Saturday, August 28, 2010

How long do I have to keep this crap?

It's one of my favorite questions, and one that I get every year.

How long do you have to keep your tax records? Is it really seven years?

No, not really. But there also isn't a straightforward answer, either.

In general, the IRS has three years from the later of when a return is filed or is due to assess additional tax (remember, filing the return qualifies as an assessment). See 26 USC 6501. After that, the IRS is stuck with whatever tax is shown on the return. Consequently, the IRS has the incentive to move fast to assess additional taxes, which means you should hear from them no more than 18 months after you've filed your return. In 20 years of practice, I have not seen an audit notice more than two years after a return has been filed, but plenty at the 18 month mark.

So I can toss my 2009 tax records on April 15, 2013 then? 

Not so quick. Many states have longer deadlines, usually four years, though a number have shorter deadlines which mirror the IRS. So, if all is in order, and you're not doing anything funky on your return, you can toss your stuff on April 15, 2014. Or sooner, if your state statute allows.

What do you mean by 'in general'?

Well, in certain circumstances, the statute can be extended. For example, you might agree to extend the statute as part of an audit. Amending a tax return refreshes the statute, at least as it applies to new items. The IRS might allege a gross (more than 25%) understatement of income, which extends the statute to six years, instead of three. Or the IRS might allege tax fraud, which removes any statute of limitations entirely. Been filing since 1916? The IRS can go all the way back until then. Finally, the statute is suspended for a period of time (150 days, generally) after a notice of deficiency is issued. So there are a number of exceptions which you need to consider.

And if I'm not doing anything funky or being audited or amending?

Check with your state, but you should be free to empty that box in four years, not seven.

That's a relief.

I'm sure your closet agrees.

Saturday, August 7, 2010

And you thought YOUR performance review was bad...

No one - no one - likes performance reviews. Whether your firm/company does them mid-year, at the end of the year, or some other time, it's pretty much a given that it doesn't matter which side of the table you're on - giver or recipient - you're not going to be happy.

But at least it's private (for most people). Your boss (probably) doesn't stand at the head of the department and say "Bob really screwed up this year! Boy, it's amazing that Fishbottom is still a client after he handled their leveraged buyout! I haven't seen work that sloppy since I looked at my six-year-old's homework!"

So, imagine, if you will, how much fun it must have been to the attorneys for Canal Corporation (formerly Chesapeake) from Troy Gould (Clifton Cates III) and Ivens, Phillips & Barker (David Sherwood and Robert Wellen) to get out of bed on Friday and find that not only had they lost, but that the court had made the effort to shred the work done by Pricewaterhousecoopers that formed the basis of their arguments. And David Miller of PWC is probably wishing that he'd let Donald Compton handle the opinion letter instead. Why? Well, read what the court wrote (thanks to TaxProfBlog for the tip):

Mr. Miller did not have direct authority requiring this percentage. He merely made this determination based on Rev. Proc. 89-12, 1989-1 C.B. 798, which was declared obsolete by Rev. Rul. 2003-99, 2003-2 C.B. 388.8 ...

A bad start, considering Mr. Miller was an attorney for the now-defunct Jenkins & Gilchrist (who bit it as a result of Enron...) and should know better than to cite without checking if the cite's still good. But it gets worse..

Chesapeake paid PWC an $800,000 flat fee for the opinion, not based on time devoted to preparing the opinion. Mr. Miller testified that he and his team spent hours on the opinion. We find this testimony inconsistent with the opinion that was admitted into evidence. The Court questions how much time could have been devoted to the draft opinion because it is littered with typographical errors, disorganized and incomplete. Moreover, Mr. Miller failed to recognize several parts of the opinion. The Court doubts that any firm would have had such a cavalier approach if the firm was being compensated solely for time devoted to rendering the opinion.

In addition, the opinion was riddled with questionable conclusions and unreasonable assumptions. Mr. Miller based his opinion on WISCO maintaining 20 percent of the LLC debt. Mr. Miller had no case law or Code authority to support this percentage, however. He instead relied on an irrelevant revenue procedure as the basis for issuing the “should” opinion. A “should” opinion is the highest level of comfort PWC offers to a client regarding whether the position taken by the client will succeed on the merits. We find it unreasonable that anyone, let alone an attorney, would issue the highest level opinion a firm offers on such dubious legal reasoning.

