Let Us Entertain You (or Not)

September 20th, 2018

The Tax Cuts and Jobs Act (TCJA) or, as I like to call it, the 2017 tax reform law, changed quite a few things for taxes. Most of these lower rates, or add a new deduction or credit. However, there were changes the other way, too. One of these involves “Entertainment” expenses.

If you’re in business you’re allowed to deduct all “necessary and ordinary” business expenses. Of course, there are some exceptions. Meals and Entertainment expenses have been limited to 50% of the amount spent. There are substantiation rules, too. The TCJA removed the ability to deduct entertainment expenses.

So let’s say you had season tickets to the Vegas Golden Knights, and you took a client (a different one) to each of the 41 home games. You discussed business, either during the game (there are stops and intermissions in hockey) or immediately before or after. You noted who you spoke to and the business purpose (and topics) in a log. In 2017, that expense would be deductible. Today that expense is not deductible.

A client called me up and asked me how he could get around the rules. (Lovely, I thought: Ask your tax professional how to commit tax evasion.) What if we call it advertising? I noted that if you were advertising in, say, the Knights’ program that would indeed be advertising. But it was hard for me to see how watching a hockey game is advertising. Well, he said, if there was a seat license fee (something that’s common for football) could we call it a “licensing” expense? No, you’re not paying to have your business licensed. It’s entertainment. I did tell him that if he took a client to the game and purchased food, and discussed business then the food expense would likely qualify as a meal deduction (assuming proper documentation, of course).

The problem is the Duck Test. “If it looks like a duck, walks like a duck and quacks like a duck, then it just may be a duck.” Tickets for athletic events, concerts, etc. are for entertainment. You can slap another label on it (“office expense” is one I expect to see next year) but it will still be an entertainment expense. And those are decidedly no longer deductible. The Tax Code giveth, and the Tax Code taketh away.

One Tiptoe Forward for Representation, With that Giant Step Backwards Still Coming

September 19th, 2018

The IRS released a Fact Sheet today on the new transcript redaction policy that begins on Monday. There’s one very slight piece of good news for tax professionals in the Fact Sheet:

If necessary for return preparation, a client may also order a complete (not redacted) wage and income transcript through the IRS. A client must first authenticate their identity with the IRS and a complete (not redacted) wage and income transcript will be mailed to the address of record within five to 10 days. If a practitioner cannot obtain Forms W-2 from the client, or if the client is unable to receive a complete (not redacted) transcript at the address of record, then the practitioner may have to file a paper return.

This is slightly better than it was, but is still unacceptable. First, if I have a Power of Attorney for my client for a particular tax year, I am authorized to act for the client (on the client’s behalf). That means that there’s no reason why the IRS shouldn’t send a tax professional with proper authorization an unredacted Wage & Income transcript. The IRS’s reasoning on this is flawed. Assume an individual hires a tax professional to come into compliance (or deal with an issue). Who do you think will be using the Wage & Income transcript: the client or the tax professional? All this will do is lengthen the process for no particularly good reason. Additionally, all the issues with mailed transcripts remain (security, expatriates, etc.)

Indeed, I strongly believe that tax professionals should be able to pull unredacted transcripts through IRS e-Services (with proper authorization, of course). The goal of obtaining transcripts is for some aspect of compliance; I’m unaware of any tax professionals who pull transcripts “just to have them.” The only thing I (and other tax professionals) have to sell is our time. We simply don’t have the time to waste to pull transcripts that are not needed. Overall, the IRS’s new policy remains poor (though there was that tiptoe forward).

IRS Extends Deadlines for Those Impacted by Hurricane Florence

September 15th, 2018

Hurricane Florence is battering North and South Carolina. News reports indicate “biblical” amounts of rain will fall, with catastrophic flooding probable throughout the Carolinas. Today, the IRS announced that they are extending deadlines for those in the federal disaster zone to January 31, 2019.

Hurricane Florence victims in parts of North Carolina and elsewhere have until Jan. 31, 2019, to file certain individual and business tax returns and make certain tax payments, the Internal Revenue Service announced today.

