Archive for March, 2012

A few things you may have missed this weekend while watching Tiger Woods make news for reasons other than rampant infidelity or hilariously filthy text messaging for the first time in nearly three years. Of course, the real winner on the weekend was Tiger’s ex-wife, Elin, who’ll surely see a good piece of that $1,000,000 prize purse.  

Spend enough time in your Unabomber-style shack in upstate Vermont, and you’re likely to conjure any number of farcical legal arguments for not paying your income tax. Unfortunately, none of them will convince the IRS, and you’ll end up sharing a cell with Wesley Snipes.   

If you’re wealthy and have a portfolio full of dividend-paying stocks, it’s time to acknowledge that for the wealthiest individuals, tax rates on dividend income are set to triple in 2013, and maybe its time to start selling some of your high-yield holdings. Caveat: everything I know about the stock market I learned from the movie Trading Places, so I may not be the best source of advice.  

Fact: 60% percent of individual taxpayers with 2010 AGI > $1,000,000 were audited by the IRS. No joke there; if you’re pulling down over a million a year, you’d better have your ducks in a row.

Here’s 5 “smart” ways to spend a $1,000 tax refund. Personally, I’d recommend the George Best approach: Blow as much of it as you can on booze and fast women. The rest of it, feel free to just waste.

Lastly, little known fact: This woman was previously a Junior Vice President at Tax Masters.[i]

[i]  Not true. Don’t sue me.

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If you’re the highly suggestible type, like I am — or so I’ve been told, and I totally believe it — an election year can leave your head spinning. Both sides of the partisan equation make compelling arguments, and when you don’t blindly toe a party line, sifting through the rhetoric in search of the truth can be a daunting task.   

Take, for example, the recent budget proposal fronted by House Republican Paul Ryan, discussed here. To quickly summarize, Ryan’s plan would produce a 10-year deficit of $3.13 trillion, less than half the amount to be complied under President Obama’s budget. It accomplishes this despite making sweeping tax cuts, including reducing the top individual and corporate tax rates to 25%. So if tax revenue is presumably going down, how does the deficit shrink under Ryan’s plan? By dramatically reducing government spending, with much of the cuts aimed at Medicare and other “safety net” programs.

Is Ryan’s plan a “good” thing for America? Hell if I know, because quite frankly, I’ve spent the past three decades so wrapped up in a Chuck Klosterman-like obsession with sports and music, I’ve failed to gain any semblance of an understanding of the inner workings of the government. But I will say this: if you’re willing to read arguments from both sides without any preconceived partisan leanings, they both sound pretty damn convincing.

If you don’t believe me, check out these dueling point/counter-point columns regarding Ryan’s proposed tax reform published on Forbes this week.

The first, authored by Peter Ferrara, lauds Ryan’s plan as forward-thinking, with Ferrara opining, “…the plan would help produce millions of new jobs, and the restoration of traditional American prosperity.”

Published one day later, Howard Gleckman’s column takes the polar opposite view of the Republican proposal, deriding it as “more big tax cuts for the rich.”

So who’s right? You decide.

From Ferrara:

Unlike President Obama, Paul Ryan in this budget shows the leadership to propose both sweeping tax reform and sweeping entitlement reform. Instead of raising tax rates as Obama has proposed, and indeed already enacted under current law, Ryan proposes to consolidate the current 6 individual income tax rates, ranging up to 35%, to just two rates of 10% and 25%.

President Obama, by contrast, is already raising the top marginal tax rate at least to 45%, even without any of the new tax increases he has proposed. Ryan has indicated the 10% rate would apply to families making less than $100,000 per year, with the 25% rate applying to families making over that, with sharply increased personal exemptions ensuring no tax increase for anyone from current law. But the actual parameters would be finalized based on what is necessary to make the reform revenue neutral.

Even with all of those tax reductions, federal revenues under Ryan’s budget would nearly double by 2022 compared to 2012. But federal taxes would still be $3.27 trillion less over the next 10 years than projected under President Obama’s budget. This reflects the basic truth that America suffers from soaring federal deficits and debt not because we are taxed too little, but rather because the government spends too much.

