Posts Tagged ‘court’

When the calendar turns to mid-March and tax season makes the leap from annoying to soul-crushing, I spend more time than I should daydreaming about goin’ all Walter White and breaking bad, only instead of cooking meth, I’d use my well-honed number-crunching skills to become an underground bookie.

Oh, what a life it would be. Instead of spending March Madness in a tiny office cranking out tax returns, I’d spend it in a giant war room complete with wall-to-wall flat screens, building my riches on the failed dreams of student athletes. I’d work the phone better than Gordon Gecko, avoiding detection by using subversive colloquialisms like “unit” and “juice.” I’d threaten to break thumbs with impunity. And I’d make money. Lots and lots of money. Because the house never loses.

The house doesn’t lose because it is (generally) indifferent to who the bettors favor. Not to get into Gambling 101, but if you bet $100 on the Seahawks + 2 ½ in the Super Bowl, you won $100, But if you bet $100 on the Broncos to cover the 2 ½ points (sucker), you lost $110. The $10 the loser pays over and above the wagered amount is the “vig.”

Thanks to the vig, bookies generally don’t care who people are betting on, as long as the bets are fairly even on both sides. And of course, bookies have the advantage of being able to move the line to make sure this happens.

When it comes to horse racing — which in my bookie fantasy world, I will  occasionally dabble in but not invest heavily – the house has an added level of protection in the form of “parimutuel wagering.” It works like so:

The entire amount wagered on a particular race is referred to as the betting pool or “handle.” The pool can then be managed to ensure that the track receives a share of the betting pool regardless of the winning horse. This share of the betting pool that the track keeps for itself is often referred to as the “takeout,” and the percentage is driven by state law, but generally ranges from 15% to 25%.

The takeout is then used to defray the track’s expenses, including purse money for the winning horses, taxes, licenses, and fees. The takeout can also be used, if needed, to cover any shortfall in the amount necessary to pay off winning bettors. To the extent any excess takeout remains after covering these two classes of obligations, the track has profit.

Once the betting pool has been reduced by the takeout, the balance is generally used to pay off any winning wagers, with the excess, once again, representing profits. Great business model, isn’t it?

Yesterday, an enterprising CPA with a raging gambling habit threatened to strike a blow for bettors everywhere when he took on the IRS in the Tax Court and argued that the portion of his wagers attributable to the “takeout” were deductible without limitation. But before we can understand the significance of the case, we need to understand some basics about the taxation of gambling.

Treatment of Gambling Expenses, In General

Section 165(d) provides that “losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.” Generally, any winnings are reported on page 1 of the Form 1040, while the losses (but only to the extent of winnings) must be claimed as itemized deductions. Thus, if a bettor is one of the 66% of Americans who don’t itemize their deductions, they would effectively be whipsawed – they would be forced to recognize the gambling income, but would receive no benefit from the losses.

Section 162, however, generally allows a deduction for “all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.”

Putting these two provisions together, many bettors have taken the position that if their gambling activities are so frequent, continuous and substantial as to rise to the level of an unhealthy addiction a Section 162 trade or business, then gambling losses are deductible as Section 162 business expenses, and are not subject to the loss limitations imposed by Section 165(d). In their view, if the gambling activity constitutes a business, because the losses (along with the gains) should be reported on Schedule C, rather than itemized deductions, the losses should be permitted in full.

The courts have repeatedly shot this theory down, holding that even a professional gambler who properly reports his activity on Schedule C may only deduct losses to the extent of gains.

In a very important 2011 decision out of the Tax Court, however, the court held that while gambling losses are limited to the extent of gambling winnings, any non-loss expenses of a professional gambler engaged in a trade or business – items like automobile expenses, travel, subscriptions and handicapping data – are not subject to the Section 165(d) limitation. Thus, a professional gambler could reduce his winnings to zero by his losses, and then further deduct any non-loss business expenses, generating a net loss from the activity. (See Mayo v. Commissioner, 136 T.C. 81 (2011).)

And that brings us back to our gambling CPA.  In Lakhani v. Commissioner, 142 T.C. 8 (2014), settled yesterday, an accountant/prolific track bettor made the compelling argument that his portion of the track’s “takeout expenses” represented non-loss business expenses rather than gambling losses, and were thus deductible without limitation. The taxpayer posited that by extracting takeout from the taxpayer’s wagers and using those funds to pay the track’s operating expenses, the track was acting in the capacity of a fiduciary. The taxpayer further likened the process to that of an employer who collects payroll taxes from his employees and remits them to the IRS and state agencies. Stated in another manner, the taxpayer argued that he was paying the operating expenses of the track, with the track acting as a conduit by collecting the takeout and using the funds.

Based on this position, the taxpayer argued that he was entitled to non-loss gambling business deductions in excess of $250,000 between 2005 and 2009.

The IRS disagreed with the taxpayer’s argument, countering that because the takeout is paid from the pool remaining from losing bets, “it is inseparable from the wagering transactions,” and thus constitutes wagering losses that are subject to the limits of Section 165(d). Furthermore, the Service argued that the taxpayer could not deduct business expenses for amounts paid from the takeout by the track for taxes, fees, and licenses, etc… because these were expenses owed by the track, not the individual bettor.

The Tax Court sided with the IRS, holding that the taxpayer’s share of the takeout expenses represented wagering losses that could only be deducted to the extent of winnings under Section 165(d). In reaching this conclusion, the court differentiated between an employer remitting payroll taxes on the behalf of an employee and a track using takeout funds to pay its operating expenses.