The IRS is offering this relief to any area designated by the Federal Emergency Management Agency (FEMA), as qualifying for individual assistance. Currently, this only includes parts of North Carolina, but taxpayers in localities added later to the disaster area, including those in other states, will automatically receive the same filing and payment relief. The current list of eligible localities is always available on the disaster relief page on IRS.gov.

While the list of impacted areas is a ‘work in progress’ right now (the IRS’s “Hurricane Florence” webpage doesn’t list them yet), FEMA has noted President Trump’s declaration of a disaster: Beaufort, Brunswick, Carteret, Craven, New Hanover, Onslow, Pamlico, and Pender Counties. As the rains continue to fall, I would expect this list to (unfortunately) lengthen.

The North Carolina Department of Revenue will almost certainly conform to the extensions. (The South Carolina Department of Revenue will, too, as impacted regions are declared a federal disaster area.)

The extension impacts all tax filings for those in the federal disaster zone:

The tax relief postpones various tax filing and payment deadlines that occurred starting on Sept. 7, 2018 in North Carolina. As a result, affected individuals and businesses will have until Jan. 31, 2019, to file returns and pay any taxes that were originally due during this period.

This includes quarterly estimated income tax payments due on Sept. 17, 2018, and the quarterly payroll and excise tax returns normally due on Sept. 30, 2018. Businesses with extensions also have the additional time including, among others, calendar-year partnerships whose 2017 extensions run out on Sept. 17, 2018. Taxpayers who had a valid extension to file their 2017 return due to run out on Oct. 15, 2018 will also have more time to file.

In addition, penalties on payroll and excise tax deposits due on or after Sept. 7, 2018, and before Sept. 24, 2018, will be abated as long as the deposits are made by Sept. 24, 2018.

Can a Professional Gambler Take the Foreign Earned Income Exclusion?

September 15th, 2018

I was asked that question this past week: Can a professional gambler take the Foreign Earned Income Exclusion? The Exclusion allows one to exclude about $100,000 of income from income tax.

The IRS website (which is quite good) has a page on the general rules for the Exclusion. The IRS notes,

Self-employment income: A qualifying individual may claim the foreign earned income exclusion on foreign earned self-employment income. The excluded amount will reduce the individual’s regular income tax, but will not reduce the individual’s self-employment tax. Also, the foreign housing deduction – instead of a foreign housing exclusion – may be claimed.

A professional gambler (unlike an amateur) will have self-employment income. A professional gambler files a Schedule C, and that qualifies as “earned income.” As the name implies, you must have earned income to take the Foreign Earned Income Exclusion.

But there are other requirements. Your “Tax Home” must be in a foreign country. Your Tax Home is where your main place of business, but there are other rules that influence the location of your Tax Home. One thing, though, is certain: If your Tax Home is in the United States you won’t qualify for the Exclusion.

Let’s assume your Tax Home is abroad. You also need to meet one of two other tests: The bona fide resident text or the physical presence test. A bona fide resident is an individual who, in the view of US tax law, resides in another country. Generally, you must be a citizen or official resident of another country (more than just being present in another country via a “tourist visa”). Additionally, you must be a bona fide resident for an entire calendar year to qualify under this test. If you’re residing in, say, the United Kingdom for the entire year and have a work permit for the U.K., you’re likely a bona fide resident of the United Kingdom.

The physical presence test is simpler. You must be outside of the United States for at least 330 days out of a 365-consective day period that includes part of the tax year involved. (If the 365-day period is split among two calendar years, the maximum exclusion is pro-rated based on the number of days in the tax year that fall in the 365-consecutive day period.) There are some other rules about this test: A day in (or above) international waters is considered a day in the United States; if you change planes in the United States (say you’re flying from Toronto to Mexico City), that does not count as a day in the United States; and any portion of a day in the United States (other than transit between foreign points) is considered a full day in the United States.

Finally, the Exclusion only covers foreign earned income. Let’s say a professional gambler qualifies for the Exclusion, earning $80,000 outside the United States. But he spent a week in the United States, and earned $20,000 while in the U.S. That $20,000 isn’t eligible for the Exclusion.

So let’s circle back to the original question: Can a professional gambler take the Foreign Earned Income Exclusion? Assuming he (a) is a professional gambler, (b) with foreign-source income, (c) has a Tax Home outside the United States, and (d) qualifies by either the bona fide resident or physical presence tests, he can take the Exclusion. Do note that while the Exclusion impacts income tax, it does not impact self-employment tax.