Ouch. So if your performance review wasn't the best, just be glad you're not David Miller today. He probably feels embarrassed to show his face at the office. And David, if your caller ID today says "Canal Corporation," you probably want to let it go to voice mail.

One wonders: Can Canal get a refund without a receipt or just a firm credit?

Tuesday, July 27, 2010

Surprise! IRS Continues to use illegal designations

Breaking news over at Tax Prof Blog: Despite Congressional orders to the contrary, the IRS still labels people as 'Tax Protester,' 'Constitutionally Challenged,' and the like. Congress' concern was that people so labeled would have a stigma attached to them, and so, in 1998 prohibited the use of such terms. In a recent report, TIGTA indicated that 196 out of 80 million returns still used the label (a small, small number, to be sure, but still...).

On the other hand, many tax protesters are not shy about sharing their views with anyone who will listen, and many who are trapped against a wall at a dinner party with no escape route. I have met several over the years, and it was all I could do to get away from them. So how the IRS attaching or not attaching a label adds or prevents a stigma from attaching is unclear to me. People who are fervently anti-tax aren't afraid of the stigma; if they were, they wouldn't be publishing websites, books and pamphlets. Besides, these people are like other extremists - they find their audience, and spend much of their time preaching to the choir. I'd guess in those instances, a label from the IRS would be a badge of honor, not shame.

Saturday, July 17, 2010

Proving undocumented expenses, shifting burdens and avoiding penalties: a look at some audit issues.

Here’s the scene: you go to the mailbox, and inside is a letter from the IRS. They want more information about your 2008 tax return, specifically some deductions on your Schedule A. Problem is, those records got lost when you moved last month, and you’re not sure you can prove all of your expenses. Is all lost?
Some may be, but not necessarily all.
What can be saved? Well, to answer that, you need to look at some tax court cases, a section or two of code, and cross your fingers. Chocolate and/or whiskey might help, too. For you. Not the agent.
In general, once the IRS issues a notice of deficiency, that notice is presumed correct, and you’re on the hook to prove that it’s not.  (See, e.g., Rule 142(a), Welch v. Helvering, 290 U.S. 111, 115 (1933), Lang v. Commissioner, T.C. Memo 2010-152, at 4 (2010)). Often, in a tax court case, a taxpayer will attempt to circumvent this general rule by citing to Section 7491, a provision of the code which shifts the burden of proof to the IRS. Does it work? Not really.
Here’s why: in order to shift the burden of proof, you, the taxpayer, must comply with certain rules. In reality, if you do, your case is not likely to get as far as Tax (or Federal District) Court in the first place. Furthermore, the burden of proof issue is only determinative when there is an evidentiary tie (See,  Knudson v. Commissioner, 131 T.C. 185, 189 (2008), Lang v. Commissioner, T.C. Memo 2010-152 at 8). Still want to try to use 7491? Then take a look at the way Section 7491 is worded:
 (a) Burden shifts where taxpayer produces credible evidence
      (1) General rule
        If, in any court proceeding, a taxpayer introduces credible
      evidence with respect to any factual issue relevant to
      ascertaining the liability of the taxpayer for any tax imposed by
      subtitle A or B, the Secretary shall have the burden of proof
      with respect to such issue.
      (2) Limitations
        Paragraph (1) shall apply with respect to an issue only if -
          (A) the taxpayer has complied with the requirements under
        this title to substantiate any item;
          (B) the taxpayer has maintained all records required under
        this title and has cooperated with reasonable requests by the
        Secretary for witnesses, information, documents, meetings, and
        Interviews; []

The first thing that stands out is the phrase ‘credible evidence.’ While not specifically defined, paragraph 2(B) provides a strong indication of what that might mean – producing the records required to substantiate the expense.

The second point to be made is what one colleague calls the ‘cooperate fully’ provision – you comply with all reasonable requests made by the IRS. This means that if they ask for your employer’s reimbursement policy, you provide it, or a reason why it cannot be provided (if your employer does not have a reimbursement policy, you’ll need to have them say so in a letter. Agents don’t have to, and likely won’t, rely upon your oral statements only). “Reasonable request” gives the IRS pretty wide latitude, too. As long as the IRS can provide a plausible explanation why the record is needed, you’ll need to ante up the document. You can certainly challenge it later, if needed, but that fight isn’t particularly advised at the early stages of an audit (unless you know you’re on shaky ground. If you are, damage control is your best option).