The employee, the court stated, is ultimately responsible for his share of the payroll taxes on his wages, and it is the remittance of these taxes by the employer that discharges the employee of this obligation. To the contrary, at no point are the expenses of the track imposed on the individual bettor; they are always obligations of the track. The tracks use of the takeout to pay its expenses, the court stated, does not discharge any obligation of the bettor.

As a result, the court concluded that because the track’s expenses were never an obligation or expense of the bettor, the takeout could not qualify as the bettor’s business expense. Instead, the takeout represented an additional gambling loss by the taxpayer, and could only be deducted – when added to his other losses – to the extent of his winnings.

follow along on twitter @nittigrittytax

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My father-in-law came to visit this week, and over Friday night pizza, the conversation turned to politics; specifically, Mitt Romney’s much-ballyhooed 13.9% effective tax rate in 2010.

Being a tax guy, I wanted my father-in-law to understand exactly why Romney’s rate was so low given his $21,000,000 of AGI, which required a primer on the taxation of carried interest. [For your own primer, click here.]

As the discussion advanced, my father-in-law understandably struggled to understand why the profits received by private equity fund managers on their carried interest were taxed any differently than, say, the wages he earned over his 40-year career working for an insurance carrier.

Even after I advanced the standard arguments for a 15% rate on carried interest — the equity fund manager’s risk, the uncertainty of the profit stream, the “sweat equity” element, etc… — my father-in-law’s opinion remained blissfully simple:

“It still sounds like compensation to me.”

Now, my father-in-law is a staunch Republican in every way, shape and form. But yet, he failed to see how a 15% tax rate is justified on the income received by fund managers to do what they do: manage funds. Of course, my father-in-law is not the final arbitrator on such matters: after all, this is the same man who once advised me to buy a house located squarely within the Delaware River’s floodplain.

So perhaps you should decide for yourself. To facilitate your decision-making process, the Wall Street Journal has published this point/counterpoint on the carried interest tax issue, with Michael Graetz, a professor of tax law at Columbia Law School, arguing for carried interest to be taxed as ordinary income, while David Tuerck, executive director of the Beacon Hill Institute and a professor and chairman of the economics department at Suffolk University in Boston, argues that the preferential capital gains rates should be preserved.

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The opening day of the Supreme Court’s hearings on the Patient Protection and Affordable Care Act went pretty much as expected, with 90 minutes spent arguing semantics; specifically, whether the tax penalty imposed by I.R.C. § 5000A on individuals who fail to procure health insurance is more “tax” than “penalty.”  

As a reminder, today’s debate could have ended the highly anticipated hearing on the constitutionality of the individual insurance mandate before it began. If the I.R.C. § 5000A penalty was found to be a “tax,” then the Supreme Court would be barred from ruling on the  constitutionality of the insurance requirement by the Anti-Injunction Act — a 145-year old law — until after the tax has been imposed and collected — 2015 at the earliest. If the penalty is truly a “penalty,” however, then the Court can move forward with the argument everyone is longing to hear and determine the fate of Obamacare.

Well, we’ve perused the transcript from today, and while this is nothing more than our opinion, it appears that the majority of justices are in favor of settling the constitutionality debate sooner rather than later. If you’re scoring at home — and if you are, your loneliness saddens me — it would appear from the transcript that Justices Ginsburg, Scalia, Breyer, Kagan and Sotomayor are in favor of addressing whether Obamacare is constitutional now, while Justices Roberts and Alito would prefer to apply the Anti-Injunction Act and table any constitutionality discussion until 2015. It should be noted that it doesn’t appear that politics were the overriding motivation for any of the justice’s positions, as both conservative (Scalia) and liberal (Kagan) seemed to agree that the Anti-Injunction Act did not apply to I.R.C. § 5000A.

Perhaps the most fascinating aspect of the day was the unenviable position in which the government’s attorney -U.S. Solicitor General Donald Verrilli — found himself. Today, Verrilli vehemently argued that the I.R.C. § 5000A charge was not a tax but a penalty, and thus the Supreme Court was not prohibited from ruling on the provision’s constitutionality prior to the date the tax is collected. Verilli’s argument was made all the more difficult by the fact that everyone in attendance was keenly aware that tomorrow, when justifying the insurance mandate as constitutional, Verrilli would be back in the very same court room arguing that the I.R.C. § 5000A charge is in fact a tax, and is imposed as part of Congress’s taxing authority. Verrilli articulated his dueling positions thusly:  

Congress has authority under the taxing power to enact a measure not labeled as a tax, and it did so when it put section 5000A into the Internal Revenue Code. But for purposes of the Anti-Injunction Act, the precise language Congress used [calling it a penalty, rather than a tax] is determinative.

Verrilli wasn’t the only one in a tough spot on Monday. While the various states challenging the law are chomping at the bit to challenge the constitutionality of the insurance mandate, because both sides would prefer to determine the fate of Obamacare soon, no one was jumping at the chance to argue that the I.R.C. § 5000A tax penalty is in fact a tax, and thus subject to the Anti-Injunction Act. So to facilitate debate, the Supreme Court brought in their own attorney to do so, Robert Long.

Mr. Long — likely longing for his care-free days as a member of the popular rap group Black Sheep[i] — was stuck spending 30 minutes trying to convince some of the brightest people on the planet of something they appeared to have already decided they wouldn’t be convinced of. To be fair, the justices went easy on him., but there can’t be anything fun about getting hired to engage in an argument you know you can’t win.

Up today is the main event: the discussion of whether Congress has overstepped its taxing authority in requiring all American’s to obtain health insurance or suffer a tax…penalty…whatever. We’ll let you know how it goes.

[i] Not verified. May be an entirely different Mr. Long.

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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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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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