Regulations Matter, Too

September 10th, 2018

I used to have my office in Irvine, California. Today, like most days, the weather in Irvine will be absolutely gorgeous: A high of 79 and a low of 66. You can’t ask for better (weather) climate. How about the business climate?

Well, I tell my clients that taxes matter but they’re not the only thing. Regulations matter, too. Let’s say I hire Joe to work remotely as a tax professional assisting me. I give him a return to work on, but I don’t care if he works at 8am or 8pm–just get it done in the next week. Joe works on his computer in his home at his pace. Almost everywhere he would be considered an independent contractor. But not in California.

The California Supreme Court ruled
in Dynamex Operations West, Inc. v. Superior Court of Los Angeles County that in order to have an independent contractor in California three conditions must be met:

1. That the worker is free from control and director of the hirer in regards to the performance of the work;
2. That the worker performs work that is outside the usual course of the hiring entity’s business; and
3. That the worker is customarily engaged in an independent trade, occupation or business in regards to the work performed for the hiring entity.

Note the second condition. This means that it is impossible in California for a software company to hire an independent contractor to write software. Or for a hair salon to hire independent contractor hair stylists (even though that is the norm in this industry and has been so for decades). Or for a tax professional to hire an independent contractor tax preparer.

Back in 2011 I wrote about why I left the Bronze Golden State. I noted:

With the growth of my business, I looked at possibly hiring another tax accountant in 2010. When I ran the numbers, I found that I would lose money by hiring a productive tax accountant. That’s because of all the regulations and costs that I would immediately incur if I had an employee. I’m not stupid: If I lose money by hiring someone, I’m not going to do it.

A question I was asked by friends was, “Why didn’t you hire an independent contractor?” The reason was that California’s Employment Development Department (one of four California statewide tax agencies) was stating that a business that was in activity A (whatever that activity was) couldn’t have independent contractors doing A. I didn’t care to be a test case. I was left with two choices: Hire an employee and lose money or hire an independent contractor and likely lose more money. Neither option appealed to me, so I’m in Las Vegas.

The CBS Sacramento article notes the problem impacts small businesses. It actually impacts all California businesses. It’s yet another factor causing businesses in California to pay more than a comparable business in a neighboring state. Is California free to do this? Absolutely. Are California business owners free to take their businesses elsewhere? You bet, and I suspect that this ruling will just increase the flow.

Another way of stating this: California, doing everything it can to cause full employment in neighboring states.

Should I Violate Federal Law or State Law?

August 28th, 2018

Suppose you have a federal license to perform your occupation in your state of residence. That license allowed you to do [whatever it is you do] anywhere in the United States. Now, further suppose your state legislature passed a law specifically overriding that license, and, in fact, making some of [whatever it is you do] illegal under state law. And further suppose that if you obey that new state law you would be violating federal law as you would not be performing [whatever it is you do] properly under federal law. No state legislature could be that stupid uninformed, right?

One should never take a bet against legislatures doing dumb things, and the actions over the past fifteen months of the Nevada legislature demonstrate that. In 2017 the Nevada Legislature passed AB 324 that amended NRS (Nevada Revised Statutes) Chapter 240A; that reclassified Enrolled Agents (what my federal license is) as people who performed “Document preparation services.” We would have to register with the Nevada Secretary of State, post a surety bond, and we would not be able to negotiate with anyone else or communicate to anyone else the position of a client; if we did so, we would be subject to penalties including possible imprisonment. Hmmm, might an Enrolled Agent need to negotiate on behalf of clients with tax agencies such as the IRS and collect confidential information?

The Nevada Society of Enrolled Agents (NVSEA) filed a lawsuit, and in November 2017 had a temporary injunction placed on enforcement of the law. Last month the court heard arguments, and the ruling came out on August 16th.

