Posts Tagged ‘ny’

Substantiation is a critical component of any tax deduction. In order to withstand an IRS challenge, it’s essential that a taxpayer maintain sufficient records to support their claimed deductions. And while the statute requires varying degrees of substantiation for different types of expenses, some simple universal truths apply to all deductions:

  • The burden falls on the taxpayer to substantiate the expenses; the IRS is not required to prove the expenses didn’t happen.
  • The fact that an expense was reported on a prior year return and created a net operating loss does not in itself substantiate those deductions. Tax returns are not substantiation.[i]
  • While the Cohan Rule[ii] permits the IRS to estimate a taxpayer’s deductions in the absence of the required substantiation, the IRS can’t do so if it has no reasonable way to approximate the expenses. In other words, you’ve got to be able to show the IRS something.

Failure to heed these rules can quickly lead to an adverse IRS exam or court decision, as one Maryland couple found out yesterday in a decision chock full of  perverted/litigious/murderous goodness:

Steven Esrig (Esrig) and his wife failed to timely file their tax returns from 1998 through 2003, and when they finally got around to it, they claimed significant deductions including net operating loss carryovers, business losses, and office expenses.   

Citing a lack of substantiation for all of the claimed losses and expenses, the IRS disallowed the deductions and assessed over $700,000 in additional tax for the six-year period, along with substantial late filing penalties.

In his defense, Esrig argued that he kept adequate records for his business expenses, though he never actually produced any of them at trial. Thus, it was left to the Tax Court to determine whether Esrig’s oral testimony constituted sufficient substantiation for his claimed deductions, and in order to do so, the court first had to gauge his credibility. As you’ll soon see, this is where things started to go bad for Steven Esrig:

Esrig liked to refer to himself as an “entrepreneur.” Now while normally, calling oneself an entrepreneur is simply a pleasant alternative to calling oneself  “unemployed,” in this case it appears Esrig truly was an innovative visionary along the lines of Steve Jobs. Behold:

Steven told us at trial that he got the idea for the company after an incident involving one of his children. Apparently, his then-five-year-old child asked to look at the Power Rangers website.  Steven logged on but inadvertently mistyped a character in the web address. Instead of getting the Power Rangers website, up popped a seriously pornographic one. This, he told us, was the reason he started Stelor, a company he claims invented a technology that protects children from predators and pornography and “shuts down identity theft.”

Esrig then also laid claim to inventing quotation fingers, the tankini, Jack and Cokes, and raccoons. [iii]

For obvious reasons, the court wasn’t buying Esrig’s story, its doubts prompting it to ask the logical question, “How could a company with such a multifaceted wonder product fail to achieve any level of success?”

Steven told us that the company failed because it “ran into some litigation” after it bought the domain name “googles.com” from someone who had it before Google. This, he said, led to five or six years of litigation with Google and ultimately bankrupted his company.

Now that’s a tough break. Who would have guessed that poaching a domain name from the world’s largest tech giant would lead to costly litigation? It almost makes me wonder if my recent decision to purchase the web address “Facebulk.com” to promote my Aspen Lip Collagen Clinic was not the best of ideas. 

With Esrig’s credibility irreparably tarnished, the Tax Court had no choice but to side with the IRS, denying the disputed expenses in full, including the $17,700 Section 179 deduction Esrig claimed for the cost of a fish tank and dining room furniture.

There was still the matter of $180,000 in penalties, however, which would be added to Esrig’s bill unless he could convince the court that the late returns and large underpayments were not his fault:

At trial, Steven blamed the couple’s return preparer. He said that he’d asked his accountant to request extensions for all the years at issue, but his accountant missed all the deadlines because she had to serve a very long prison sentence for murdering her husband, and the person in her office who took over their account made a slew of mistakes.

Call me a softie, but if your CPA going on a killing spree isn’t “reasonable cause” for late filings, then I’m not sure what is.  But the Tax Court — likely tired of listening to Esrig’s various yarns and unable to differentiate truth from fiction —  failed to share my sympathy, upholding the full amount of the penalties.  

[i] See Lawinger v. Commissioner, 103 T.C. 428 (1994).

[ii] Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).

[iii] May not have happened.

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In perhaps the most senseless legal proceeding since my brother Mike’s false-advertising claim against the film “The Neverending Story,” an Alabama man attempted to convince the Tax Court that the repayment of a $1,000,000 loan should give rise to a tax deduction.

Sam Johnson (Johnson) and his father owned Johnson & Associates Mortgage Co, Inc., a full-service mortgage company. To stay afloat during its formative years, the company entered into a $1,000,000 line of credit with a local bank. In addition to the corporation, Johnson and his father were also listed as borrowers on the note in their individual capacities.  

