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Archive for December, 2011

Wealthy Doctor’s Young Trophy Wife Squanders All Of His Money, Shocking Absolutely No One

Posted in Uncategorized, tagged , , , , , , , , , on December 30, 2011 | 1 Comment »

Imagine you’re a doctor. You’ve endured the demanding curriculum, steadily mounting debt, and cut-throat culture that come standard with the medical school experience. You persevered, however; driven not by a desire or sense of obligation to heal the sick, but by the knowledge that when it was all said and done you’d be a doctor, and that alone would be enough to procure the best crazy-young-stripper-wife money could buy. 

But, things don’t always work out as planned in matters of the heart. I mean, other than your friends, co-workers, kids from a previous marriage, and any number of restaurant patrons who witnessed the two of you dining at your favorite Italian place, you droning on about fine art while she admired her nails and mentally undressed the waiter, who could have possibly foreseen that your crazy-young-stripper-wife would liquidate your bank accounts and run off with another guy?

But sadly, it happens. And when you’re left destitute, alone, and in desperate need of some penicillin, you’d think the IRS would have the common decency to allow you to recover a portion of your financial de-pantsing in the form of a theft loss deduction, right?

Not so fast.

First, a primer on theft losses:

A deduction is allowed for any theft loss sustained by taxpayer that is not compensated for by insurance or otherwise.[1] A theft loss is generally only permitted for the tax year in which the taxpayer discovers it.[2]

Whether certain actions constitute theft depends on the law defining the crime of theft in the jurisdiction where the alleged theft occurred.[3]

To summarize, in order to deduct a theft loss, a taxpayer has the rather obvious obligation to establish that a theft has actually occurred, a fact that appeared lost on the taxpayer in Moragne v. Commissioner.

While in his late 60′s and suffering from poor health, Dr. Moragne married Loretta Hill (Loretta). Shortly thereafter, Dr. Moragne asked his former assistant to turn over his checkbook to Loretta, who would have check writing responsibilities and general responsibility over his financial affairs. Dr. Moragne arranged with his bank for Loretta to have check writing authority and authorized her to make various payments on his behalf.

Dr. Moragne solely owned a residence in Chicago (the Ellis property) before he married Loretta. In late 2004 the Ellis property was sold for $450,000, with some of the proceeds used to purchase a residence in Olympia Fields, Illinois for $425,000 (the Graymoor property), which was titled in Loretta’s name only. Loretta then took out a home equity line of credit of $250,000 on the Graymoor property.

Also in 2004, Dr. Moragne and Loretta’s joint checking account reflected that 1) $12,500 was paid for a Jaguar for Loretta; 2) Loretta wrote a check to herself for $26,000 and to “cash” for $50,015; and 3) Loretta wrote checks of $15,000 and $413,000 to Dr. Moragne and herself that both Dr. Moragne and Loretta endorsed.

In 2005, Dr. Morange filed for divorce, which was granted in 2007. On his tax returns for 2002 and 2004, Dr. Morange claimed $319,569 and $384,540 in theft losses related to the amounts spent by Loretta.

The IRS denied the theft loss deductions, and the Tax Court agreed, holding that Dr. Morange did nothing to establish that he’s actually been the victim of a crime, rather than simply being the victim of poor taste and an unreasonable amount of trust:

Petitioner failed to provide any explanation, however, how Loretta used the funds or more importantly whether Dr. Moragne approved or authorized the expenditures. In addition, several of the checks were endorsed by Dr. Moragne along with Loretta. We are compelled to find that Dr. Moragne authorized Loretta to control his checkbook and expend his funds in the same way he had authorized [his former assistant] to do before his 7-year marriage to Loretta. Petitioner also failed to present any evidence demonstrating that every dollar deposited into the account was Dr. Moragne’s and that every dollar withdrawn was spent for Loretta’s benefit, not Dr. Moragne’s. We hold that petitioner failed to establish the amount of any loss and is therefore not entitled to any deduction.

What’s the lesson? Escorts are a fine source of companionship and generally considerably cheaper than a bad marriage, as they rarely require check writing authority.

Estate of Rudolph Moragne v Commissioner, T.C. Memo 2011-299

[1] I.R.C. § 165(a)

[2] Sec. 165(e); Marine v. Commissioner, 92 T.C. 958, 976 (1989).