The Court finds, that as a result of the amendments made to Chapter 240A by AB 324, Nevada Enrolled Agents cannot comply with both federal and state law. Under federal regulations, Nevada Enrolled Agents must provide competent tax advice, must assist clients in preparing accurate tax returns and other forms, must collect documentation which supports a client’s position and must competently and diligently represent taxpayer clients in proceedings before the IRS. Under Chapter 240A as amended, Enrolled Agents in Nevada are prohibited from performing these duties and face civil and criminal liability for violations of the state law.

The Court went on to note why the law is unconstitutional:

This Court finds that Chapter 240A…hinders and obstructs the free use of the Enrolled Agents’ license to practice before the IRS…Pursuant to NRS 240A.240(5), Enrolled Agents are no longer able to “negotiate with another person concerning the rights or responsibilities of a client, communicate the position of a client to another person or convey the position of another person to a client.” This contradicts Section 10.2(4) of Circular 230, which allows agents to “correspond[] and communicat[e] wit hthe Internal Revenue Service” and engage in “matters connected with a presentation to the Internal Revenue Service or any of its officers or employees relating to a taxpayer’s rights, privileges, or liabilities.” The amended law also prohibits an Enrolled Agent from “appear[ing] on behalf of a client in a court proceeding or other formal adjudicative proceeding….” NRS 240A.240(6). This provision conflicts with Section 10.2 of Circular 230, which allows agents to “represent[] a client at conferences, hearings, and meetings.” The amended law prohibits Enrolled Agents from providing “advice, explanation, opinion, or recommendation to a client about possible legal rights, remedies, defenses, options or the selection of documents or strategies….” NRS 240A.240(7) This contradicts Circular 230, which states that Enrolled Agents may give written advice regarding tax matters. 31 C.F.R. §§ 10.2, 10.33, 10.37. Finally, the amended statute contradicts Circular 230 because it requires an Enrolled Agent to provide a copy of a client’s file to government entities. NRS 240A.220(1). Yet, pursuant to IRC §§ 7525, 7216, 6713, Enrolled Agents must keep client information confidential and only share client files when ordered to do by a court…

Accordingly, the Court finds that Chapter 240A of the Nevada Revised Statutes, as amended by A.B. 324, conflicts with federal law to the extent it seeks to regulate Enrolled Agents who are authorized to practice before the Internal Revenue Service. The law is therefore unconstitutional pursuant to the Supremacy Clause of the United States Constitution, Article VI, Clause 2.

The permanent injunction was granted by the Court. While the Nevada Attorney General can appeal (the office has another 20 days or so to do so), it’s not likely; the law is clearly unconstitutional on its face.

There are two points I want to make. First, I didn’t write about this earlier because this law was so stupid it was clear to me that it was going to be found unconstitutional. Even before the temporary injunction was granted the Nevada Secretary of State’s office didn’t enforce the law as it pertained to Enrolled Agents.

The second point is how this law was enacted. The state legislature didn’t contact any tax professionals about the law. There apparently is a problem with some document preparer services, and the Assemblyman who wrote AB 324 made an assumption that Enrolled Agents were part of the problem. We’re actually part of the solution in that we help resolve taxpayer problems, but I digress. I’m a member of the National Association of Enrolled Agents and NVSEA to help with legislative policies vis-a-vis Enrolled Agents. While I don’t agree with all of what the NAEA would like to pass, I agree with most of it. And my dues and contributions to NVSEA helped fight an uninformed law.

No matter your profession, stay informed. Talk to your local legislators. Generally, state legislators are approachable and most want to be informed. I’m making a point of meeting mine later this year, and explaining what Nevada Enrolled Agents do, what we had to do, and why we did what we did. Unfortunately, we remain the Lichtenstein of the tax world.

We’re Not Gonna Take It

August 23rd, 2018

The IRS issued proposed regulations today on charitable contributions as it relates to state and local tax credits. Here’s a hint to politicians in Connecticut, New Jersey, and New York. The IRS is telling you:

Here’s an excerpt from the IRS press release:

The proposed regulations issued today are designed to clarify the relationship between state and local tax credits and the federal tax rules for charitable contribution deductions. The proposed regulations are available in the Federal Register.

Under the proposed regulations, a taxpayer who makes payments or transfers property to an entity eligible to receive tax deductible contributions must reduce their charitable deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive.