From Gleckman:

No surprise here, but the tax cuts in Paul Ryan’s 2013 budget plan would result in huge benefits for high-income people and very modest—or no— benefits for low income working households, according to a new analysis by the Tax Policy Center.

TPC looked only at the tax reductions in Ryan’s plan, which also included offsetting–but unidentified–cuts in tax credits, exclusions, and deductions. TPC found that in 2015, relative to today’s tax system, those making $1 million or more would enjoy an average tax cut of $265,000 and see their after-tax income increase by 12.5 percent. By contrast, half of those making between $20,000 and $30,000 would get no tax cut at all. On average, people in that income group would get a tax reduction of $129. Ryan would raise their after-tax income by 0.5 percent.

Nearly all middle-income households (those making between $50,000 and $75,000) would see their taxes fall, by an average of roughly $1,000. Ryan would increase their after-tax income by about 2 percent.

In truth, unless Republicans raise taxes on capital gains and dividends, it is hard to imagine the highest income households getting anything other than a windfall from this budget. Other tax preferences, such as the mortgage interest deduction, are just not that valuable to them.

And since no high-profile Republicans want to raise taxes on gains and dividends (and many would cut investment taxes even further) this budget would likely result in a huge tax cut for those who need it least. That’s not a great way to start an exercise whose stated goal is to eliminate the budget deficit

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Obama’s proposed tax reform would result in a tax cut for all taxpayers compared to the previous president, so long as that previous president was named Eisenhower.

Have we seen the end of Tax Masters and Patrick Cox, in all his bearded glory?

The biggest hurdle facing the new IRS SWAT team? Sewing pocket protectors onto all those bullet-proof vests. HI-YO!!!

Difficult as this may be for most parents to fathom,  little Jimmy probably won’t be earning that full athletic scholarship, regardless of how sparkling a second base he plays for his Little League team. So you better start planning.

NASA employee puts plans to colonize Mars on hold just long enough to suffer crushing defeat in Tax Court. In bizarre post-trial rant, blames his loss on those damn, dirty apes.

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If you’ve got teenaged kids who aren’t cut out for life in the carnival, you’re probably starting to stress about funding their college education,  particularly in light of the fact that the average four-year education at a private university will run you upwards of $120,000.

Hopefully, you started socking away money long ago, so your primary concern at this point is maximizing your eligibility for financial aid. If that’s the case, then it’s high time you start paying attention to your tax returns, as the information included on your Form 1040 will, in large part, determine just how much you’re entitled to in educational handouts.

William (don’t call me Billy) Baldwin over at Forbes has published a wonderful column detailing the numerous tricks a taxpayer can employ to “manage” their adjusted gross income for several different reasons, one of which is to maximize educational assistance. Your first order of business? Start thinking outside the typical “defer income/accelerate deductions” box:

Accelerate income.Most taxpayers would like to defer income and the tax bill that goes with it. But it makes sense to go the other way if your tax bracket is headed upward or if you will be filling out college aid forms two years from now or if you are planning a joint replacement next year. If your child is going to college in fall 2015 and you’re going to sell some appreciated stock to cover the costs, you should probably sell that stock now so that it doesn’t inflate the 2013 income shown on your financial aid application, says Barry Picker, a Brooklyn, N.Y. CPA.

As Baldwin points out, additional dollars of taxable income during your application years will cost you dearly:

Who’s the tax collector with the stiffest rate? For many middle-class families the ogre is a college bursar. Take home an extra $100 and the financial aid ­formula will snatch $37 away. That makes income planning a powerful idea for taxpayers with kids likely to qualify for tuition breaks. The idea is to shrink your income in the years that will show up on any aid application.

Carefully choosing your deductions can also mean more cash come college time. Baldwin explains:

Some things that lower your adjusted gross income also lower the income measured by aid formulas. One is the deduction (up to $7,250) for contributions to a health savings account. But some things that work fine with federal taxes don’t cut any ice with aid officers, warns Troy Onink, a FORBES contributor whose Strategee.com gives advice on financing education.

A deductible contribution to a 401(k), for example, reduces your AGI and thus your federal tax bill. But it gets added back in the income measure used by colleges. Perversely, colleges do count retirement assets going the other way. If you withdraw from a tax-deferred account or convert it into a Roth, the aid formula will treat the money as if it were lottery winnings.