[3] Edwards v. Bromberg, 232 F.2d 107, 111 (5th Cir. 1956);

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Tax Court: Ignorance is Bliss

Posted in Uncategorized, tagged , , , , , , , , , , , , , , , , on December 29, 2011 | 1 Comment »

“Plausible deniability” is a term often used in political and military circles to describe the protective chain of command enlisted to insure that when a powerful public figure’s underlings undertake unsavory acts on his behalf, all information regarding the acts is purposely withheld from the public figure. This way, should the shady dealings of the lower-rung lackeys be revealed and potentially implicate the public figure, he can credibly and honestly deny any knowledge of the act.

Stated more simply, in certain situations, ignorance can be your ally.

From a tax perspective, never has this been more evident than on Tuesday, when the Tax Court settled two nearly identical cases; counter-intuitively ruling in favor of a taxpayer who practiced willful ignorance and against a taxpayer who, for lack of a better term, “knew what they were getting themselves into.”  
Let me explain:

Assume you own 100% of the stock of a C corporation that owned only one asset, with a fair market value (FMV) of $1,000,000 and a tax basis of $0. Assume further that you need to unload the business, and because you have a high basis in your stock and wish to take advantage of the favorable tax rate currently imposed on capital gains, you find a stock sale desirable.

Of course, it takes two to tango macarena Zumba, and a buyer would certainly prefer an asset purchase so as to avoid paying $1,000,000 and being stuck with the historical $0 basis in the acquired asset.

Because you’re desperate enough, you eventually give in and sell the asset. As a result, for a moment in time the C corporation will possess the following:

Cash:                                       $1,000,000;

Contingent Tax Liability ($400,000)[1]

Net Value                               $600,000

At this point, the only thing left to do is pay the tax and liquidate the corporation, leaving you with $600,000.[2]

But what if there were another alternative? What if after your asset sale, a buyer proposed to purchase your stock for $750,000 and assume your federal and state tax liability? Sweet deal, right? You walk away with $750,000 (as opposed to $600,000), and you’re off the hook for the corporate tax liability.[3]

As the seller, before finalizing the transaction, would you stop and ask the completley reasonable question, “What’s in it for the buyer? Why would someone pay $750,000 for stock worth $600,000 and pay my $400,000 tax bill?”

Believe it or not, the decision to ask that question may well determine whether you will be on the hook for your corporation’s tax liability when the buyer fails to pay it, which coincidentally, is exactly what’s “in it for the buyer.” Consider the following:

The buyer purchases your corporation, the only asset of which is cash of $1,000,000, for only $750,000. The buyer’s only “downside” is that they must assume the $400,000 of federal and state tax liabilities, but the buyer knows full well prior to entering into the transaction that the liabilities will never be paid. Instead,  the buyer will use the $1,000,000 in cash to pay off the $750,000 borrowed from a third party to purchase the stock, liquidate the remaining $250,000 for themselves, and attempt to shield the tax liability with net operating losses generated from other activities which typically involve tax shelters. In the event the IRS disallows the net operating losses and assesses a deficiency to the buyer, the buyer simply throws up his hands, knowing the corporations are insolvent and unable to pay the tax, and allows the IRS to pursue the seller — you — for the deficiency under the transferee liability laws.

And when that happens, based on the lessons imparted by the Tax Court on Tuesday the less you know, the better.

In Frank Sawyer Trust of May 1992, the taxpayer (the Trust) sold all of the assets in several C corporations to unrelated buyers, then sold the stock of the corporations to Midcoast Credit Corp, who paid a “premium” over the net value of the corporations and assumed the tax liabilities. As illustrated above, the liabilities were never paid, and the IRS pursued the Trust for the deficiency.

The Tax Court held for the taxpayer, noting that the Trust never asked, and thus had no actual or constructive knowledge, as to Midcoast’s plans for the acquired stock:

Faced with a substantial estate tax liability, the trust chose to maximize the cash proceeds from the sales by selling the stock of the corporations rather than liquidating them. Had the trust known of [Midcoast’s] illegitimate scheme to fraudulently offset the tax liabilities of the corporations, then we would be inclined to disregard the form of the stock sales in favor of respondent’s contention. However, there are legitimate tax planning strategies to defer or avoid paying taxes, so it was not unreasonable for the trust to believe that [Midcoast] had alegitimate method of doing so.