If, for some reason, you do not have proof of an expense, you can – under what is known as the Cohan rule – estimate the expense. Cohan refers to composer George M. Cohan (of “Yankee Doodle” fame) who was audited by the IRS in 1930[1]. Cohan had certain entertainment and business-related expenses that he couldn’t provide receipts for, but which he alleged were business-related. Based solely upon testimony he provided, the court (in an opinion written by the great jurist Learned Hand) agreed, and overruled the IRS’ denial of all expenses. In his opinion, Judge Hand stated,

“… the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making. But to allow nothing at all appears to us inconsistent with saying that something was spent. True, we do not know how many trips Cohan made, nor how large his entertainments were; yet there was obviously some basis for computation, if necessary by drawing upon the Board's personal estimates of the minimum of such expenses. The amount may be trivial and unsatisfactory, but there was basis for some allowance, and it was wrong to refuse any, even though it were the travelling expenses of a single trip. It is not fatal that the result will inevitably be speculative; many important decisions must be such. We think that the Board was in error as to this and must reconsider the evidence.”

Since Cohan was decided, the law has been considerably narrowed. For example, estimation is not acceptable in regard to travel , meals and entertainment (Section 274(d) requires documentation; without documentation, no expense is permitted), and courts have made it clear that when a section of the code requires specific types of documentation, an estimate is unacceptable.  Moreover, courts routinely refuse to provide any estimation where insufficient evidence exists in the record to provide a basis for estimation. [2]

While it can be said that alternate means of proof are acceptable substitutes for receipts, that doesn’t mean that alternate means are a cure for what ails you. Again, courts require documentation: "In the absence of adequate records, a taxpayer may alternatively establish an element of an expenditure by “his own statement, whether written or oral, containing specific information in detail as to such element” and by “other corroborative evidence sufficient to establish such element."” Lang, at 7, quoting Larson v. Commissioner. The use of the phrase 'specific information in detail' is vague enough that it gives the IRS latitude in deciding how specific you need to be. Suffice to say that your testimony alone is probably not even close to being enough.

Finally, to add insult to injury, the IRS can, under Section 6662, tack on an accuracy related penalty. Here again, you might be tempted to rely upon Section 7491 burden of proof requirements. Don’t . The Services burden here is ridiculously small. All the IRS has to do is show the greater of two things:  either 1) that you understated your tax by more than $5,000.00, or 2) that the amount of understatement is greater than ten percent (10%) of the tax shown on the return. If the Notice of Deficiency does that, the IRS burden of proof has been met, and you’ll be assessed the tax.

Frequently, the Code gives taxpayers and out, and here a safe harbor exists which may allow a taxpayer to avoid the penalty under Section 6662 – as the Court in Lang noted:

The accuracy-related penalty is not imposed with respect to any portion of the underpayment as to which the taxpayer acted with reasonable cause and in good faith. Sec. 6664(c)(1). The decision as to whether the taxpayer acted with reasonable cause and in good faith depends upon all of the pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Relevant factors include the taxpayer’s efforts to assess his proper tax liability, including the taxpayer’s reasonable and good faith reliance on the advice of a professional such as an accountant. Id. Furthermore, an honest misunderstanding of fact or law that is reasonable in the light of the experience, knowledge, and education of the taxpayer may indicate reasonable cause and good faith. See Remy v. Commissioner, T.C. Memo. 1997-72.

What does that mean? Well, where the taxpayer has been found to have sufficient knowledge, experience or education, or attempted to assess his or her proper tax liability, a penalty has been assessed[3], but where a taxpayer has shown that they have little financial knowledge, the penalty has been waived. So a cleaning lady whose unreimbursed expenses are disallowed will have better luck laying the blame at the tax preparer’s feet (provided it can be shown that they are a competent preparer) than, say, a law professor who teaches tax law. It is very much a fact and circumstance based test, and what works for one taxpayer may not work for another.

In short, just because you do not have, or cannot find a particular receipt does not mean you automatically lose a particular deduction. It does mean that you have a harder row to hoe, and a higher likelihood of disallowance, but don’t start writing a check just yet – hire a professional, and start pushing back.