For example, if a state grants a 70 percent state tax credit and the taxpayer pays $1,000 to an eligible entity, the taxpayer receives a $700 state tax credit. The taxpayer must reduce the $1,000 contribution by the $700 state tax credit, leaving an allowable contribution deduction of $300 on the taxpayer’s federal income tax return. The proposed regulations also apply to payments made by trusts or decedents’ estates in determining the amount of their contribution deduction.

There’s a de minimis exception for tax credits of no more than 15% of the payment amount.

This proposed regulation isn’t a surprise. Indeed, it’s hard to see under the Tax Code how tax credits as charitable contributions would succeed. As for the current lawsuit against the IRS regarding the new tax law, that has even less of a chance of success in my view. But it sounds good, so the lawsuit happened. The idea of a state like New York changing their tax laws to lower their tax rates apparently hasn’t occurred to New York politicians.

One Giant Step Forward for Security (Maybe), One Huge Step Backward for Representation

August 23rd, 2018

If you are a tax professional who does any representation work, do I have news for you…and it’s not good. Yesterday, the IRS made an announcement about redacting information on transcripts. Here’s an excerpt of the announcement:

Moving to better protect taxpayer data, the Internal Revenue Service today announced a new format for individual tax transcripts that will redact personally identifiable information from the Form 1040 series…The following information will be provided on the new transcript:
• Last 4 digits of any SSN listed on the transcript: XXX-XX-1234
• Last 4 digits of any EIN listed on the transcript: XX-XXX-1234
• Last 4 digits of any account or telephone number
• First 4 characters of the last name for any individual
• First 4 characters of a business name
• First 6 characters of the street address, including spaces
• All money amounts, including balance due, interest and penalties

But there’s more information—information not included in this announcement that’s very important if you do any tax representation work. If a tax professional with authorization (either an IRS Power of Attorney or Tax Information Authorization) calls the IRS up and requests a transcript, we can have it faxed to us (if we have a secure fax machine). Effective January 1, 2019, the IRS will no longer fax transcripts; they will only be mailed, and then, apparently only to the taxpayer’s address of record (not to tax professionals with the appropriate authorization). This is a huge problem.

Consider nonfilers–people not in the system. There is no address in the system to mail anything to. This will slow down work and hinder compliance with tax law.

Next, consider taxpayers who are overseas. Mail to locations outside the United States takes much longer and, in many countries, is of dubious security.

Now those of us with access to IRS E-Services will still be able to download transcripts once the CAF Unit processes the authorization (but see below on two additional issues). But when there’s an immediate issue, and the authorization hasn’t been processed, we will have to tell all involved, “We have to wait for the POA to be processed. Please add two weeks additional to your timeline.” I’m sure IRS Revenue Officers, Tax Compliance Officers, and Revenue Agents will appreciate this.

Unfortunately, there are two other major issues with this policy. First, the redaction of Employer Identification Numbers (EINs) will impact efiling and state tax issues. Let’s assume I request a Wage & Income Transcript for John Smith. Today, that transcript will show the full EIN for any issuers of tax documents. That allows tax professionals to prepare returns that can be electronically filed (EINs are required for efiling). In the future, the transcript will just show “xx-xxx9999″ as the EIN. If we happen to have a W-2 on file for that employer we’ll be able to use the EIN; otherwise, that tax return will have to be paper filed. This impacts state tax returns, too. Many states mandate efiling, and also mandate that we provide EINs on the tax return. We will be unable to comply with this in the future for impacted clients.

Additionally, business names will be redacted; only the first four characters will be shown. Imagine seeing “ACME xxxxxxxxxxxx xxxxxxxxxxxxx” as the business name. The business address will be redacted (just the first six characters will be shown); our address would be shown as “1919 S”; maybe with the first four characters of our name (CLAY) and those characters you could figure out who we are but I doubt it in a city one-tenth the size of Las Vegas. Basically, when I’m entering W-2s based off a transcript I’ll enter four characters and hope it matches correctly (good luck with that!). As to trying to call someone, how? Clients’ memories of prior years are, much of the time, hazy; the transcripts will be of little use. And many payors listed on information returns are parent companies rather than the payor itself; matching will be near impossible.