To the contrary, on nearly identical facts, the Tax Court ruled in favor of the IRS in Ray Feldman, holding the selling shareholders liable for the corporate tax liability assumed by Midcoast as part of the stock purchase. At the risk of oversimplifying things, the only notable difference between the two cases was that the taxpayer in Feldman was aware that Midcoast had no intention to pay the liabilities, and yet still willingly sold its stock to Midcoast in hopes of taking advantage of a transaction that would yield tax advantages over a straight liquidation:

The credible evidence before us establishes that petitioners’ interest in the MidCoast transaction relied almost entirely on the assumption and calculation that the Woodside Ranch tax liability would remain unpaid; the impetus for taking the cumbersome route of a nominal stock sale was the mutual understanding between petitioners and MidCoast that each party would pocket and retain a portion of the unpaid taxes. MidCoast offered a “no-cost” liquidation as a solution to the tax “dilemma” in which petitioners found themselves. In spite of representations to the contrary in some of the transaction documents, the record is replete with notice to petitioners that MidCoast never intended to pay Woodside Ranch’s Federal income tax liability.

As a result, the Tax Court disregarded the stock sale and treated the transaction as a liquidation of the corporations, holding the former shareholders liable for over $1,000,000 of additional tax liability. Quite a steep price for asking the right questions of a potential buyer.

Note, I am not questioning the court’s decision to hold the shareholders in Feldman liable for the unpaid taxes; to the contrary, I simply believe the shareholders in Frank Sawyer should not benefit from their unwillingness to ask questions and perform the due diligence that any reasonable seller would undertake.

Frank Sawyer Trust of May 1992, T.C. Memo 2011-298 (12.27.11)

Ray Feldman v. Commissioner, T.C. Memo 2011-297 (12.27.11)

[1] (assuming a 40% combined federal and state tax rate);

[2] Ignoring the potential tax implications of the liquidation under Section 331

[3] Note, since a taxable liquidation of a corporation is treated as a sale of the stock for the liquidation proceeds, the stock sale to an unrelated party would not generate any material additional tax liability. For example, the stock sale would result in the seller recognizing $750,000 of amount realized for their stock, while a liquidation would result in the seller recognizing only $600,000, a $150,000 difference that assuming a 40% tax rate, resulting in additional tax of $60,000, leaving the seller with $90,000 of additional after-tax cash.

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Part-Time Photographer Falls Victim to the “Hobby Loss” Rules

Posted in Uncategorized on December 28, 2011 | 2 Comments »

I’ve always maintained that there’s a fine line between being a “photographer” and simply hammering away at a button on a fancy digital camera.

Apparently, the Tax Court agrees, as it recently denied purported business deductions related to a taxpayer’s photography business, holding that the activity was in fact a hobby under the rules of Section 183. 

Wayne Wilmot was an oceanographer by trade; employed full-time as a consultant and part-time as a professor at Johns Hopkins.

Wilmot’s passion, however, was photography. In 2001 he began taking college courses on the craft, and soon after launched a photography “business,” which in five years never earned a dollar of revenue, but racked up a significant amount of expenses, and as a consequence, large tax losses reported on Wilmot’s Schedule C.

The IRS denied Wilmot’s loss for 2004, arguing that the photography activity was a “hobby” subject to the limitations of Section 183. Now, in this’ blog’s infancy, we’ve probably devoted more discussion to the “hobby loss” rules than to any other tax issue, covering it here, here, and here.

In general, these rules limit the deductible expenses to the amount of income generated by an activity if the activity is proven to be a hobby rather than a for-profit business. To make this determination, the regulations provide nine factors that require analysis. The factors are:

1. The manner in which the taxpayer carries on the activity;  2. The expertise of the taxpayer or his advisers;  3. The time and effort expended by the taxpayer in carrying on the activity; 4. The expectation that the assets used in the activity may appreciate in value; 5. The success of the taxpayer in carrying on similar or dissimilar activities; 6. The taxpayers history of income or losses with respect to the activity; 7. The amount of occasional profits; 8. The financial status of the taxpayer, and 9.  Does the activity lack elements of  personal pleasure or recreation?

We’ve beat these factors up in the past, so we won’t rehash the finer points of each one here. What is worthy of note in Wilmot,  however, was the court’s conclusion that the taxpayer failed the first factor. Not because it’s a rarity for a taxpayer to fail to carry on an activity in a business-like manner, but because as opposed to many hobby loss cases, Wilmot actually maintained organized records for the expenses of the activity. As the Tax Court explained:

Although he kept detailed records of his expenses, it seems he did so solely to substantiate tax deductions. (records do not indicate profit motive when kept only to “memorialize for tax purposes the existence of the subject transactions”); Bush v. Commissioner, T.C. Memo. 2002-33 (records do not indicate profit motive if “maintained primarily to support tax deductions”).