In 2003,  half of the line of credit was repaid using life insurance proceeds paid upon the death of Johnson’s father. The repaid balance was promptly replaced with a new $500,000 note, which again was entered into by both the corporation and Johnson in his individual capacity.

This replacement note was subsequently repaid from Johnson’s personal account in 2004. On his 2003 individual tax return, Johnson claimed a $1,000,000 bad debt deduction related to his payments on the line of credit.[i]

Johnson argued that he was permitted the deduction because he had personally guaranteed the corporate liabilities in that amount. Presumably, Johnson believed that because he paid the notes in his individual capacity, he was entitled to repayment from the corporation, and the failure of the corporation to “make him whole” entitled him to a bad debt deduction pursuant to I.R.C. § 166.

Needless to say, the Tax Court disagreed, holding that because Johnson was listed as a separate borrower on the corporate notes, he did not make payment as a guarantor, but rather as a primary obligor. Citing prior case history — as well as common sense — the court held that Johnson’s repayment of a loan on which he was primarily responsible did not give rise to a tax deduction.[ii]

Of course, the most notable aspect of this case is that it ever managed to find its way onto the court’s docket to begin with. With so many legitimate tax issues of first impression yet to find their way into judicial precedent, it’s fascinating that such a well-established and fundamental tax concept was actually tried in front of the Tax Court. It would appear Judge Dean felt the same sense of frustration, as he was quick to slap Johnson with an accuracy related penalty.

[i] Good luck working through the math here, as only $500,000 of the debt was repaid in 2003 by Johnson personally. The other $500,000 was paid by his father’s life-insurance company upon his death in 2003. Presumably, Johnson was the beneficiary on the policy so he felt he “paid” this portion of the note.

[ii] See Brenner v. Commissioner, 62 T.C. 878 (1974).

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Every guy has a friend like my buddy Todd, who despite being an otherwise normally functioning adult, thinks it’s an indictment on his manhood to admit that he’s really into a girl.  

The thing is, he’s not fooling anyone. He’s been dating this same girl exclusively for the last nine months. He’s met her family. She’s met his. They go camping together, skiing together, make fondue together, all the adorable crap that defines the traditional boyfriend-girlfriend relationship.   

Only Todd refuses to refer to this girl as his “girlfriend.” Won’t do it. Even though everyone they come into contact with walks away certain that she is just that, he won’t concede it to his friends, lest a level of permanency attach to their relationship and jeopardize his self-aggrandizing “ladies man” persona.

Ridiculous, right? We’ll that’s exactly the same silly posturing Congress has engaged in for the last fifty years by refusing to make certain tax provisions permanent, instead enacting them with arbitrary deadlines and routinely allowing them to expire before retroactively extending them again and again and again.

Take, for example, the R&D credit. According to Congress, the credit is a “temporary” provision, but it’s been in the Code for 30 years! Every few years, the credit expires — as it did most recently on December 31, 2011 — and taxpayers and practitioners alike are left to put their faith in their pattern recognition skills and trust that Congress will again retroactively reinstate Section 41. Based on the history of these extenders, we can be confident it will get done, but we can never really be certain, and it makes tax planning needlessly complicated.

So why does Congress go through this song and dance every few years? It’s simple really: when the national budget is determined, any tax provisions that are set to “expire” at the beginning of the year are left out, typically yielding a much smaller budget deficit than what would otherwise appear. I wish I were making that up.  

Luckily, Montana Senator Max Baucus is taking up our cause, calling for a long-term solution that would end the uncertainty caused by the frequent renewal required for more than 50 tax provisions.

Until that day comes however, we’re left doing the annual year-end will-they-or-won’t-they bit. As for this year, according to MSNBC, our best chance at seeing expired provisions — including the R&D creidt — extended in the near future is if Congress is willing to tack the extenders package onto the proposed extension of the payroll tax cut, which is set to expire at the end of February.

Whether it happens remains to be seen, but in the interim, it can be awfully awkward extolling the virtues of an R&D study to a client when the statute permitting the credit technically no longer exists.

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When it comes to conjuring badass imagery, international airspace will always live in the shadow of its cousin, international waters. To wit:

International airspace = miniature bags of Rold Gold pretzels and insufferable Sandra Bullock films.

International waters = pirate ships and legalized monkey knife-fights.

Winner: International waters.

Both areas, however, are equally troublesome to the tax law. Consider the case of Andrea Ready (Ready). Ready was a dual citizen of the U.S. and U.K. who resided in France. Ready was employed as a flight attendant for United, where she regularly worked international flights.