What to do?

First, fund your retirement accounts to the max when your kids are young. Assets parked in retirement accounts are beyond the reach of aid officers.

Next, be careful about converting to a Roth if you have kids aged 16 to 21. It may cost you in reduced aid more than it saves over the years in federal taxes.

Finally, if you have a child in college and are contributing pretax money to a 401(k), think about switching to an aftertax (i.e., Roth) contribution. That will raise your 2012 taxes, lower your taxes in retirement and—surprise—increase the aid you get in 2013. That’s because aid formulas do deduct current tax bills in computing disposable income.

It is somewhat paradoxical that converting is bad, but electing a Roth for new money is good. Here’s the arithmetic. If you are in a combined 40% state and federal bracket, then converting $10,000 raises your tax bill by $4,000 and lowers your aid by $2,220. Switching from a $10,000 pretax to a $10,000 aftertax contribution raises your tax bill by $4,000 and raises your aid by $1,480.

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Now that the country’s foremost tax geeks have had some time to digest President Obama’s proposed tax reform, some of the current administration’s claims have begun to spring leaks.

For a reminder of the president’s proposals, click here: 2012 Presidential Candidates – The Tax Proposals

An analysis of the president’s budget performed by the Tax Policy Center – an insanely meticulous Washington research group that does this sort of thing for a living — revealed that despite the administration’s promise to raise taxes only on those earning more than $250,000, 27.3% of all taxpayers will see their tax bill increase in 2013 under the proposed reform when compared with a “current policy[i]” baseline, including 51% of taxpayers earning between $100,000 and $200,000.

To be fair, the group targeted by the president to bear the burden of his tax increases — those earning more than $1,000,000 — will experience an increase in their 2013 tax bill by an average of $179,118, while those earning between $100,000 and $200,000 will only see their tax climb by an average of $58. But even with that, these results stand in stark contrast with many of the promises made by the current administration. Click to enlarge the Tax Policy Center’s illustrative table:


What gives rise to the disconnect?

It appears the Obama administration compares the results of its proposed tax reform to a “current law” baseline, which assumes that the Bush tax cuts expire for all taxpayers and no  “patch” is provided to index the AMT exemption for inflation. Under this scenario, only 6.5% of all taxpayers would see their tax bill increase in 2013, with only 0.7% of those taxpayers earning between $100,000 and $200,000 experiencing a rise in tax liability. Again, click to enlarge:

The problem with such an analysis, unfortunately, is a little thing called reality. Few believe that under any scenario, the Bush tax cuts would be allowed to expire for all taxpayers, making the “current law” baseline a highly implausible one.

Going back to the more realistic “current policy” baseline, a natural question arises as to how much of the middle class can experience a tax increase if President Obama is primarily proposing to raise the top two tax brackets, leaving the others unchanged. The answer, according to the Tax Policy Center, is found in the president’s corporate proposals, as taxpayers at all income levels own corporate stock. As Roberton Williams, a senior fellow at the Tax Policy Center explained to Bloomberg News, “There are enough corporate tax increases in the president’s plan to have a measurable impact on the distribution.”

The Tax Policy Center’s analysis wasn’t the only recent bit of bad news for the current administration, however. The Joint Committee on Taxation released an estimate that the president’s proposed “Buffet Rule”– which would require taxpayers earning more than $1,000,000 to pay a minimum 30% tax rate — would raise a mere $47 billion in tax revenue over the next decade, an amount which would cover only half the cost of the recent 10-month extension of the 2% payroll tax cut.  

From Bloomberg:

“The president’s so-called Buffett rule is a dog that just won’t hunt,” Senator Orrin Hatch of Utah, the top Republican on the Finance Committee, said in a statement, adding that the proposal would have little effect on reducing the federal budget deficit. “It was designed for no other reason than politics.

There is no economic rationale for it.”

It should be interesting to see if the president modifies his proposals in light of these pieces of analysis, or whether he dismisses them as conjecture.

[i] “Current policy” assumes that the Bush tax cuts will be extended, the AMT exemption is indexed for inflation, and the estate tax applies at its 2012 levels.