Just as important as substantiating deductions is what the taxpayer does with this business records; are they being used to drive profitability? In Wilmot, the court held that they were not:

There is no evidence that Wilmot used his records to make business decisions or improve operations. See Golanty v. Commissioner, 72 T.C. 411, 430 (1979).

The lesson here is obvious: simply gathering receipts for your purported photography/Amway/sock puppet-Shakespeare business isn’t going to convince the IRS or the courts that the activity is not a hobby within the meaning of Section 183.  It’s vital that you can establish that the records have been utilized to make key business decisions with the hopes of improving profitability.

Of course, even where the first factor of the hobby loss regulations can be satisfied, you’ve still got eight more to contend with, and as the IRS has held in litany of cases, no one factor is determinative. So if you’re conducting an activity that you’re concerned may toe the line between hobby and business, read up on our prior discussions and take note of the right and wrong way to do things.

Wilmot v. Commissioner, T.C. Memo 2011-293

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Year End Resolutions: Lay off the Yodels, Consider Taking a Deemed Dividend From Your S Corporation

Posted in Uncategorized on December 27, 2011 | Leave a Comment »

Hey you! Yeah, you.

As the end of 2011 approaches, are you tired of having no basis in your S corporation stock,[1] leaving you unable to utilize yet another tax loss?

Does your S corporation have E&P from previous C corporation years that, when distributed, will be taxed as a dividend?

Has the brutal economy left both you and your S corporation so devoid of excess cash that taking a distribution or contributing additional cash to the corporation is an impossibility?

Have “traditional” sit-ups left you with an aching neck and a still-flabby midsection?

It the answer to all of these questions is a resounding “yes!” we’ve got the solution to all of your problems (well, all except that last thing. For ripped abs that glisten in the summer sun, you’ll need this.)  

Here’s how it works:

At the moment, the tax rate on qualified dividends is only 15%. Only the most optimistic among us expect things to stay that way, with many anticipating a return to the old days where dividends were taxed at ordinary income rates as high as 35%. As a result, now is the ideal time to “purge” your S corporation’s E&P and pay tax on the resulting dividend at the current preferential rate.

But with cash at a premium, taking a distribution of E&P out of an S corporation would appear foolish for two reasons: 1) the S corporation may not have the cash necessary to make the distribution, particularly since in order for an S corporation distribution to be one made from E&P, the total distributions during the year must generally exceed the corporation’s AAA balance; and 2) even with the preferential tax rates on dividends potentially soon to expire, who would want to accelerate taxable income that could otherwise remain deferred in the S corporation?

Well, what if I told you that you could purge the corporation’s E&P, pay tax on the dividend at only 15%, and create enough stock basis to free up the S corporation’s otherwise unusable 2011 loss — thereby potentially fully offsetting the dividend income — all without spending a penny of anyone’s hard-earned cash?

Look no further than the “deemed dividend” rule of Treas. Reg. § 1.1368-1(f)(3).

A deemed dividend is an election available to an S corporation and its shareholders to make a hypothetical distribution of the corporation’s E&P from previous C corporation years to all shareholders as of the last day of the corporation’s tax year. Importantly, NO cash is required to make the election; hence the term “deemed dividend.”

Under the fiction created by the regulations, the amount elected is treated as a cash distribution from E&P that is received by the shareholders and then is immediately contributed to the capital of the corporation. This deemed contribution has the effect of  increasing stock basis to the extent of the deemed dividend, making it highly advisable to shareholders with reduced or nonexistent stock basis that are facing a 2011 tax loss[2]; especially now in light of the preferential rate afforded dividends.

Example: On Dec. 31, 2011, X, the sole shareholder of S Co., has no basis in his S stock. S Co. anticipates a tax loss of $100,000 for 2011, none of which can be utilized by X on his 2011 Form 1040 due to X’s lack of stock basis. S Co. also has accumulated E&P of $100,000 and AAA of $200,000.

S Co. may make a deemed dividend election with its 2011 tax return to distribute $100,000 of E&P, reversing the normal rules whereby a distribution first comes from an S corporation’s AAA. As a result of making the election, X will be treated as having received a $100,000 dividend, which will be taxed at 15%. However, X is also treated as having contributed the $100,000 back to S Co., increasing X’s stock basis by $100,000 and allowing X to utilize the $100,000 loss generated by S Co. in 2011. Assuming this loss is not subject to limitation under Sections 465 or 469, X has effectively traded $15,000 of tax liability for a $35,000 tax benefit (assuming a 35% ordinary tax rate), a net benefit of $20,000.