On her 2006 and 2007 U.S. tax returns, Ready properly reported her wages earned from United.[i] Attached to each return, however, was From 2555-EZ, Foreign Earned Income Exclusion, claiming that all of Ready’s wages during those years represented foreign earned income excludable from gross income under I.R.C. § 911.

By way of background, I.R.C. §  911(a) permits a qualifying individual to elect to exclude “foreign earned income” from taxable income. Foreign earned income is defined as income received by a qualifying individual from sources within a foreign country which constitutes earned income attributable to services performed.[ii] Earned income is from sources within a foreign country only if it is attributable to services performed by the individual within a foreign country or countries.”[iii].

The IRS argued that the wages earned by Ready on flights in the U.S. and in international airspace did not constitute foreign earned income, as they were not earned in France or another foreign country, and thus were not eligible for exclusion from her taxable income.

While the Tax Court quickly agreed with the IRS with regards to Ready’s services performed within the U.S., the court had to dig a little deeper before reaching the conclusion that income earned in international airspace is not earned in a foreign country. Luckily, they’d already covered this seemingly obscure issue:

In Rogers v. Commissioner, T.C. Memo. 2009-111, 97 T.C.M. 1573, we concluded that income earned by a flight attendant while in international airspace was not foreign earned income and had to be included in the taxpayer’s gross income. The taxpayer in Rogers, like petitioner, was a U.S. citizen residing abroad and working as a flight attendant for United. In holding that the taxpayer in Rogers could not exclude income earned while in international airspace, we reasoned that income earned in international airspace was akin to income earned in international waters. We see no cause for disturbing our holding in Rogers, and we rely upon its reasoning to hold that petitioner may not exclude income earned in international airspace under section 911.

The lesson? There’s nothing new under the sun, or apparently, in the U.S. Tax Court.  

[i] Even though Ready was a resident of France, I.R.C. § 1 imposes an income tax on the taxable income of every individual who is a citizen of the United States, regardless of where they call home.

[ii] I.R.C. § 911(d)(1)(A).

[iii] Treas. Reg. §1.911-3(a).

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While Eli and the gang ready themselves for Sunday’s game, team ownership is preparing to fight it out in court over a $1,500,000 property tax bill East Rutherford says the team owes.

At the root of the issue is whether the team’s new training facility — which was built with private funds as part of the construction of Met Life Stadium — should enjoy the same tax-exempt status as the old state-owned Giants Stadium.

The team argues that the current training facility is grandfathered under the previous, tax-exempt arrangement:

“The new stadium replaced the old stadium. The Giants had a practice facility here and offices here. Now they have a practice facility and offices. Nothing has changed.”

From the county’s perspective, however, the Giants gave up the right to its property tax exemption when it borrowed $650,000 of private money to construct its current facility. As Mayor James Cassella put it,  “It’s an office building…Why should someone who owns an office building, built by a private company, not pay taxes?”

Of course, if the Giants have too much pride to lay down on Sunday, they could also try and cover their tax bill by laying $150 bucks at 10,000 to 1 that they’ll win by more than 29 but less then 33 points. It could happen, right?  Right????

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Managing the tax law is no different than installing hardwood, baking a casserole[i], or concocting an email that bilks the unwary by posing as the deposed prince of Nigeria: the devil is in the details. 

Take, for example, the case of Francis[ii] and Maureen Foster.[iii] A well-intentioned couple, they believed they had met the statutory requirements of a straight-forward tax provision, but by mishandling some subtle non-tax housekeeping, they cost themselves $8,000.  

In February 2006, the Foster’s put their home of 30 years on the market, though the property didn’t sell until June of 2007. During the 16 months between the initial listing and the subsequent sale, the Foster’s made several damaging administrative missteps:

  • They moved in with Mrs.. Foster’s parents, but failed to pay rent or any portion of the utilities.    
  • Mrs. Foster renewed her driver’s license at the old address, rather than at her parent’s address.
  • They used the old address on their 2005 tax return.  
  • During 2006 and 2007, the Fosters continued to visit the old home, where they maintained all utilities services, requently stayed overnight, and received mail.
  • On a 2007 rental application, the Foster’s again listed the address of the old home as their primary residence.

In July 2009, the Foster’s purchased a new home and claimed the $8,000 first-time homebuyer’s credit on their tax return. The IRS disallowed the credit in full, arguing that the Foster’s failed to qualify as first-time homebuyers.

The Service based its position on  I.R.C. § 36(c)(1), which defines a “first-time homebuyer” as any individual having no present ownership interest in a principal residence for three years prior to the date of purchase of a principal residence. The IRS argued that since the Foster’s hadn’t sold their previous primary residence until June 2007, a date only 2 years prior to the purchase of the new home, they failed to qualify for the credit.

