Taxable Talk

Suppose you discover an error in your 2001 tax return. You've forgotten to include a $55,065 deduction that will lower your taxes by $13,769. You timely amend your return to get the deduction (you have three years from the due date of the return or the filing date, whichever is later, to amend a return), and make a claim for the refund. The IRS questions your refund claim and eventually denies it. You appeal internally (administratively) within the IRS, and, after spending $7,253 on accountants and attorneys, prevail, and get your check for $14,921 (inclusive of about $1,200 of interest). You file a Tax Court claim for the $7,253 you spent on fighting (rightly) the IRS, because Section 7430 of the Internal Revenue Code allows you to recover funds when you are the prevailing party in an administrative or court proceeding. Do you get your $7,253?

The Tax Court looked at that issue today. A taxpayer filed his 2001 tax return and had a Roth IRA (converted from a regular IRA under §408A(d)(3), and timely filed and paid his tax. In October 2001, he reconverted his IRA back to a regular IRA under §408A(d)(6), and asked for a refund of $13,769. The IRS disputed the refund, and denied it as the reconversion wasn't timely.

The taxpayer went to the IRS' National Office of Chief Counsel a ruling as to whether or not the reconversion was timely. The Office of Chief Counsel ruled it was. The taxpayer resubmitted his amended tax return, attaching a copy of the letter from the Office of Chief Counsel. Eventually the taxpayer got his refund along with additional interest. Still, the taxpayer was out the costs of fighting the IRS of $7,253.

After filing a claim with the IRS Appeals Office (which was denied), the case went to the Tax Court. Unfortunately, to win a claim under §7430, the petitioner must be the "prevailing party." The IRS must have adopted a "position" on the matter. And that only happens, according to the Tax Court, if there's a notice of deficiency or an IRS appeals office ruling—neither of which occurred in this case.

The Tax Court sympathizes with the petitioner, and notes,

"...[T]axpayers (such as petitioners herein) who do a good job at the administrative level of resolving issues and getting respondent to realize the error of his ways are precluded from recovering administrative costs incurred in achieving those favorable results. To the contrary, taxpayers who do not do as good a job at the administrative level and who receive adverse Appeals Office notices of decision or notices of deficiency, but who later convince respondent to concede issues or who substantially prevail in litigation on the issues, are able to seek a recovery of administrative costs. In effect, taxpayers who do a better job at the administrative level of resolving issues raised by respondent on audit are prejudiced in their ability to recover administrative costs under section 7430."

But "Courts do not have the power to repeal or amend the enactments of the legislature even though they may disagree with the result." (Metzger Trust v. Commissioner, 76 T.C. 42, 59 (1981), affd. 693 F.2d 459 (5th Cir. 1982) So our unlucky taxpayer is out the money, because he was good at going through the administrative system. There's a moral here, but I don't like it at all.

Case: Kwestel v. Commissioner, T.C. Memo 2007-135

What happens when you receive a Form 1099-MISC, but you never received the income shown on the information return? You don't include it on your tax return—after all, you didn't receive the income, so you don't owe tax on it. But then the IRS sends you a notice saying you do owe tax on the money.

That's the situation that the Tax Court faced today. A Colorado insurance agent accepted a new client, and assigned the commissions to the client. (Why he would do that is not known, but the evidence in the case showed that the checks from the insurance company were deposited into the clients' accounts.) The IRS sent a notice to the insurance agent, and the case ended up in Tax Court.

Normally, the petitioner in Tax Court has the burden of proof. However, when the underlying issue is a dispute over an information return (such as a 1099-MISC), and the petitioner cooperates with the IRS (as was the case here), then the burden of proof shifts to the IRS.

That's very important here, because there was no evidence of any money ending up with the insurance agent. After the IRS admitted that the commissions ended up with the client (it was hard not to admit that, given that the checks were deposited into their bank accounts), they still contended that the insurance agent must have received some income. "Respondent nevertheless determined that petitioner had unreported income, around $2,000 to $3,000, which respondent asserts was the amount petitioner received from Investments for the use of his license in selling the insurance policies that generated the commissions reported by NACOLAH." ("Investments" is the client and "NACOLAH" is the insurance company.)

There was only one thing missing for the respondent (IRS) to prove their case: any evidence. Without any evidence, the Court ruled for the petitioner. "Accordingly, the Court finds that petitioner is not liable for the 2003 deficiency and section 6662(a) accuracy-related penalty because respondent has failed to satisfy his burden of production with respect to the deficiency and the Form 1099-MISC under section 6201(d)."

Case: Cirbo v. Commissioner, T.C. Summary Opinion 2007-85

The Tax Court today looked into whether a non-profit corporation that provides help to the terminally ill and provides medical marijuana to the terminally ill is allowed to deduct its operating costs.

The non-profit, Californians Helping to Alleviate Medical Problems, Inc., was a San Francisco based corporation that helped the terminally ill. In its view, as a secondary service the provided medical marijuana to their patients; in the view of the IRS, it was intertwined with its other goal—and the non-profit only had one line of business.

A few tax facts first. If you are in an illegal occupation or you sell illegal or illicit drugs, you must report the income from your occupation; illegal income is just as taxable as legal income. Medical marijuana is in a curious category; under California law, properly prescribed medical marijuana is a legal line of business. However, for federal purposes marijuana—even marijuana legally prescribed—is considered a Schedule I controlled substance for tax purposes. And §280(E) of the Code prohibits deductions or credits for trafficking in controlled substances (Schedule I or II).

The IRS did not dispute the actual amounts of the expenses. So the Tax Court was left with two questions to answer: (1) Could the non-profit deduct expenses related to the distribution of medical marijuana; and (2) Could the non-profit deduct the expenses related to providing care for the terminally ill or were the two lines of business one?

The Court held

"...that section 280E does not preclude petitioner from deducting expenses attributable to a trade or business other than that of illegal trafficking in controlled substances simply because petitioner also is involved in the trafficking in a controlled substance...We define and apply the gerund “trafficking” by reference to the verb “traffic”, which as relevant herein denotes “to engage in commercial activity: buy and sell regularly”. Webster’s Third New International Dictionary 2423 (2002). Petitioner’s supplying of medical marijuana to its members is within that definition in that petitioner regularly bought and sold the marijuana, such sales occurring when petitioner distributed the medical marijuana to its members in exchange for part of their membership fees."

The Court then turned to the second question: Was there one line of business or two?

"Petitioner was regularly and extensively involved in the provision of caregiving services, and those services are substantially different from petitioner’s provision of medical marijuana. By conducting its recurring discussion groups, regularly distributing food and hygiene supplies, advertising and making available the services of personal counselors, coordinating social events and field trips, hosting educational classes, and providing other social services, petitioner’s caregiving business stood on its own, separate and apart from petitioner’s provision of medical marijuana."

The Court then held that the expenses will be allocated, and the expenses allocated to the caregiving will be allowed but the expenses allocated to medical marijuana will not be allowed.

Thus, for federal tax purposes, even if you legally supply medical marijuana, you can't deduct related expenses. However, if you have another line of business, those expenses are deductible. Note that it is very likely that the expenses related to medical marijuana are deductible on the California tax return.

Case: Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. No. 104