There are a couple of additional considerations:

  • As mentioned, the election reverses the typical order of S corporation distributions by providing that all distributions made throughout the year first come from E&P, rather than the corporation’s AAA balance. Thus, any previous cash distribution made during the year that was originally planned to not come from E&P will now be deemed to have done so; a fact that warrants consideration prior to making the election. Of course, since  in my example, you’ve got no basis in  your S corporation stock, it doesn’t really matter if a distribution is treated as a distribution from AAA — in which case it will be treated as capital gain[3] — or a dividend, since either way the applicable tax rate is 15%.
  • The election to make a deemed dividend is made by attaching a statement to the S corporation’s timely filed original or amended income tax return (Form 1120S) for the year in which the distributions are made. This means that you’ve got not only until the end of 2011, but until the date you timely file your 2011 tax return to make the election and have the deemed dividend/recontribution apply.
  • The statement must declare that the corporation is electing to make a deemed dividend under Reg. 1.1368-1(f) and that each affected shareholder consents. Each shareholder who receives a distribution during the tax year (including a deemed dividend) must consent to the election. Furthermore, the statement must include the amount of the deemed dividend that is distributed to each shareholder
  • The election is irrevocable and is effective only for the tax year for which it is made. No specific IRS form is necessary to make the election.

[1] Or basis in any loans made directly to the S corporation

[2] Or shareholders that have suspended losses from previous years

[3] As required under I.R.C. § 1367 if a distribution exceeds the shareholder’s stock basis.

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Congress Extends 2% Payroll Tax Cut; American Workers, Local Best Buy Manager Rejoice

Posted in Uncategorized on December 23, 2011 | 1 Comment »

If you’re gainfully employed, Congress just put some extra loot in your pocket by extending for two months the current 4.2% tax rate on an employee’s share of social security payroll taxes,  which was reduced from 6.2% as part of a previous tax-cutting measure but was set to expire at the end of 2011. So if you were slated to earn $5,000 in gross payroll in January and February of 2012, you just made a cool $100 this morning, despite the fact that you all you’ve done today is nurse a wicked eggnog-induced hangover and ruminate on the slightly suggestive, exceedingly uncomfortable things you said to the cute chick from marketing at last night’s office party.

 To reward yourself for your financial windfall, we here at Double Taxation suggest you go out and spend the money you don’t yet have on some super cool electronic device that you really don’t need. It’s the American way!

Coverage from CNN

 

 

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Taxpayer Likens the IRS to Nazis, Surprisingly Fails to Win Over Tax Court

Posted in Uncategorized on December 22, 2011 | 1 Comment »

If you’ve never heard of Godwin’s Law, it’s the astute — and sadly, accurate — observation that given enough time, any discussion on an internet forum or online chat room will inevitably denigrate to the point where someone makes an ill-advised reference to Hitler or Nazi Germany.

Apparently, this principle is equally applicable to Tax Court briefs, as I’ve read a truly depressing amount of court cases in my time, and until yesterday I’d never seen the IRS and Tax Court compared to “those good law-abiding Germans who drove the trains to the death camps.” But Erik Thompson pulled it off, and shockingly, things didn’t go well from there.

Erik was a peaceful boy. As a youngster, he left rural Milan, Minnesota, to go to Stanford, where he earned three degrees. After graduation, he eschewed the material trappings of corporate life in favor of joining the Peace Corps for a mission to Micronesia, presumably to soothe local discontent resulting from Derek Zoolander’s near-assassination of the Micronesian prime minister.

After his father died, Thompson moved back to the States, became the big wheel at his home town bank, and bought a few rental properties to house some Micronesian immigrants that I’d like to imagine were concealed in his carry-on luggage and stowed neatly in the overhead compartment on his way back home. Once back on U.S. soil, Thompson also promptly ceased complying with this country’s tax laws.

In defense of his failure to file his tax returns, Thompson offered the following passionate — albeit misguided –defenses:

  • He didn’t file returns for tax years 2004 and 2006 because he disapproved of the wars in Iraq and Afghanistan and didn’t want to fuel “the government’s killing machine,” which I believe is some sort of kick-ass hovercraft.
  • As mentioned in the intro, Thompson also felt compelled to analogize working for the IRS with shuttling prisoners to a concentration camp. 
  • He added, “You may be curious about my decision not to file; my actions are designed to call us back to the rule of law and stop the slaughter of innocents.”
  • Lastly, and most formally, Thompson posited that paying his taxes would violate the Nuremberg Principles, which for those of you who aren’t up to speed on your mid-1940′s military tribunals, provided that compliance with the law would be no excuse for those tried if the conduct would be complicit in, for example, a crime against humanity.