(This is also going to make responding to IRS Automated Underreporting Unit (AUR) notices quite interesting. Imagine your client receives such a notice, and all it says is “ACME” and the client says he never worked for ACME. How is a tax professional or the client going to find out the truth? There won’t be near enough information on the notice. You can expect a surge in Tax Court filings in about a year.)

“But Russ,” you ask, “Shouldn’t clients keep good records and all their W-2s (and other tax documents)?” Absolutely, but we have to deal with the world as it is, not how we want it to be. I’ve had two representation clients in the last month who have been victims of casualty losses: One lost all his records because of a fire; the other lost his records due to a flood. And many representation clients simply don’t have the records.

I understand why the IRS is doing this (the security issue) but this is going to make representation clients wait even longer to get their cases resolved, and will make overall compliance worse. It will cause paper filing to increase (not by a huge percentage, but it will still be noticeable) and will impact states, too. Overall, the unintended consequences were not thought out by the IRS.

When It’s Too Good to be True (Tax Shelter Edition)

August 21st, 2018

When reading Tax Court decisions, always be on the lookout for the word “scheme.” It’s usually a heads-up that what you’re reading isn’t going to cut it (from a tax perspective). So when the decision begins,

These consolidated cases involve a complex tax shelter scheme featuring four C corporations, five individual shareholder-employees of the C corporations, five employee stock ownership plans (ESOPs), five S corporations, and (inevitably) a partnership. [emphasis added]

You know things aren’t going to end up well for the petitioners.

Rightly concluding that this scheme was too good to be true, the Internal Revenue Service (IRS or respondent) attacked it on numerous grounds for tax years that (owing to calender and fiscal year differences) span 2002-2005. We hold that the “factoring fees” and most of the “management fees” were not deductible expenses of the C corporations but rather were disguised distributions of corporate profits.

So what happened? Actually, a lot of transactions. Thousands of transactions. Make that many thousands of transactions–all designed to get rid of tax.

Implementation of the tax shelter scheme entailed many thousands of cash transfers among 15 entities and individuals. In their proposed findings of fact the parties often do not agree on the net results of these transactions, or even on what the dollar amounts remaining in dispute actually are. We have done our best to work our way through this fog.

First, let me give a fundamental rule in tax: Everything needs an economic substance to be legal. Business transactions can be designed in a tax advantaged way, but there needs to be a real transaction. The scheme involved factoring and management fees. I’m familiar with factoring; it’s common in the garment industry (among other industries). Factoring allows the sale of accounts receivable and the seller to immediately obtain cash; in exchange, the buyer collects the receivables and earns the difference between the sales price and the receivables. The problem was that the way this factoring worked wasn’t the way it works in practice.

While factoring receivables theoretically enabled the Water Companies to accelerate their incoming cashflow, this benefit was illusory given how the “factoring” operated. PMG could not function as a “factor” without the management fees it received from the Water Companies, as shown by the 10-month delay in PMG’s commencement of “factoring.” In effect, the Water Companies had to provide working capital to PMG (rather than the other way around) to enable PMG to purchase the accounts receivable. Given this circular flow of funds, the “factoring” generated no liquidity benefits for the Water Companies…

We conclude that the purported factoring arrangement with PMG had no economic substance but was a device to extract profits from the Water Companies in the guise of tax-deductible payments. The Water Companies derived no economic benefit from this arrangement, and the factoring fees they paid were not “ordinary and necessary” expenses of their business. [internal note omitted]

The factoring also failed an ‘arms-length’ test. When parties are related, the transactions have to follow what I call the disinterested buyer/seller model: What would a disinterested [buyer/seller] pay (or receive) for what’s being sold? A question this court pondered was whether these agreements in practice followed normal factoring practices.

In an arm’s-length factoring arrangement, the factor typically: (1) receives an assignment of accounts receivable from the client, (2) verifies the genuineness of the accounts and balances shown, and (3) immediately pays the client a lump sum equal to the face amount of the receivables less the agreed-upon discount. Mr. Zadek observed that PMG’s payment practices were erratic and regularly flouted these norms. On some occasions PMG would make payment before receiving executed assignments of the receivables and without verifying the account balances. On other occasions PMG would not make the stipulated upfront payment but would instead pay for the receivables in installments, sometimes in seven or eight tranches spread over many months. This was contrary to standard factoring practice, which aims to provide the client with immediate liquidity. The trial evidence supported Mr. Zadek’s conclusion that the timing of the supposed “factoring” payments was largely dictated, not by the terms of the MFAs, but by “when there was money in the bank to do it,” as Ms. Quarry testified.

