Archive for the ‘Tax Court’ Category

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How Not to Deduct 85,491 Miles

Tuesday, April 30th, 2013

Having resided in Southern California, I know you can put a lot of miles on your car in that area. One engineering teacher learned the hard way from Tax Court that a written mileage log is essential if you want to deduct your business miles.

The petitioner taught at several schools in Southern California. He was not reimbursed by the schools for his mileage. He claimed 85,491 business miles driven–a deduction of $46,593. The IRS allowed only 4,970 miles. That’s a difference of 80,000 miles and a difference that large led to the case going to trial.

Unfortunately, the petitioner did not keep a contemporaneous written mileage log. The Cohan rule (allowing the Court to estimate an expense) does not apply to automobile expenses.

To meet the heightened substantiation requirements, a taxpayer must substantiate the amount, time of use, and business purpose of the expense. Sec. 274(d); see also sec. 1.274-5T(b)(6), Temporary Income Tax Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985). To substantiate by adequate records, the taxpayer must provide both an account book, a log, or a similar record, as well as documentary evidence, which are together sufficient to establish each element of an expenditure…Documentary evidence includes receipts, paid bills, or similar evidence…To substantiate by sufficient evidence corroborating the taxpayer’s own statement, the taxpayer must establish each element by the taxpayer’s statement and by direct evidence, such as documentary evidence.

Unfortunately, the petitioner didn’t maintain a contemporaneous log.

During his testimony petitioner submitted into evidence a mileage log which was created after the 2008 tax year. Petitioner claimed he drove 88,820 miles related to business travel in 2008. Corroborative evidence used to support a taxpayer’s reconstruction of expenditures “‘must have a high degree of probative value to elevate such [a] statement’ to the level of credibility of a contemporaneous record.”

The question for the Court was whether the testimony of the petitioner was enough to prove the 80,000 miles were for business but not commuting (commuting mileage is never deductible).

We find the mileage summary to be insufficient under section 274(d) because the mileage amounts were not entered at the time the vehicle was used. Petitioner testified that the mileage log he presented at trial was prepared “after [he] was approached by the IRS”. Outside of the syllabi petitioner presented, we are unable to determine for what purpose petitioner was traveling to and from the various schools outside of class time. Petitioner provided no evidence to corroborate entries in the mileage log for random trips to the schools other than testimony that he made various trips to prepare for the semester. We are unable to verify whether these trips were for business or were personal.

The petitioner also attempted to argue that even if the mileage were commuting mileage, these were temporary positions. The problem is that commuting to temporary positions outside of the metropolitan area where you reside can be deducted (this would be a travel expense). Unfortunately, all of the positions were within the Los Angeles metropolitan area.

Petitioner worked and lived in the same metropolitan area, and therefore we find that petitioner’s commuting expenses do not qualify for the exception to the general rule of nondeductibility. We hold that petitioner’s commuting expenses were nondeductible.

If you’re going to deduct mileage, keep a contemporaneous written mileage log. It takes just a few seconds to note your starting and ending mileage, the date, where you went, and the business purpose. It could be the difference in deducting 80,000 business miles.

Case: Daniel-Berhe v. Commissioner, T.C. Summary Opinion 2013-33

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The Goal of Profit Making Businesses Is to Make Profits

Thursday, February 21st, 2013

I resisted the urge this morning to make another pun; besides, Tony Nitti already did with his headline, “Former NFL Tough Guy Bill Romanowski Gets Laid Out By Tax Court.”

Yesterday, the Tax Court decided two cases related to horse breeding. I’ve covered horse activities in the past; all forms of activities related to race horses are expensive, and profits are hard to come by. In both cases, the petitioners looked at breeding horses as a means to lower taxes. That’s not a good way to get the Tax Court on your side. In both cases, the petitioners were left out in the cold without their losses. The Romanowskis did avoid the accuracy-related penalty; however, the other couple (the Pedersons) did not.

The moral is clear: If you really have a business and your is making money, you have a good shot of coming out of the Tax Court with your losses intact. If your goal in a business is losing money, your losses will likely evaporate in Tax Court. Tony Nitti and Joe Kristan have more.

Cases: Pederson v. Commissioner, T.C. Memo 2013-54, Romanowski v. Commissioner, T.C. Memo 2013-55

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Will the Third Time be the Charm for Appeals?