The Tax Court quickly made short work of his “Nuremberg” defense, providing rather sternly that they did not accept Thompson’s claim that he was indirectly complicit in “crimes against humanity” by completing and mailing off his Form 1040. Which is quite the relief, or the guys at H&R Block would be facing some serious jail time.

The IRS — using information begrudgingly supplied by Thompson — was able to piece together tax returns for 2004 and 2006. After doing so, the IRS denied deductions on each return for Thompson’s investment interest expense and rental losses related to his Micronesian sweatshop hostel.

The bulk of Thompson’s 2004 investment interest deduction resulted from the carryover of interest expense that was limited on Thompson’s properly filed 2003 tax return.[1] Thompson argued that the fact the IRS accepted the 2003 return as filed “fixed” the amount of his interest carryover, and thus it should be accepted on his 2004 return, without Thomspon being required to substantiate the underlying expenses.

It’s a compelling argument, but ultimately the incorrect one. Tax returns don’t substantiate deductions or losses; they are nothing more than a statement of a taxpayer’s claims.[2] Thompson therefore couldn’t rely solely on his old return or his current say-so to prove the disputed amount. Because Thompson was unable to prove his interest expense amounts for 2003 or beyond, the Tax Court sustained the IRS disallowance.

For good measure, the Court denied Thompson’s rental losses — again on the basis of inadequate substantiation — and tacked on failure to file, failure to pay, and underpayment of estimated tax penalties, with the threat of a $25,000 frivolous argument penalty should Thompson ever feel inclined to liken the Tax Court to the Third Reich again.

[1] The expense can offset only net

investment income. Sec. 163(d)(1).

[2] Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979).

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Can A Partner Deduct Expenses Paid on Behalf of a Partnership?

Posted in Uncategorized, tagged , , , , , , , , , , , , , , , on December 21, 2011 | 4 Comments »

Depends. It’s not just the brand of highly-absorbent adult diapers endorsed by Stern Show staffer Richard Christy for use at marathon Coheed and Cambria concerts, it’s also the go-to answer for many a tax professional, and quite often, the only correct one.

For example, assume a partner in a partnership incurs a number of expenses in his individual capacity that relate to the business of the partnership, and are not reimbursed by the partnership. Can the partner deduct the unreimbursed expenses on his individual return?

The answer? Depends. What it depends on, exactly, is whether the partnership agreement requires the partner to use his own funds to pay partnership expenses, without providing for the potential for reimbursement, either formally or in routine practice.

Consider the case of Mr. McLauchlan. McLauchlan was a lawyer, and he earned around $300K each year as a partner in his law firm, AR. In 2005 and 2006, McLauchlan paid various expenses in connection with practicing law at AR, including the following:

  • advertising,
  • home office,
  • automobile,
  • travel,
  • meals, entertainment,
  • cell phone,
  • professional organizations,
  • continuing legal education,
  • State bar membership.

AR reimbursed McLauchlan for over $60,000 of expenses for each of 2005 and 2006. McLauchlan contended, however, that he paid over $100,000 of AR expenses in each of those years for which he was not reimbursed. He categorized and claimed these expenses on Schedules C.

AR Partnership Agreement

AR had a written reimbursement policy that specifically provided for reimbursement of certain indirect AR expenses, such as lease and rental automobile expenses incurred for client travel, business meals and entertainment and continuing legal education expenses. In addition, as a matter of routine practice, AR would reimburse other indirect AR expenses that were not provided for in the written reimbursement policy, including State bar membership expenses and professional organization expenses.

Relevant Law

Generally, a partner may not directly deduct the expenses of the partnership on his or her individual returns, even if the expenses were incurred by the partner in furtherance of partnership business.

An exception applies, however, when there is an agreement among partners, or a routine practice equal to an agreement, that requires a partner to use his or her own funds to pay a partnership expense.[1] In this case, the partner can deduct the expenses, provided he meets any necessary substantiation requirements.

In McLauchlan, since AR provided for the potential for reimbursement — both formally and in its routine practice — of all expenses incurred by McLauchlan in his individual capacity, he was not permitted to deduct the expenses on his individual return.

One to Grow On

Clearly, if a partnership contemplates that a partner will be required to shell out his or her own cash to pay expenses of the partnership, the partnership agreement should expressly provide that no reimbursement will be made, and the partnership should not deviate from that agreement in routine practice. Of course, the partners should also be sure to comply with the substantiation requirements of Section 274 — for example, in deducting expenses related to the use of an auto — to secure the deduction.