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Who’s up for a little S Corporation 101?

Well, I’m doing it anyway. S corporations generally don’t pay tax. Instead, the corporation’s taxable income or loss is divvied up and allocated to its shareholders, who report the income on their Form 1040.[i]

S corporation shareholders are required to maintain their “basis” in their S corporation stock. This is done primarily for three reasons: to determine gain or loss on the sale of the stock, to determine the taxability of S corporation distributions[ii], and lastly, to determine the maximum amount of S corporation loss allowable on the shareholder’s individual income tax return. It is this final reason we concern ourselves with today.

Unlike a C corporation, a shareholder’s stock basis in an S corporation is not static. Because of the “flow through” nature of S corporations, a shareholder’s basis must constantly be adjusted to prevent the corporation’s income from being taxed twice.[iii]

In general, a shareholder’s basis in his S corporation stock is increased for:

  • Capital contributions
  • Items of income (including tax exempt income)

And decreased for:

  • Distributions
  • Items of loss and deduction (including non-deductible expenses like M&E)[iv]

For any tax year, a shareholder’s allocable share of the S corporation’s loss can only be deducted to the extent of the shareholder’s basis in his stock, after accounting for the increases listed above.[v] To the extent a loss is limited under this rule, it is “suspended” and carried forward, where it is treated as a new loss in the succeeding year and is again subject to the basis limitation rule.

Today, the Tax Court tackled a seemingly simple, yet interesting issue. What if a shareholder neglects to deduct a loss they are entitled to. Must they reduce their stock basis for the loss, even though they received no tax benefit from the loss?

Let’s apply some round numbers to make it easier to follow. In 1995, A set up S Co. with a $50,000 capital contribution. During 1995 and 1996, A was allocated $200,000 of loss from S Co. which reduced his basis to $0 as of the end of 1996. Because the loss exceeded A’s positive basis of $50,000, A only received the benefit of $50,000 of loss during those two years, with the remaining $150,000 of loss suspended as of December 31, 1996.

In 1997, A contributed $250,000 to S Co. S Co. allocated a $50,000 loss to A in  1997, which he deducted on his Form 1040. A, however, failed to deduct the prior year suspended loss of $150,000, despite the fact that his capital contribution gave him ample basis to do so. As a result, A did not decrease his basis for the suspended loss, leaving him with $200,000 of stock basis as of December 31, 1997.

Fast forward five years. From 1998-2003, A continued to reflect this “extra” $150,000 in his basis, which stood at $300,000 on January 1, 2003. In 2003, S Co. allocated a $275,000 loss to A, which he deducted in full on his return.

The IRS disallowed $125,000 of the loss, arguing that A’s stock basis was required to be reduced by $150,000 of additional losses in 1998 — even though A did not deduct the loss on his return, as he was entitled to. Because under this calculation, A would have only $150,000 of stock basis on January 1, 2003 ($300,000 according to A less $150,000 downward adjustment from 1998), S Co.’s 2003 loss of $275,000 was limited to A’s stock basis of $150,000.

In defense of his stock basis calculation, A argued that I.R.C. § 1367 requires basis reduction only for losses that the S corporation shareholder reports on his or her tax return and claims as a deduction when calculating tax liability.

The Tax Court disagreed and sided with the IRS, holding that a shareholder is required to reduce his basis in S corporation stock for his allocable share of the S corporation’s loss, even if the shareholder did not deduct the loss on his Form 1040. From the court:

The class of losses described in section 1366(a)(1)(A)[S corporation losses] is not limited to losses that were actually claimed as a deduction by the shareholder on the shareholder’s tax return. Therefore, the basis reduction rule in section 1367(a)(2)(B) is not limited, as the Barneses contend, to losses that were actually claimed as a deduction on a return.

As a result, A was denied $150,000 of loss on his 2003 tax return. Of course, A would have been entitled to amend his 1996 return to take the $150,000 loss he was entitled to during that year, if it weren’t closed by statute. Ouch.

[i] S corporation shareholders are generally required to be individuals, but see I.R.C. § 1361 for the rules regarding certain qualifying trusts.