Tuesday, February 5th, 2013

The IRS Office of Appeals describes its mission as,

[T]o resolve tax controversies, without litigation, on a basis which is fair and impartial to both the Government and the taxpayer in a manner that will enhance voluntary compliance and public confidence in the integrity and efficiency of the Service.

A case decided in Tax Court yesterday isn’t making Appeals look good.

Jurate Antioco sold a bed and breakfast on Martha’s Vineyard in 2006 and came into some money. With the proceeds she bought an apartment building in San Francisco and lived in one of the units; she moved her ailing 96-year-old mother into another. Three other units are rented and she lives off that income.

What Ms. Antioco didn’t realize until April 2008 is that she owed taxes on some of that money, a tax debt of $170,000. With all of her money tied up in the apartment building she couldn’t pay the IRS. So she suggested an installment agreement. The IRS wanted to seize (levy) the apartment building.

Fast forward to 2009, when IRS Appeals gets the case for the first time. Ms. Antioco has issues with borrowing against her apartment building (the current lender wouldn’t agree to it), and she has obvious economic hardships. No matter, IRS Appeals denies Ms. Antioco’s request; she filed a Tax Court case.

Before the case was heard, the IRS moved to remand the case stating that the Appeals officer had abused her discretion. Yes, the IRS admitted that the Appeals officer erred. The case was remanded, with the Tax Court noting that new financial documentation (an IRS Form 433-A) should be reviewed. You would think things would go smoothly; after all, the Tax Court told the IRS to look again at the financial issues.

No. The new Appeals officer called Ms. Antioco requesting documentation:

[H]e called Ms. Antioco several more times that day and at one point told her she was being uncooperative and that she didn’t have to go through with the case. He also told her to “put your money where your mouth is” and that he had been a witness in Tax Court. Ms. Antioco felt so threatened by Mr. Owyang’s calls that she stopped answering and hired an attorney to help her.

The Appeals officer made a preliminary determination that, “Ms. Antioco could pay her liabilities but “simply chose not to do so.” [emphasis in original]” Indeed, the Appeals officer thought that fraud had occurred when Ms. Antioco added her mother to the deed. Only there wasn’t fraud; she had provided documentation and adding her mother to the deed was a requirement of a new lender.

The Appeals officer further called Ms. Antioco a “won’t pay taxpayer.” The only problem is that,

There is nothing in the record to support any of these conclusions either. The record in fact shows just the opposite: Ms. Antioco didn’t even find out she owed any tax for 2006 and 2007 until her accountant told her in April 2008.

The Appeals officer also didn’t consider her mother’s ill health. “These were precisely the reasons Ms. Antioco listed as grounds for entering into a short-term installment agreement until she could either obtain a loan or sell the building after her mother passed away.” Only the Appeals officer ignored this. Ms. Antioco also noted economic hardships; again, the Appeals officer ignored this.

We have found that Mr. Owyang abused his discretion in sustaining the proposed levy and that we cannot uphold the supplemental notice of determination on any of the stated grounds…We will therefore again remand the case to Appeals to consider Ms. Antioco’s proposed installment agreement, her financial information, and whether special circumstances or economic hardship exists.

Hopefully, the third IRS Appeals officer will actually get it right.

Case: Antioco v. Commissioner, T.C. Memo 2013-35

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Is the IRS Time-Barred From Imposing a Penalty on a Frivolous Amended Return?

Monday, September 17th, 2012

The IRS is allowed to impose a penalty on the filing of a frivolous tax return (Internal Revenue Code Section 6702(a)). Today, the Tax Court looked at a taxpayer who filed a normal tax return, but then filed an amended return where she claimed she wasn’t a “person.”

Well, we’re all people (I hope), and the petitioner, one Marla Crites, also said that wages aren’t taxable (helpful hint: they are taxable). When the IRS imposed a $5,000 penalty on the frivolous amended return, she asked for a Collection Due Process Hearing. Ms. Crites filed four amended returns (not one), and they all appear to have said that she wasn’t liable for tax. At the CDP, the Appeals officer upheld the IRS. She then went to Tax Court.