McLauchlan v. Commissioner, T.C. Memo 2011-289

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Home for the Holidays

Posted in Uncategorized on December 16, 2011 | 1 Comment »

The Western half of Double Taxation is heading back to the Garden State for the holidays, leaving behind his favorite ski partner and all-around best pal. But at least we were able to get out for one last sunrise climb together to enjoy what we both love best:

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The IRS Kindly Reminds Us that Giving to Those Less Fortunate is Needlessly Complicated

Posted in Uncategorized on December 16, 2011 | 1 Comment »

Today, the IRS issued IR-2011-118, reminding individuals and businesses of several important law provisions that have taken effect in recent years that may impact year-end charitable contributions. There are a number of traps awaiting an unwary donor, most of which revolve around the various substantiation requirements that depend on the nature and amount of the contributions.

Some of these changes include the following:

Special Charitable Contributions for Certain IRA Owners

This provision, currently scheduled to expire at the end of 2011, offers older owners of individual retirement accounts (IRAs) a different way to give to charity. An IRA owner, age 70½ or over, can directly transfer tax-free up to $100,000 per year to an eligible charity. This option, created in 2006, is available for distributions from IRAs, regardless of whether the owners itemize their deductions. Distributions from employer-sponsored retirement plans, including SIMPLE IRAs and simplified employee pension (SEP) plans, are not eligible.

To qualify, the funds must be contributed directly by the IRA trustee to the eligible charity. Amounts so transferred are not taxable and no deduction is available for the transfer.

Not all charities are eligible. For example, donor-advised funds and supporting organizations are not eligible recipients.

Amounts transferred to a charity from an IRA are counted in determining whether the owner has met the IRA’s required minimum distribution. Where individuals have made nondeductible contributions to their traditional IRAs, a special rule treats transferred amounts as coming first from taxable funds, instead of proportionately from taxable and nontaxable funds, as would be the case with regular distributions. See Publication 590, Individual Retirement Arrangements (IRAs), for more information on qualified charitable distributions.

Rules for Clothing and Household Items

To be deductible, clothing and household items donated to charity generally must be in good used condition or better. A clothing or household item for which a taxpayer claims a deduction of over $500 does not have to meet this standard if the taxpayer includes a qualified appraisal of the item with the return. Household items include furniture, furnishings, electronics, appliances and linens.

Guidelines for Monetary Donations

To deduct any charitable donation of money, regardless of amount, a taxpayer must have a bank record or a written communication from the charity showing the name of the charity and the date and amount of the contribution. Bank records include canceled checks, bank or credit union statements, and credit card statements. Bank or credit union statements should show the name of the charity, the date, and the amount paid. Credit card statements should show the name of the charity, the date, and the transaction posting date.

Donations of money include those made in cash or by check, electronic funds transfer, credit card and payroll deduction. For payroll deductions, the taxpayer should retain a pay stub, a Form W-2 wage statement or other document furnished by the employer showing the total amount withheld for charity, along with the pledge card showing the name of the charity.

These requirements for the deduction of monetary donations do not change the long-standing requirement that a taxpayer obtain an acknowledgment from a charity for each deductible donation (either money or property) of $250 or more. However, one statement containing all of the required information may meet both requirements.

Reminders

To help taxpayers plan their holiday-season and year-end giving, the IRS offers the following additional reminders:

  • Contributions are deductible in the year made. Thus, donations charged to a credit card before the end of 2011 count for 2011. This is true even if the credit card bill isn’t paid until 2012. Also, checks count for 2011 as long as they are mailed in 2011.
  • Check that the organization is qualified. Only donations to qualified organizations are tax-deductible. IRS Publication 78, searchable and available online, lists most organizations that are qualified to receive deductible contributions. It can be found at IRS.gov under Search for Charities. In addition, churches, synagogues, temples, mosques and government agencies are eligible to receive deductible donations, even if they are not listed in Publication 78.
  • For all donations of property, including clothing and household items, get from the charity, if possible, a receipt that includes the name of the charity, date of the contribution, and a reasonably-detailed description of the donated property. If a donation is left at a charity’s unattended drop site, keep a written record of the donation that includes this information, as well as the fair market value of the property at the time of the donation and the method used to determine that value. Additional rules apply for a contribution of $250 or more.
  • The deduction for a motor vehicle, boat or airplane donated to charity is usually limited to the gross proceeds from its sale. This rule applies if the claimed value is more than $500. Form 1098-C, or a similar statement, must be provided to the donor by the organization and attached to the donor’s tax return.
  • If the amount of a taxpayer’s deduction for all noncash contributions is over $500, a properly-completed Form 8283 must be submitted with the tax return.