[ii] See I.R.C. § 1368 and our previous post here

[iii] To illustrate, assume Mr. A contributed $100 to S Co. in exchange for all of its stock. S Co then earns $20 in year 1, which is not taxed at the S corporation level, but rather flows through to Mr. A and is taxed on his Form 1040. Presumably, the value of S Co. is now $120. If Mr. A sells the stock for $120, were he not required to adjust his basis in the S Co. stock, he would recognize $20 on the sale ($120 sales price – $100 basis). By increasing Mr. A’s stock basis by the $20 of income recognized by S Co., Mr. A recognizes no gain on the sale of the S Co. stock ($120 sales price – $120 basis). Thus, the $20 earned by S Co. is only taxed once.

[iv] I.R.C. § 1367

[v] The regulations at Treas. Reg. §1.1367-1(f) also require distributions to reduce stock basis before losses.

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The U.S. government announced today the formation of an “IRS SWAT Team,” perhaps the least intimidating name for a collection of presumably tough guys since my 2009 fantasy football team was christened “The Fightin’ Amish.”

The SWAT team — comprised primarily of former Big 4 auditors and attorneys — will be charged with cracking down on “transfer pricing” — companies that shift overseas profits from country to country in search of favorable tax rates.

Reuters has more…

Transfer pricing is a booming field of global tax law. It involves multinational corporations that are constantly moving goods, services and assets from one subsidiary to another in different countries and how they account for these “transfers.”

By carefully manipulating the pricing of such moves, companies can effectively shift profits to low-tax countries from high-tax ones, lowering their overall tax costs.

Governments in the developing and developed world, many of them faced with crushing deficits, are working to curb transfer pricing because it reduces corporate tax revenues.

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Donald Carl Barker is the rare man with three names who failed to fulfill his destiny of becoming a serial killer, Nascar driver, or high profile assassin, and instead actually did something useful with his life. Barker works for NASA, and he’s made it his personal mission to enable humans to one day colonize Mars, where we’ll create a utopian society where jet packs are abundant, high-fives replace cash as currency, and we’re free to marry our attractive cousins without judgment.

Barker has the education necessary to make his dreams a reality: a double bachelor of science in physics and psychology, a master’s degree in physics, psychology and math, another master’s degree in space architecture, and at the time of his appearance in front of the Tax Court, a half completed Ph.D. in geology. Kinda’ puts your Liberal Arts degree to shame, no?

Alas, in all that learning, Barker never garnered an understanding of the finer points of the Internal Revenue Code. In 2003, Barker launched a Schedule C “business” called Mars Advanced Exploration & Development, Inc. (MAXD), which was established to obtain funding for various technologies relating to exploring the Red Planet.

Over the next half decade, MAXD sporadically pursued its goals: submitting a funding proposal to NASA in 2003 (denied), applying for a patent in 2005 (also denied), and publishing a design study in 2008. Over that same span, it generated exactly zero dollars in revenue.

None of that kept Barker from deducting expenses in each year, including $7,500 in 2006. The IRS denied the expenses, arguing that MAXD never actually…you know…did anything, and thus wasn’t engaged in an active trade or business.

The Tax Court was left to decide whether MAXD’s activity did in fact rise to the level of a trade or business, necessitating a review of three factors previously established by the courts:[i]

(1) whether the taxpayer undertook the activity intending to earn a profit;

(2) whether the taxpayer is regularly and actively involved in the activity; and

(3) whether the taxpayer’s activity has actually commenced.

To determine whether Barker undertook the activity intending to earn a profit, the Tax Court analyzed the nine regulatory “hobby loss” factors,[ii] which quite frankly, we’ve beaten to death on this blog, discussing it here, here, here, and here. 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.  Whether the activity lack elements of  personal pleasure or recreation.

In ruling that MAXD did not carry on a trade or business, the court held that Barker failed to keep accurate books and records, did not expend significant time on the activity during the year at issue, and was generating consistent losses that were offsetting Barker’s compensation income from his NASA job.

Next, the Tax Court addressed the second factor: whether Barker was regularly and actively involved in MAXD. Because Barker was working two jobs while also pursuing his Ph.D., the court found there was insufficient evidence to establish that Barker was involved with MAXD with any regularity.