I’m not going to go over the arguments that wages aren’t taxable, or that she’s not a person; neither argument is worth any time. Nor is her argument that an amended return isn’t a return under IRC Section 6702; the Tax Court (and other courts) have held that it is.

The interesting issue is whether the statute of limitations time bars the IRS from imposing a frivolous return penalty on an amended return that the IRS does not process. The Tax Court notes,

As the Commissioner observes, penalties under section 6702 do not have a readily observable statute of limitations. The section penalizes not just frivolous “returns”–and even here Congress was careful to penalize not just returns but “what purports to be a return”–but frivolous “submissions”. It would be odd if penalties keyed to “submissions” had somehow to be tied to the limitations period for tax that is supposed to be shown on a “return”…

But let us assume–and here we are expressly assuming without deciding–that Crites is right that the filing date of her “return” is the key date. She had two returns, and the one that the Commissioner wants to punish her for is the amended return that she sent the IRS in October 2008. He assessed the penalty in July 2009, well within three years of her submitting it.

The IRS then asked the Court to impose a penalty for filing a frivolous case at the Tax Court. I hope Ms. Crites looks carefully at the last line of the decision:

…[T]his is Crites’s first trip to Tax Court, and by submitting the case under Rule 122, she did save us the burden of trial. And one of her arguments, the statute-of-limitations issue as applied to frivolous amended returns, was one we had not yet addressed and was not itself obviously frivolous. We will therefore exercise our discretion not to sanction her under section 6673.

This time.

Case: Crites v. Commissioner, T.C. Memo 2012-267

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A Penny Saved, Lots of Dollars Lost

Tuesday, September 11th, 2012

The old cliche is, “A penny saved, a penny earned.” In real life, though, sometimes when you save some pennies you lose lots and lots of dollars. So was the case for two taxpayers who filed a case in Tax Court.

The Tax Court has very strict deadlines. You typically have 90 days from the date on a Notice of Deficiency to file a Tax Court case. Marcius and Andrea Scaggs wanted to file a Tax Court case. They were apparently procrastinators, so they waited to the last allowed day to file the case. They also didn’t trudge to the Post Office; had they done so and mailed their petition using certified mail, return receipt requested, they would have been fine.

Instead, they went to FedEx. There’s nothing wrong with using FedEx, but you need to use the right service. They used “Express Saver Third Business Day.” That is not an approved delivery method so the petition was considered filed on the date of receipt, not the date it was sent. So their case was thrown out. Had they spent a few more dollars and used FedEx Priority Overnight, FedEx Standard Overnight, or even FedEx Two-Day, they would have been fine.

As an aside, many post offices now have Automated Postal Centers. These will time stamp a letter as of the current date and time, so you can timely file on the last day after the post office has closed! I’ve had a couple of clients use this for filing tax returns at the very last minute, and they were successful.

For the Scaggses, they must now pay the tax and file a lawsuit in either Federal District Court or the Federal Court of Claims. And that’s far more expensive.

Joe Kristan and the TaxProf have more.

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“I Don’t Need Proof: Since I Worked for the IRS and am a CPA, You Should Just Accept my Deductions.”

Thursday, August 16th, 2012

The title to this piece is not a literal quote…but it’s effectively what today’s petitioner told both the IRS and the Tax Court. Needless to say, that’s not a good strategy.

Bobby Perry worked for the IRS for a few years and is now a certified public accountant (CPA). Now, many CPAs know the Tax Code and rules quite well; however, many CPAs don’t practice in tax. Mr. Perry’s S-Corporation “prepar[ed] tax returns and provid[ed] consulting services.” He also sold insurance through a sole proprietorship.

The petitioner’s S-Corporation return was audited, and the IRS made many adjustments including disallowing travel expenses, depreciation, cost of goods sold, and rental payments. This led to a deficiency of $306,336 and an accuracy penalty of $41,365. Mr. Perry challenged this in Tax Court.

There were several items in dispute. First was travel expenses. While you can take deductions for ordinary and necessary business expenses you have, you must keep records. The Cohan rule allows the Court to make an estimate of the deduction. However, the Cohan rule doesn’t apply for certain expenses:

Deductions for travel expenses, gifts, and meals and entertainment, as well as for “listed property”, are disallowed unless the taxpayer substantiates them by adequate records or by sufficient evidence corroborating the taxpayer’s own statement. Sec. 274(d).

