Double Taxation: A Take On All Things Taxes

Section 6663 imposes a 75% penalty in the event that any portion of a tax underpayment is attributable to fraud. The problem, of course, is that an allegation of fraud speaks to a taxpayers’ intent, which as you might imagine can be a rather difficult thing to establish. That’s not to say that fraud can’t be proven, however, because like pornography or the infield fly rule, while we may not be able to define it,  we typically know it when we see it.

And the Tax Court certainly saw it today, assessing fraud penalties against a corporation and its sole shareholder. Earlier this week, we warned against using a corporation as an incorporated pocketbook, but this is precisely what Gary Garcia did. When revenue came into his wholly-owned airplane repair company, he redirected many of the funds to pay his personal expenses, including his home mortgage. Making matters worse, the funds were paid out of a bank account that was hidden from his CPA.

Over time, the IRS came calling, and Garcia again neglected to turn over detail of the corporation’s secret account. Unfortunately for Gary, the IRS —  as opposed to your run-of-the-mill CPA – has the power to issue a summons to a bank requesting all of a taxpayer’s data, and the Service did just that, bringing to light Garcia’s shenanigans.

While Garcia eventually conceded to the additions to tax at both the corporate and personal level — for under-reported corporate income and  the assessment of constructive dividend income on his individual return —  he fought the imposition of the fraud penalty.

As part of his argument, Garcia maintained that he did not act fraudulently because he relied in good faith on his accountant to prepare his personal return. This is relevant because prior decisions have established that a taxpayer’s justifiable reliance on an accountant to prepare income tax returns may indicate an absence of fraudulent intent.[i]

There was just one small hole in Garcia’s argument: you cannot rely on the fact that a CPA prepared your returns if you concealed the information necessary for your accountant to prepare an accurate tax return. In fact, the purposeful suppression of relevant tax information works the other way; it is evidence of a taxpayer’s intent to conceal and deceive, one of the major indicia of fraud.

The lesson? Be honest with your tax preparer. Give them all of the information necessary to file a complete return, and if they screw up or do something unethical, while an increased tax liability may be coming your way, at least you won’t be stuck with a 75% fraud penalty, like poor Gary Garcia.

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Any tax adviser who has ever been saddled with the unenviable task of reporting a client’s charitable contribution of real estate knows that it’s a colossal pain in the ass. The rules of I.R.C. § 170 and the related regulations contain numerous substantiation requirements for contributions of property with value in excess of $5,000, including the need for a qualified appraisal that must be attached to the return containing the contribution. The “qualified appraisal,” in turn, comes with its own lengthy set of requirements, ranging from who can be considered a “qualified appraiser” to a laundry list of information that must be contained within the report. These onerous substantiation requirements have left some tax advisers pondering whether the IRS is actually trying to discourage charitable giving.

Expect that sentiment to reach well beyond the tax world when word leaks out about the Tax Court’s decision today in Mohamed v. Commissioner, T.C. Memo 2012-152. In Mohamed, a prominent California entrepreneur and philanthropist who everyone seems to concede contributed over $18,000,000 in real estate to qualified charities, received zero charitable contribution deduction because of his failure to comply with the substantiation requirements of Treas. Reg. §1.170-13.

Joseph Mohamed made his millions in real estate; as a broker and certified appraiser, he amassed a fortune in real property. Mohamed and his wife wanted to share their considerable wealth, so they established a charitable remainder unitrust  — or CRUT — to facilitate the transfer of some of their properties to charitable organizations.

During 2003 and 2004, Mohamed donated six properties to his CRUT, claiming $4.2 million in charitable contribution deductions, with another $15 million limited by AGI and carried forward to future years.

Mohamed is a bright guy with one fatal flaw: he ventured to prepare his own tax return. In doing so, he filled out Form 8283 — Noncash Charitable Contributions — without reading the instructions, because it “seemed so clear that he didn’t think he needed to.” This would prove to be a costly mistake.

Before we go any further, a quick primer on the specific substantiation requirements for property contributions in excess of $5,000 is in order. These requirements are found in Treas. Reg. §1.170-13.