The Fosters, to the contrary, argued that the ceased using the old home as a principal residence in February 2006 when they listed it for sale, and thus qualified for the credit as three years had passed prior to their purchase of the new home.

The Tax Court sided with the IRS, citing the damaging facts and circumstances bulleted above as evidence that the Foster’s continued to use their old home as their primary residence even after they moved out and until it was sold in 2007.

The takeaway lesson, quite obviously, is that paying attention to detail could have preserved the credit for the Fosters. Had they taken the steps necessary to distance themselves from their old home — by paying rent to Mrs. Foster’s parents, switching the address used for their licenses, tax returns, mail service, and rental applications to their temporary home and by cutting off any non-essential utilities and ceasing visitation at their old home  —  the Foster’s would likely be $8,000 wealthier today.

[i] Or so I’m told.

[ii] Note, the court did not indicate whether Francis Foster preferred to be called “Psycho.”

[iii] Foster v. Commissioner, 138 T.C. 4 (1.30.12)

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On Wednesday, we posted a quick tutorial on how to determine the deductible amount of mortgage interest when total mortgage debt exceeds the statutory limits. While we briefly mentioned that any interest in excess of the allowable amount was subject to the interest tracing rules, we failed to expand further on this concept.

Lucky for us, on Thursday the Tax Court explained the interest tracing principles beautifully, providing a ready-made supplement to our previous post.[i] 

Robert Brooks (Brooks) worked for Dain Rauscher (Dain) as a stock broker. As part of his compensation, Dain lent him more than $500,000, which Brooks promised to repay, including accrued interest. Dain, however, promised to forgive the loan, including the accrued interest, if Brooks remained a Dain employee.[ii]

In 2003 Dain forgave the entire loan and included $650,342 ($506,300 in principal and $144,042 of accrued interest) on Brooks’ 2003 Form W-2. Brooks recognized the income on his 2003 tax return, but upon a subsequent IRS audit, he changed his position and argued that the accrued interest of $144,042 should not have been included in income.

The basis for Brooks’ argument lay in I.R.C. § 108(e)(2). In general, I.R.C. § 61 requires all cancellation of indebtedness (COD)income — including cancellation of any accrued but unpaid interest — to be included in income of the debtor. An exception to this general rule is found in I.R.C. § 108(e)(2), however, which provides that a debtor will not realize COD income to the extent payment of the liability would’ve given rise to a deduction.

Thus, the determination of whether Brooks could exclude the forgiven interest depends entirely on whether it would have been deductible on Brooks 2003 tax return had he actually paid it: if it would have been, Brooks could exclude the income; if it would not have been deductible, then the forgiven interest must be included in Brooks’ taxable income.

To determine the deductibility of the interest, the interest tracing rules must be applied. These rules generally allocate interest expense based on the use of the debt proceeds. Stated in another manner, Brooks was required to prove what the money borrowed from Dain was used for; if it was used in a trade or business, to generate investment income, or for the production of income under I.R.C. § 212; the underlying interest would be deductible as business interest, investment interest, or I.R.C. § 212 interest, respectively. To the contrary,if the proceeds were used for personal purposes, any interest would be non-deductible personal interest.[iii]

Brooks argued that the loan proceeds were used to purchase shares of stock, and thus the underlying interest should be deductible as investment interest. The Tax Court disagreed, for two reasons:

1. Brooks did not provide adequate support for how the borrowed funds were used. The only proof he provided was to point to the long list of stock transactions he attached to his 2003 return, which the court held was not sufficient to “trace” the use of the funds.[iv]

2. Even if the use of the funds could be traced to the purchase of stock, the interest would be investment interest, which is subject to limitation. Investment interest is only deductible to the extent a taxpayer has “net investment income,” defined as investment income less related expenses. Because Brooks had no net investment income in 2003, no investment interest would have been deductible by Brooks even if paid in 2003. Since payment of the interest would not have given rise to a deduction, I.R.C. § 108(e)(2) would not apply, and Brooks would be required to include the forgiven interest in income.

[i] Brooks v. Commissioner, T.C. Memo 2012-25.

[ii] The real issue here, as recognized by the Tax Court, was whether the loan should have been treated as compensation to income to Brooks when it was made in 1998. Since neither parties argued that the loan proceeds were compensation in 1998, the Tax Court “looked the other way” on the matter.

[iii] I.R.C. § 163(h)(1).

[iv] Brooks should have presented bank account statements and brokerage account records to show the flow of funds from Dain to Brooks to the purchase of stock.

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