The petitioner is a CPA, worked for the IRS, and he prepares tax returns; surely he had backup for his deductions.

Petitioner did not substantiate that he met the requirements under section 1.274-5T(b)(2), Temporary Income Tax Regs., supra, by adequate records or sufficient evidence corroborating his testimony for each of the claimed travel expenses. Petitioner therefore is not entitled to deduct any of the claimed travel expenses for 2006.

Petitioner’s claim for depreciation expense didn’t fair better.

Here, petitioner failed to prove the adjusted basis of the portion of his home with respect to which he claimed the depreciation expense. There is no persuasive evidence in the record on the cost of the home (and the portion of that amount attributable to the underlying real property) or the cost of improvements. Nor is there any persuasive evidence in the record establishing the percentage of petitioner’s home that was actually used by the Company to conduct business…

While we are allowed to estimate the amount of an expense that we find to be deductible when the exact amount cannot be ascertained, for us to do so, petitioner had to supply us with some basis upon which an estimate could be made. See Vanicek v. Commissioner, 85 T.C. at 742-743. There is no evidence in the record on the adjusted basis of petitioner’s home other than his own self-serving and uncorroborated testimony. We are not required to accept such testimony and decline to do so.

Well, he must have had some proof of his cost of goods sold from his insurance business. After all, those expenses should be obvious. There’s a problem, though: What is he selling? He’s selling his services, and there isn’t a cost of goods sold with a service business.

We have held that a business must involve the sale of a material product to which direct cost may be allocated to reduce gross receipts by the costs of goods sold in computing gross income. More generally, we have held that gross receipts equal gross income where a business is primarily engaged in providing services; i.e., ability, know-how and experience. [citations omitted]

Then there were the rental payments. The petitioner supposedly rented a portion of his house for his business to his S-Corporation and received just under $33,000; the IRS thought that was compensation. No matter how those payments were characterized, they were income on the petitioner’s return. The difference is that if they were compensation, employment taxes would be owed. So the petitioner undoubtedly provided his rental agreement or other documentation or–well, I’m writing this so I think you know where this is headed:

Petitioner did not produce a rental agreement between himself and the Company for 2006. Petitioner did not provide any checks or documentation demonstrating that the Company paid him rent for use of his home. More generally, there is no documentation in the record reflecting that the Company rented a portion of petitioner’s home. The only evidence supporting petitioner’s claim that the Company rented a portion of his home is his testimony. This Court is not required to accept petitioner’s self-serving, unverified and undocumented testimony, and we decline to do so.

Then there was the accuracy-related penalty. Let me state what should be obvious: If I am ever in front of the Tax Court, I’m going to be held to a higher standard than the average taxpayer because I’m supposed to know the rules. The same was true for the petitioner:

Petitioner, a CPA and former IRS revenue agent, prepared the Form 1040 he filed for 2006 and the Form 1120S that the Company filed for the same year. Petitioner exercised a lack of care and reckless disregard for rules and regulations in reporting income and claiming deductions against income on the returns, resulting in the remaining underpayment. Petitioner failed to offer any persuasive evidence that he acted with reasonable cause and in good faith with respect to any portion of the remaining underpayment.

There isn’t much to add to what the Tax Court said. If you have expenses, document, document, and document some more. You will be happy you have done so. And if you’re a tax professional and you don’t, well, have your checkbook handy.

Case: Perry v. Commissioner, T.C. Memo 2012-237

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What a Drag

Thursday, August 9th, 2012

A successful entrepreneur and life-long drag racing afficianado starts a drag racing business. The business isn’t profitable. The records, according to the entrepreneur, went down the drain when Hurricane Katrina destroyed their facility. The IRS alleges that the whole thing is a hobby, so the expenses are subject to the hobby loss rules, and the taxpayer owes a whole lot of money (and penalties) to the IRS. The Tax Court is left to decide whether the entrepreneur he had an expensive hobby or just a very unprofitable business.

Christopher Johnson is a successful entrepreneur who has always enjoyed drag racing. He decided back in 2003 to start his own drag racing business. Automobile racing in all forms is very expensive; Mr. Johnson had expenses in 2003 – 2005 of $186,282, $221,672, and $154,335. During the same years revenue grew from $1,500 to $2,318 to $3,154. It was no surprise that the IRS selected Mr. Johnson’s return for examination.