• A qualified appraisal must be made not more than 60 days before the gift and no later than the due date of the return;
• It must be signed by a qualified appraiser, who cannot be the donor or taxpayer claiming the deduction or the donee of the property.
• The qualified appraisal must contain scores of information required by the regulations, including a description of the property, the basis of the property, and the appraised FMV of the property.

Having read neither the regulations nor the form instructions, Mohammed knew not of these requirements. Instead, he took a rational approach when completing Form 8283: he was a real estate appraiser, he knew the value of the contributed properties, so he filled out the form with the information as he saw it. As a result, Mohamed failed to comply with the regulations in the following ways:

• He didn’t obtain an independent appraisal. Instead, he appraised the properties himself, a direct violation of the regulations;
• He did not sign the Declaration of Appraiser (because Form 8283 indicated he could not since he was the donor, which should have tipped him off to larger problems);
• He attached statements to the return that failed to contain much of  the required information concerning the properties, including basis of the contributed properties and their manner of acquisition.

The IRS began auditing Mohamed in 2005, and sought to strike down the full amount of his charitable contribution deductions . To combat the IRS scrutiny, Mohamed obtained an independent appraisal in 2005, which verified that the values actually exceeded the amounts claimed on the return. Undeterred, the IRS then  shifted its attack to the substantiation requirements, arguing that since Mohamed failed to satisfy the rules of Treas. Reg. §1.170-13, the deductions must be denied in full.

In his defense, Mohamed posed three argument:

1. That the I.R.C. § 170 regulations were invalid,

2. That he substantially complied with the substantiation requirements, or

3. That Form 8283 was not adequate in advising taxpayers of the substantiation requirements.

The Tax Court quickly dismissed arguments 1 and 3, holding that the regulations were indeed valid, and that while Form 8823 may be confusing, the ultimate sources of law are the statute, regulations, and judicial decisions and not the form instructions.

As a result, the Tax Court was left to decide whether Mohamed substantially complied with the substantiation regulations; in other words, did he do enough to justify a deduction even in the absence of meeting the formal requirements of Treas. Reg. §1.170-13?

Ultimately, while conceding that the ruling was extremely harsh, the Tax Court disallowed all of Mohamed’s charitable contribution deductions, holding that he failed to substantially comply with the regulations, as he made the following fatal mistakes:

• He failed to comply with the “essential requirement” of obtaining a qualified appraisal,
• He failed to qualify as a qualified appraiser, since he was both the donor and donee;
• His attachments to Form 8283 lacked detailed information to put the IRS on notice of the nature of the donation;  
• He didn’t sign his statements or indicate the method for computing the valuations;
• The appraisals by the independent appraiser were performed more than a year and a half after the required due dates, and thus could not be “qualified appraisals.”

There are two lessons of note here: First and foremost, this is a cruel reminder that good intentions do not guarantee tax deductions. You must comply with any substantiation requirements, onerous and unnecessary as they may seem. The IRS and Tax Court both conceded that Mohamed made a deduction of eligible property to a qualified organization, and in fact may have understated the properties’ values, but failure to follow the substantiation rules doomed his entire deduction.

Secondly, no matter how smart you fancy yourself, hire a tax preparer. I’ve met some bad preparers in my day, but there’s nary a one who would claim a $19 million charitable deduction without making sure the required i’s were dotted and t’s crossed. The tax rules are too complicated for those outside the industry to fully grasp; do yourself a favor and get some professional help.

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[Ed note: I'm aware that we planned to publish a video blog every Friday morning, but since we don't expect many people to be working tomorrow, we've moved it up a day.]

Last week our video blog (or “vlog,” as one of my hip co-workers clarified the lexicon for me) focused on Situation 1 of Revenue Ruling 99-6, which provides the tax consequences upon the conversion of a multi-member partnership into a single member LLC disregarded as separate from its owner. Specifically, Situation 1 dealt with a fact pattern where one partner purchased the interests from the remaining partners, converting the partnership into a SMLLC. 

Today we take on Situation 2 of Revenue Ruling 99-6, which again deals with the conversion of a multi-member partnership into a SMLLC, but this time addresses a fact pattern where an outside buyer purchases all the partnership interests from the current members.