 

 

 

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Informal Claim for Refund and other Awesome Statute of Limitation Issues

Posted in Uncategorized, tagged , , , , , , , , , , , , , , , , on December 15, 2011 | 3 Comments »

Time for a quick quiz on everyone’s favorite topic: IRS practice and procedure:

Consider the following timeline:

  • Sometime in 2006, Sam files an extension of time to file his 2005 federal Form 1040. On the Form 4868, he reflects an estimated tax liability of $8,320 and total estimated payments of $10,229.
  • On September 23, 2008, Sam sends a letter to the IRS apologizing for the delay in filing his 2005 return and requesting an additional extension until December 31, 2008. In the latter, Sam writes “I had [sic] always received refunds and I know that it will be the same for the  [sic] 2006 and 2006.”
  • On October 26, 2009, the IRS issues a notice of deficiency with regards to Sam’s 2005 tax return.
  • On February 1, 2010, Sam files his 2005 return.
  • On September 20, 2010, Sam sends a “corrected” return for 2005 to the IRS, which the IRS accepts. After accepting the return, the IRS conceded that Sam overpaid his 2005 tax, as his withholding exceeded his 2005 tax liability.

Question: Is Sam entitled to a refund of his 2005 overpayment?

Answer: No.

Discussion: A taxpayer seeking a refund of overpaid taxes ordinarily must file a timely claim for a refund with the IRS that meets the requirements of Section 6511. If no tax return is filed, the claim for refund must be filed within 2 years from the time the tax was paid.[1]

Section 6511 also provides a look-back period to determine the amount of taxes that may be refunded upon the filing of a claim for refund. If a return is not filed and the IRS issues a notice of deficiency prior to the taxpayer’s filing of a claim for refund,  then upon petitioning the Tax Court, Section 6512 permits the taxpayer to a refund of only that portion of the tax paid during the 2 years immediately preceding the mailing of the notice of deficiency.

In the immediate case, Sam argued that either his undated 2005 extension on Form 4868 or his letter dated September 23, 2008 constituted an “informal claim for refund” that was made within the prescribed time limits of Section 6511. Thus, he was entitled to a refund of his 2005 overpaid taxes.

The Tax Court disagreed for the following reasons:

1. While the Tax Court has permitted informal claims for refund in certain cases, neither Sam’s Form 4868 nor his poorly worded 2008 letter constituted such a claim.

Sam’s extension request was not a claim for refund, as unlike a Form 1040, the Form 4868 does not contain a line on which to enter an amount to be refunded, only a line on which to indicate the balance due. Thus, the IRS could not have been expected to determine an overpayment of tax based only on the estimate of Sam’s income tax liability provided by him on the Form 4868.

Similarly, letters to the IRS have also been held to represent informal claims for refund, however, Sam’s letter does not rise to the level of such a claim. The Seventh Circuit has established that to be considered an adequate informal claim, the writing must be “sufficient to apprise the IRS that a refund is sought and to focus attention on the merits of the dispute so that an examination of the claim may be commenced if the IRS wishes.”[2]

Sam’s letter of September 23, 2008, was premature and unspecific. There was no “dispute” to which the attention of the IRS could have been drawn. Sam himself had not yet computed his tax liability. In addition, Sam’s letter “[failed] to satisfy the most basic requirement of a claim–advising the Commissioner that a refund [was] being sought.” The letter stated that petitioner “had always received refunds” and expresses the opinion that “it will be the same” for 2005; but a refund was not requested.

2.  Even with the failure to file a timely claim for refund, Sam could have received a refund of his underpayment from the Tax Court under Section 6512. All that he needed to prove was that the tax had been paid within the appropriate look-back period. Because Sam failed to file his 2005 tax return prior to the mailing of the notice of deficiency by the IRS on October 26, 2009, the applicable look-back period was the two-year period ending with the mailing of the notice of deficiency. Since Sam’s 2005 withholding was deemed paid on April 15, 2006,[3] the tax was not paid within 2 years of the October 26, 2009 mailing of the letter of deficiency, and thus no refund was allowed.  

Rabie v. Commissioner

[1] I.R.C. § 6511(a)(1).

[2] Martin v. U.S., 833 F.2d 655 (7th Cir. 1987).

[3] I.R.C. § 6513(b)(1).

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