Taxable Talk

The Tax Court delivered a trick on Halloween to these taxpayers. They operated a timber operation (perhaps), accounting services (although the husband was "...suspended from practice before the Internal Revenue Service since 1981"), real estate (although the wife asked, "[please] don't issue me a 1099"), and they sort of used leased employees. It was ugly....

The taxpayers formed an S Corporation, or tried to. They filed the paperwork, but they specified that their "natural business year" ended in January. The IRS didn't approve, so the S Corporation was never really formed. Although I'm only slightly cynical, might the taxpayers involved tried January so that they could defer tax payments for eleven months? But I digress.

As the Tax Court noted, "An election of a corporation to be an S corporation under sections 1361(a) and 1362(a)(1) must be complete, properly filed, and made in accordance with regulations...." The taxpayers took flow-through losses which the IRS challenged. They didn't substantiate them in court. Strike one.

The taxpayers claimed they weren't subject to the self-employment tax. But they weren't employees and received payments for services. Strike two.

Finally, they claimed that they paid out about $18,000 for "leased employees." But the Tax Court noted that the money came from the taxpayers personal services. That doesn't sound like leased employees to me, and it didn't to the Tax Court. Strike three.

We could throw in strike four and more for labor expenses that paperwork shows happened in 2000 but were deducted in 2001, and interest expenses without backup, and repair expenses without backup. The Tax Court threw in accuracy related penalties for the taxpayers' strike-out. ("Petitioners make no argument and offered no evidence to show that they had reasonable cause.")

Case: Arnold, et. al., v. Commissioner

Let's say that your small corporation borrows some money. Let's further suppose that you that that borrowed money and then purchased dividend paying stocks with that money. You can't deduct those dividends. It's considered a form of double-dipping, as you can deduct the interest you pay on the borrowed money and the interest.

However, let's assume your a large corporation, like Berkshire Hathaway, the famous investment vehicle run by Warren Buffet. You borrow $750 million which you characterize as strengthening your financial situation. You also purchase some dividend paying stocks. The IRS audits you and denies your dividend deduction, claiming that you violated the tax rules.

Berkshire Hathaway paid the tax and then sued in US District Court in Omaha. In a decision delivered today (but not yet available on the Internet), the court ruled that, "[It is] virtually impossible for the [IRS] to trace debt proceeds and thus assess tax deficiencies ... against companies like Berkshire who engage in numerous investment transactions." Berkshire Hathaway will receive a refund of $23 million plus interest, subject to a possible appeal by the IRS.

News Coverage: Reuters.

With the withdrawal of Harriet Miers as a nominee for the Supreme Court, speculation has centered on several individuals as a possible nominee, including Judge Michael McConnell. In this unpublished opinion, which is a model of brevity, Judge McConnell rejects some tax protesters' appeal of the dismissal of their case at the Tax Court. As I've said many times before, you're not going to win in court saying that the US doesn't have an income tax.

What I liked most about the opinion is that it is short, sweet, and to the point. As Judge McConnell wrote, "As with their other frivolous arguments, petitioners have failed to put forth any relevant legal authority to support their claim that respondent “defaulted” during the administrative proceedings in this case."

While I was off this past week, the Tax Reform Panel came out with two proposals that are similar. The two proposals would:

1. Eliminate state and local tax deductions for individuals. Given that a large percentage of the US population lives in high-tax states (such as California), this isn't going to pass.

2. Limitation on deducting health insurance. This is another non-starter given the high cost of health insurance. I do understand the panel's reasoning (if taxpayers feel more pain, they will do more to lower health insurance costs) but I find a hard time seeing this passing.

3. Elimination of the Alternative Minimum Tax (AMT). This will be applauded by all.

4. Increasing charitable deductions; changing charitable deductions to excess of 1% of AGI. This makes both economic and political sense.

5. Changes to deductibility of mortgage interest; credit instead of deduction; limitation on amount. This is a political non-starter (see item #1 above). The proposed rules are complex, and will change the cap from $1 million of purchase-based interest (as a Schedule A deduction) to the maximum amount of FHA interest (will vary depending on location), to be taken as a credit. This will strike at higher-income taxpayers, and will, thus, be politically unpopular.