One of the things I note to my clients is the need to keep good records. That posed a problem for the petitioners (Mr. Johnson and his wife):

At trial petitioners failed to produce any primary records in relation to CJ Racing for the tax years at issue. Instead, petitioners produced secondary materials in the form of bank and credit card statements in an attempt to substantiate the deductions claimed on their return. Petitioners contend that because the loss of primary documentation was due to the extensive damage caused by Hurricane Katrina, and because they attempted to reconstruct those records from secondary sources, they should be deemed to have met the requirements of section 7491(a). The Court disagrees. While petitioners made an effort to reconstruct their expenses from secondary records, those records were incomplete and inconclusive. Said records were only bolstered and supplemented by the self-serving testimony of Mr. Johnson.

If you live in an area where a natural disaster might hit, consider what would happen if your records were destroyed. What happens if there’s a fire in your building, or your city is hit by a hurricane/tornado/earthquake/whatever? We’ve gone to scanning everything, and keeping backups in multiple locations. It’s not foolproof–the Mayans allegedly predict that this effort is useless come this December–but it leaves me feeling that should something happen to my office, I’ll be able to reconstruct everything. But I digress….

The Hobby Loss rules (Section 183 of the Tax Code) only allow deductions to the extent of income, and then only as a miscellaneous itemized deduction. The key question that must be answered is whether or not, “…the taxpayer is engaged in the activity with the actual and honest objective of making a profit.” A nine-factor test is used.

The first factor is the manner in which the activity is carried on:

The Court has held that a lack of profit motive is indicated where a taxpayer fails to create a business plan or formal budget, fails to estimate income and practice cost control, and fails to maintain a separate bank account for the activity…Specific to the field of drag racing, the Court has also held that a lack of a bona fide profit objective is indicated where the taxpayer fails to procure a substantial sponsorship for his racing endeavor…At trial petitioners did not introduce any evidence to show that they ever maintained complete and accurate books or created a formal budget for CJ Racing either before or after the hurricane. There is similarly no evidence to suggest that petitioners took any measures to implement any accounting controls or operation methods that would be consistent with an intent to increase profitability. Petitioners admitted that they never formulated an actual business plan for CJ Racing. Additionally, it is clear that petitioners did not maintain a separate bank or credit account for CJ Racing. [Citations omitted.]

Add in no sponsorships and things looked to the Court like this was a hobby.

I’d like to say that there were factors favoring the petitioners…but there weren’t. One factor was held to be neutral. First impressions mean a lot, and it appears the impression the taxpayer made wasn’t positive.

There was another issue in this case: The returns were filed late. You are allowed to file returns late if you have “reasonable cause.” And definitely a hurricane that blows away all of your records would be such a reasonable cause. The years at issue were 2003-2005. One issue was that Hurricane Katrina struck in August of 2005, after the 2003 and 2004 returns were due. The petitioners lost that argument. They did win the argument for 2005, however: That return was due in 2006 and it’s quite reasonable to assume that the hurricane caused the delay.

Is it possible that Mr. Johnson truly had a profit motive? Definitely. Unfortunately for him, he didn’t run his drag racing like a business. If you are starting a business similar to this, read this case and do things differently than Mr. Johnson. Write a business plan, have a separate bank account, and keep good records! Trust me, you’ll be happy you did.

Case: Johnson v. Commissioner, T.C. Memo 2012-231

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Bad News for Medical Marijuana Dispensaries (and Espcially for the Vapor Room)

Thursday, August 2nd, 2012

Yet another important case came up while I am on vacation. Martin Olive operates the Vapor Room, a medical marijuana dispensary in California. He was audited, and the IRS held:

– That the dispensary underreported gross receipts;
– Could only deduct a small fraction of the claimed gross receipts;
– Couldn’t deduct any of the business expenses; and
– Was liable for the accuracy-related penalty.

Mr. Olive took his case to the Tax Court, and the Court made a full decision today (which serves as a precedent). And it’s not good news for the medical marijuana industry in California (or elsewhere).