Add in that the company itself and not the factor did the actual collection efforts (on past due accounts), and you have a facade of factoring and some big tax problems. But, like a bad infomercial, that’s not all! There are also excessive management fees. These were designed to change taxable income into untaxable income. Suffice to say, these didn’t work either.

The conclusion is one I (and others) have been stating for years: There is no Tax Fairy. If you (or your business) makes a lot of income, you will owe tax. Alchemy in the tax world works just as well as alchemy in the physical world: I’ve yet to see someone take lead and turn into gold or some other precious metal. Instead of spending millions on these tax shelter schemes, the businesses’ owners would have done far better using those millions to pay their taxes.

Case: Pacific Management Group v. Commissioner, T.C. Memo 2018-131

Can You Spin Garbage Into Gold?

August 18th, 2018

I guess I’ll spoil the post:

Rumpelstiltskin could spin straw into gold. Rumpelstiltskin, Inc. thought it could do the same for garbage, spinning it into tax credits. The Commissioner of the Internal Revenue Service disagreed. So did the Tax Court. So do we.

So begins the Appeals Court decision of Green Gas Delaware Statutory Trust v. Commissioner, a decision of the US Court of Appeals for the District of Columbia. The case involves tax credits for production of landfill gas (the since repealed Section 45K credits). Three entities, all related, with the parent company having the wonderful name Rumpelstiltskin, Inc. (and no, we didn’t make this up) took these tax credits worth $11.7 million while having $4.5 million in income. The IRS audited these returns, and allowed only $586,000 of tax credits. The IRS also turned the entities’ business expenses from gold into straw, disallowing most of them, and threw in a 20% accuracy penalty. The Tax Court upheld the IRS, and the entities appealed that decision.

So where did the tax credits come from?

The overwhelming majority of those claimed credits came from venting/flaring landfills, where RTC made no (and could make no) use of the gas. Green Gas, 147 T.C. at 30…[footnote:] It is, perhaps, no coincidence that some of the intermediary entities were named Bye Bye Gas GP, C U Later Gas GP, Arrivederci Gas GP, Buon Giorno Gas GP, Ciao Gas GP, and Adios Gas GP.

The first problem Rumpelstiltskin had is that the tax credits were designed for production of alternative energy, not venting (or burning) landfill gas. The second problem was that Rumpelstiltskin didn’t keep good records. Seriously, something we tell all clients is that if you keep good records an audit is an annoyance; if you don’t keep good records, an audit will be a very painful and expensive annoyance. And so it was here. Rumpelstiltskin tried to blame two deceased employees who kept 85% of the business logs; however, not only did the Tax Court find the logs (that were produced) unreliable the Court of Appeals asked the obvious question: “…the appellants could have introduced evidence from still-living employees who prepared the remaining 15% of the site logs, and yet chose not to do so.”

Rumpelstiltskin also tried to get the IRS’s rejection of business expenses reversed by the Court of Appeals. An excerpt from the Court of Appeals:

As to the appellants’ claimed deductions for consulting and legal fees, the Tax Court determined that the appellants “failed to provide a credible explanation” for why the consulting fees were “paid by other entities but deductions were claimed by” appellant Green Gas. And it held that the appellants could not claim legal-fee deductions because there was no evidence that any legal work benefited the appellants. Finally, it disallowed various miscellaneous expenses, except to the extent that the appellants could corroborate them with documentation. [citations omitted]

It does help if you are claiming an expense that you actually incur that expense….

There are two serious conclusions that can be drawn from this case. First, where there are tax credits there will be schemers trying to get money from them when it’s undeserved. “It’s free money,” they think. Second, document, document, and document some more. If you keep good records…but I said that above. In any case, as Chief Judge Merrick Garland wrote (who, like me, is a native of Lincolnwood, Illinois), the decision of the Tax Court is affirmed.

Case: Green Gas Delaware Statutory Trust v. Commissioner