By the way, this form is not yet on the IRS’ website. The draft version of the form has only 19 lines, and looks deceptively easy.

It’s not.

It’s going to make tax preparers get gray hair. Luckily, I already have gray hair so that’s not an issue….

Let’s take a look at how this deduction “works” (all sarcasm intended). You own Widgets, Inc., and you manufacture widgets, and sell them. Your plant is in the United States.

So yo enter your receipts on line 1, your cost of goods sold on line 2, your direct and indirect deductions, to get your “qualified production activities income (QPAI).” This is then compared to your income limitation, which is 3% of the lesser of the QPAI or the taxable income for the taxable year (without regard to this deduction). Additionally, the deduction is limited to 50% of the wages paid by the taxpayer to employees during the tax year. Thus, self-employed manufacturers do not get this deduction.

That’s the simple case.

Now, let’s assume that this same company has two plants, one in Irvine and one overseas in China. Both plants produce the same products, and there’s nothing to distinguish the widgets made in China from those made in Irvine.

This new deduction holds only for the products produced in Irvine, so you will have to perform an allocation (presumably based on number of units produced in each plant). This is the not-so-simple case.

Now, let’s look at a much more realistic case, one that I’ll have to face. A company has two plants, one here in California and one overseas. They make a variety of products, and also perform services (repairs, consulting, field service, etc.). The products made here and the products made overseas are distinguishable, but are freely interchangeable. The company has never tracked product sales by location of manufacture (they do track it for quality control purposes).

In order to determine the correct deduction, I’ll have to:
—allocate between the manufacturing and service businesses;
—allocate between the products manufactured domestically and internationally; and, finally,
—allocate the domestic salaries by services and manufacturing.

Now, let’s make this more confusing. Some services do qualify, courtesy of effective lobbyists, such as architectural and engineering services. Newspaper production qualifies. Unfortunately, tax preparation services do not qualify. Software development qualifies but software support doesn’t. Restaurants don’t qualify but food preparation done for wholesale does qualify.

I’m not looking forward to my first venture in preparing a return with this deduction. IRS guidance is forthcoming, but it hasn’t been released (yet). The IRS does have a brief overview of the deduction. Notice 2005-14, which gives the IRC on this deduction (§199) is here. Professor Maule previously commented on this deduction.

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One Down, Two (at least) To Go

Yesterday John Campbell (R-Irvine) won the race to replace Christopher Cox as Congressman for the 48th Congressional District. Chris Cox is now the head of the SEC.

As mentioned previously, voters in the same area of Orange County now face an election to replace Campbell as State Senator for the 35th District. That special election will be scheduled by the California Secretary of State for either February or March, with a runoff eight weeks later (April or May), if no candidate receives greater than 50% of the vote. State Assemblyman Tom Harman (R-Newport Beach) is the leading candidate to replace Campbell in the heavily Republican district.

News Story: Orange County Register

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If You Fail 3 Times…The Fourth Time Won’t be the Charm

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

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Where Paper Filing is Simpler than Electronic Filing

Come late January or early February, you may have to file your 1099s with the IRS. If you are in California, you likely believe that filing with the IRS satisfies your California filing requirement.

If you paper file, that’s true. However, if you electronically file your 1099s, you must also file them with the Franchise Tax Board. And if you forget to do so, you could be subject to fines.

If you have any questions regarding your 1099 filing requirements, please ask us. If we file your 1099s on your behalf, we’ll make sure that Sacramento gets their copy.

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Another Election on Tuesday

If you, like me, live in Orange County’s 48th Congressional District, don’t forget to vote this Tuesday for Chris Cox’s replacement. If you don’t know where your precinct will vote (and many polling places have been moved), you can find your precinct here.

If State Senator John Campbell wins (he is favored), there will be another special election (probably in March) for his replacement. And possibly a runoff in May. Followed by the June primary. And a possible special election for the replacement of the (likely) State Assemblyman who replaces Campbell. And a runoff….

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