With regards to the final factor, there remained no reason to determine whether MAXD had commenced its business,  since the court had already held that thre was no business. Thus, the Tax Court thus sided with the IRS, holding that Barker’s purported business expenses were not allowable.

Barker’s loss, however, is the American people’s gain. With this defeat behind him, Barker can refocus his efforts on helping NASA with its most daring and exciting project yet: blowing up the moon:

[i] Commissioner v. Groetzinger, 480 U.S. 23 (1987); McManus v. Commissioner, T.C. Memo. 1987-457, aff’d without published opinion, 865 F.2d 255 (4th Cir. 1988).

[ii] Treas. Reg. §1.183-2(b).

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House Republicans released a budget proposal today that would consolidate the six current individual income tax brackets into only two — a 10% and a 25% bracket — while also reducing the top corporate rate to 25% and eliminating taxes on U.S. companies’ overseas profits.

The proposal is part of  a larger election-year message signifying that Republicans — unlike their Democrat counterparts — have a plan to balance the federal budget in a way that does not necessitate tax increases.

As part of Congressman Paul Ryan’s plan, spending would be cut on Medicare, food stamps, college tuition grants, and other “safety net” programs. The plan would produce a 10-year deficit of only $3.13 trillion, less than half the deficit created by President Obama’s recently released budget.   

Equally as predictable, Democrats’ panned the proposal as screwing the poor to finance tax cuts for the rich.

Either way, from a tax perspective the proposal is as meaningful as rearranging the deck chairs on the Titanic, as neither side realistically expects the suggested reform to become law. Rather, the Republican plan is aimed towards establishing the party’s position on spending and taxes prior to the November election.

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It is with an inordinate amount of joy that I relay the news that Tax Masters — the “tax resolution” company whose commercials offering to reduce or eliminate IRS deficiencies became a staple of late night television, giving rise to parodies by Saturday Night Live, among others — has filed for bankruptcy.

In this case, it’s not just our typical schadenfreude at work; we’ve had a bit of  a personal vendetta against the company since a good buddy of ours sheepishly confessed to us that he paid Tax Masters several thousand dollars to help with a large unpaid tax bill, only to get the runaround whenever he tried to gauge the company’s progress. The standard response coming out of Tax Masters was along the lines of “We’ll need another installment payment from you before we can continue to pursue your case,” causing him to eventually abandon hope of receiving the help he had paid for and leaving him $4,500 deeper in debt.

My problem with Tax Masters is that like the makers of the shake weight and Axe Body spray, they prey on the desperate, offering quick solutions to deep-rooted problems.

As any CPA knows, negotiating a successful Offer in Compromise can be a long, arduous, and most importantly, unpredictable process. The likelihood of success is largely dependent on the specific facts: the client’s financial picture and compliance history, the size of the deficiency, and the reasonableness of the offer. To wit: in 2010, the IRS received 57,000 OIC applications, but only 14,000 were accepted.

According to Tax Masters’ three-page bankruptcy filing, the company has less than $50,000 in assets and up to 5,000 creditors with claims nearing $10,000,000, many of whom our former clients like my friend who want to be made whole, but thanks to bankruptcy protection, will likely never see a dime. From Janet Novack at Forbes:

According to a report on Houston’s KHOU this morning, the bankruptcy filing “comes as the Texas Attorney General’s Office is set to begin a trial against the tax resolution firm for misleading consumers under Texas’ Deceptive Trade Practices Act.”

Texas sued TaxMasters in May 2010…alleging that TaxMasters misled consumers by offering an installment payment plan for its fees to prospective customers, without disclosing it wouldn’t start working on a case until it got all its money—even if that meant key Internal Revenue Service deadlines were missed. Last month, KHOU’s I-Team reported that consumer complaints about TaxMasters were continuing to pour into the state.

Coming on the heels of the untimely demise of JK Harris and Roni “The Tax Lady” Deutch — two other “debt resolution” pitchmen — the Tax Masters’ bankruptcy offers a stern if painful reminder to taxpayers to steer clear of late night TV snake oil salesmen. If you find yourself owing the IRS back taxes, hire a lawyer, a CPA or an enrolled agent.

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