6. Change many deductions to credits. As best as I can tell, this will not change many taxpayers' taxes, but could have a small positive impact to low-income taxpayers.

7. Lower the number of brackets from six to four; lowest individual bracket at 15%; highest at 32%. I believe that Democrats will not like the idea of lowering the top tax bracket. This proposal does not have a huge impact. Remember, the panel had to make these reforms "revenue neutral." The big cut is the elimination of the AMT. This item is window dressing.

8. Changes to retirement plans, savings plans, etc. The changes, which will be difficult to pass, would change popular plans (such as IRAs) into refundable credits. This will aid low-impact taxpayers, but would disrupt an entire industry that has been built up around IRAs and similar programs. I doubt this will be implemented.

9. Two alternative individual plans: Either 8.25% on capital gains and interest taxed at regular tax rates or 15% on capital gains, interest, and divdends. The first plan exempts dividends (if I read it correctly) for individuals, ending double-taxation on dividends. The second plan continues the double-taxation on corporate investments but corporations can expense their investments. I need to read more about these plans to determine both their feasiblity and the chance of passage.

Overall, I think these plans will be buried in the political wastebasket. Perhaps the panel had good intent, but there's too much in these plans that is political suicide for too many members of Congress.


There have been many comments about these plans. Roth Tax Updates posts about the first alternative individual plan here. Tax Professor Daniel Shivaro comments here. The New York Times comments here. Professor Maule has his comments, and they're not positive.

Well, 48 pennies.

Most tax software rounds off numbers to whole dollars. Indeed, the IRS suggests taxpayers do this in their instructions to Form 1040: "You may round off cents to whole dollars on your return and schedules. If you do round to whole dollars, you must round all amounts. To round, drop amounts under 50 cents and increase amounts from 50 to 99 cents to the next dollar. For example, $1.39 becomes $1 and $2.50 becomes $3." This seems fairly straightforward, no?

Well, most of the time it does. But what happens when a taxpayer makes an installment plan agreement, and pays what's due, but rounds what he owes to whole dollars? In the case decided by the Tax Court, a taxpayer agreed to make two payments of $13,348.24. He made the payments on the dates agreed to, but rounded his payments to the nearest whole dollar (two payments of $13,348.00). The IRS sent a notice of delinquency—the taxpayer owed 48¢ in taxes plus a penalty of $175.44 and interest of $264.08. After a Collection Due Process Hearing that apparently went nowhere, the case ended up in Tax Court.

I am not making this up.

I wonder whether anyone at the IRS can explain why you would spend several hours attempting to collect 48¢. As the Tax Court notes, "We must decide this dispute even though the cost of the parties’ pursuit of their principles will far exceed the amount in dispute." There are, after all, plenty of taxpayers who abuse the system, for amounts that are thoursands (and millions) of times larger than 48¢. If you get the feeling that I think the IRS made "a colossal blunder" (as the taxpayer in this case put it), you're correct. But I digress.

The taxpayer had his records showing payment was made in the amount agreed to, and that he used a method that the IRS endorsed. The IRS, on the other hand, "...presented no evidence showing that penalties and interest accrued in excess of the amount petitioner paid."

The Tax Court found that "...it was an abuse of discretion to proceed with collection activities."

Case: Norris v. Commissioner, T.C. Memo 2005-237

For the very small business owner, the IRS will introduce in 2006 a new form, Form 944. You can view a draft version of the form here. The new form is for businesses who pay $1,000 or less in employment taxes annually. The IRS believes that one-sixth of the 6 million total Form 941 filers will be able to use the new form.

The new form (Form 944) has to be filed only once per year, saving paperwork time. In most cases, the taxes can be paid when filing the form.

As the SSA/IRS Reporter states, "The IRS believes that filing and paying employment taxes should be as easy as possible. By simplifying the process of employment tax filing, more small employers will have the opportunity to more easily comply with the law." And I agree.