First, let’s give the (somewhat) good news. The Court held that the Cost of Goods Sold (COGS) could be deducted where proven. But the petitioner (Mr. Olive) conducted his business in cash (rather than checks), and didn’t keep good records. Mr. Olive stated that the medical marijuana industry, “shun[s] formal ‘substantiation’ in the form of receipts.” That may be true, but:

The substantiation rules require a taxpayer to maintain sufficient reliable records to allow the Commissioner to verify the taxpayer’s income and expenditures…Neither Congress nor the Commissioner has prescribed a rule stating that a medical marijuana dispensary may meet that substantiation requirement merely by maintaining a self-prepared ledger listing the amounts and general categories of its expenditures. It is not this Court’s role to prescribe the special substantiation rule that petitioner desires for medical marijuana dispensaries and we decline to do so.

Still, the Court did allow an estimated COGS of just over 70% of gross receipts.

After that, the news was not good for the dispensary. First, the cash receipts were understated. The ledgers used had omissions, and the Court believed that the IRS’s calculated additional receipts were accurate.

Second, we turn to the “ordinary and necessary” business expenses. Most taxpayers can deduct these. However, Section 280E of the Tax Code prohibits deducting expenses for a trade or business that consists of trafficking in controlled substances in violation of federal law. “We have previously held, and the parties agree, that medical marijuana is a controlled substance under section 280E.”

Petitioner argues that he may deduct the Vapor Room’s expenses notwithstanding section 280E because, he claims, the Vapor Room’s business did not consist of the illegal trafficking in a controlled substance. He argues that the illegal trafficking in controlled substances is the only activity covered by section 280E. We disagree that section 280E is that narrow and does not apply here. We therefore reject petitioner’s contention that section 280E does not apply because the Vapor Room was a legitimate operation under California law. We have previously held that a California medical marijuana dispensary’s dispensing of medical marijuana pursuant to the CCUA was “trafficking” within the meaning of section 280E. See CHAMP, 128 T.C. at 182-183. That holding applies here with full force…

Congress in section 280E has set an illegality under Federal law as one trigger to preclude a taxpayer from deducting expenses incurred in a medical marijuana dispensary business. This is true even if the business is legal under State law.

Mr. Olive attempted to show his business had two components (providing medical marijuana and ‘caregiving’), but the Tax Court didn’t buy that. There were no revenues for caregiving, and the Tax Court,

…perceive[d] his claim now that the Vapor Room actually consists of two businesses as simply an after-the-fact attempt to artificially equate the Vapor Room with the medical marijuana dispensary in CHAMP so as to avoid the disallowance of all of the Vapor Room’s expenses under section 280E.

This decision does not bode well at all for the medical marijuana cases that are moving through audit and the Tax Court. This is a full precedential case and I don’t see the Tax Court changing its view on the issues in the future.

Case: Olive v. Commissioner, 139 T.C. No. 2

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The Tax War Against Medical Marijuana

Sunday, July 15th, 2012

Think what you may about medical marijuana (legal in about 17 states), there is a certainty for federal income tax purposes: Marijuana is a Class I narcotic so deducting expenses on a tax return for a marijuana dispensary is a violation of Section 280E of the Tax Code. This poses obvious difficulties for operators of dispensaries. And the federal government has targeted California dispensaries on two fronts: the IRS and landlords.

I’ve reported on this issue before. In early 2011, I noted it would take a while for the cases to get to the Tax Court. In Janet Novack’s excellent summary of the situation, Ms. Novack notes that two dispensaries have filed Tax Court cases. They’ll likely be heard late this year, with decisions coming in 2013.

The problem for the dispensaries is that the law is very clear here, and the IRS is likely correct in assessing the tax. It doesn’t matter that medical marijuana is legal in California–federal tax law is black and white on this issue. While I expect the probable losses in Tax Court to be appealed to the 9th Circuit Court of Appeals, the dispensaries appear to me to be in a losing battle.

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Funding an S-Corp from an S-Corp: Distribute, Don’t Loan

Thursday, June 7th, 2012

Joe Kristan has an excellent update that is a must-read for owners of multiple S-Corporations. The Tax Court validated a traditional S-Corporation planning technique: You can distribute basis from one S-Corporation to another. There are some caveats (aren’t there always?), and the paperwork is vital, but this is a technique that can work.

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