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Dimiter Hristov operated his medical practice thorough a wholly owned S corporation. Tired of handing over 45% of his income to the IRS each year, he began searching for tax saving alternatives. Because Hristov regular tax preparer was an enrolled agent who — admittedly — did not have the sophistication to conjure up such tax solutions, he eventually sought the help of a snake-oil salesman named William Alexander.

Alexander pitched pension plans and Section 419 plans for a living, and he pitched them hard. Fraudulently holding himself out as an enrolled agent, Alexander claimed to have “learned from 8-10 of the sharpest and most aggressive CPAs in the country” about how to take advantage of retirement plans and defend them on audit. To hear Alexander tell it, Hristov could lower his tax liability with large retirement contributions, yet still have access to the cash to make additional income-producing investments.

 And if Hristov’s regular accountant didn’t agree, well…she just didn’t know any better:

 What do most accountants and tax attorneys say about all of this? Most would never advise you to put these plans together and do what I do because they don’t understand and know about what I do. Why? By nature, it seems like U.S. accountants are conservative and backward people that are not creative. It’s really easier for them just to have you pay a lot of tax. You have a lady accountant now, who is conservative and backward, but if she does what I tell her to do, you can keep her; otherwise, use one of my accountants * * *.

Though skeptical at times, Hristov signed on, allowing Alexander to establish retirement plans for the S corporation. Each year from 2004 through 2006, Hristov would make a cash payment to the retirement account,  Alexander would take his cut, and the rest would be “loaned” back to Hristov, never to be repaid; a rather large violation of the qualified plan rules. But that didn’t concern Alexander:

 If I put $400K into the pension plans, you would have no tax, but obviously, you would have to borrow a lot of money from the pension plans, which my clients do as I promote this. Assets in the money purchase plan can be invested anywhere while I use fixed and variable annuities for the 419 plan, you really are not supposed to borrow money from the 419, but I’m aggressive so I have my clients do this * * *.

As if that weren’t egregious enough, Alexander encouraged Hristov to amend his 2002 return by reclassifying large expenses paid for assets to retirement plan contributions, resulting in a $100,000 refund request, from which Hristov took his 10% cut.

Throughout the process, Alexander continued to assuage Hristov’s fears with letters such as this:

 “I also think this amendment will move through easily without IRS even asking for copies of the checks because we are amending a K-1, but if I am wrong, and IRS asks for checks, we can come up with check[s]…we are just asking for a refund so the worse thing that could happen is to be denied, but typically I get the refund although sometimes it takes a while”.

To be fair, with the smooth delivery and impeccable grammar evidenced in that communication, who wouldn’t have their nerves calmed?  

 The IRS, however, predictably began auditing Hristov, resulting in a full disallowance of all the pension plan contributions and leaving Hristov on the hook for over $400,000 in back taxes. And despite Alexander’s previous assurances to Hristov that he was an acclaimed audit negotiator,  he cut and run, refusing to provide documentation to the IRS before eventually having an order of injunction filed against him, prohibiting him from promoting his pension plan scam.

But here’s the real lesson of the Hristov case: despite being rooked by Alexander, Hristov was not able to use the “reasonable cause” defense of I.R.C. § 6664 to avoid understatement penalties.

In general, the most common taxpayer appeal for reasonable cause comes in the form of “reliance upon the advice of a tax professional.” In determining whether a taxpayer’s reliance on a professional is reasonable, the courts tend to look at three factors:

 1. Was the adviser a competent professional who had sufficient expertise to justify reliance?

 2.Did the taxpayer provide necessary and accurate information to the adviser; and

 3. Did the taxpayer actually rely in good faith on the adviser’s judgment?

Hristov, the Tax Court concluded, was not reasonable in relying on Alexander for two reasons: First, there was an obvious conflict of interest: Alexander only got paid to the extent Hristov made contributions to the retirement plan pitched and managed by Alexander. Furthermore, reliance on the professional advice of a tax shelter promoter is unreasonable when the advice would seem to a reasonable person to be “too good to be true.” Because Hristov was made aware by Alexander that he would both 1) get a tax deduction for the funds contributed to the retirement plans, and 2) have access to the cash, he should have sought independent confirmation from a reliable and disinterested adviser familiar with retirement plans.

Failure to do so cost him dearly.

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