[1] Cohan v. Commissioner, 39 F2d 540 (2nd, 1930).
[2] See, e.g., Lang, where the Court permitted the taxpayer a $96 deduction for Ross Reports magazine, because the taxpayer 1) provided two receipts showing he’d purchased the magazine for $8, and 2) testified that he bought the magazine monthly. However, the court did not allow a deduction for Backstage magazine, which the taxpayer claimed to buy weekly at $2 a pop, because he could not even produce one receipt showing a purchase.
[3] See Lang, where, in denying relief under 6664, the Court noted, “While a taxpayer’s reliance on the specific advice of a tax return preparer may constitute reasonable cause, petitioner has failed to offer testimony or evidence regarding the qualifications of his tax return preparer. Petitioner’s general statements that he relied on his tax return preparer are not sufficient to prove a reasonable basis, substantial authority, or reasonable cause for his disallowed deductions. Secs. 6662(d)(2)(B), 6664(c)(1).” Lang, at 23.

Tuesday, July 13, 2010

Live in NV? Haven't filed in a while? Here's your chance....

There's only a handful of ways to put money in the state's coffers. One is to raise taxes, an unpopular option, which could backfire. Another is to increase enforcement via audits, equally unpopular. A third is an amnesty, which avoids the unpleasantness of the other two options, and allows non-filers to get an albatross off their necks and avoid penalties and interest to boot. Even better, there may be no requirement to file timely afterward (though it's probably a good idea).

Nevada's the latest state to join the amnesty train. New York, Pennsylvania, Maine, Florida and New Mexico also have had or are having programs, and twelve states had amnesties in 2009. Several cities (including Oakland and Los Angeles in 2009, and Philly in 2010) have also had amnesties. Ironically, Illinois and California - two very strapped states - have not had amnesties recently, though one for 2010 was introduced in Illinois late last year, but never went anywhere.

Is there a downside? Well, one writer posits that amnesties, if used too often, can promote noncompliance, though most states don't do them frequently enough to make that a good strategy. Moreover, if you've dropped off the radar, you'll suddenly find yourself back on it, so you should pay up for all outstanding years even if not covered by the amnesty, because you could soon find yourself getting a rather large bill.

When it rains, it pours...

If you commit a crime these days - particularly white-collar crime, such as identity theft, or fraud - you're likely to also be hit with tax-related charges. Take Kathy Chen, for example. Ms. Chen - who, in addition to being a real estate agent, owned a tax service, two financial service firms and an escrow firm - used information gained from those businesses to either steal or create wholly fictitious identities. She - and her alleged co-conspirators - then convinced banks to loan her upwards of $17 million dollars on 35 properties.

The scam was simple - get the loan, make payments for a while, then take off with the money. The losers were the banks, and the individuals whose identities were stolen.

Now, considering that you're reading about it here, the plan didn't work out in the end - Chen, after all, was convicted. But interestingly enough, the State of California wasn't satisfied with merely putting her in jail for fraud - they also convicted her of three counts of filing false tax returns.

Time was when Charlie Martin Smith (as Agent Oscar Wallace) talked of getting Capone for tax evasion and Kevin Costner (as Elliot Ness) chuckled with amusement. While tax evasion - and tax related charges - have been around for a while, they are underutilized as an enforcement weapon. But it's nice to see the state can pile on when it wants to.

Saturday, July 10, 2010

This just in: IRS releases 2008 data

The IRS has released their report on 2008 tax data.

It's 190 pages of engrossing reading.

Ok, maybe not, but it does serve as a useful guide for answering that annual question: How much can I deduct?

The correct answer, of course, is: you can deduct what you actually paid (assuming you can deduct anything, of course), and not a penny more. But for those clients who are skittish about taking the deduction in the first place (I've had clients refuse to take perfectly legit deductions because they were certain if they did, they'd be audited), or who are worried that their deductions are abnormally high (clue: if you make $40,000.00 a year, and claim $15,000 in charitable contributions, you don't need this guide to tell you the answer is 'yes') this is a good starting point for discussion.

In general, the data is broken down by income range, and some tables show the amount of the deduction/credit, others show the actual amounts, and still others show both, so it should go without saying that you should take the time to read the footnotes and headings to make sure you don't misinterpret.

What will you find?

Well, for example, the report will tell you that 1.2 million taxpayers making between $30,000 and $40,000 per year took education credits on their 2008 returns. Ironically there were fewer taxpayers in the next bracket - $40-50,000 - who took education credits (972,000), though the number bumped up to 1.3 million for those making between $50 and $60,000.00.

(Why the drop? Reasons abound, but one reason could be that these people were not aware of the credit, which would provide a planning opportunity for their preparers that is being missed.)

While falling into the bands suggested by this report won't protect you from audit, falling outside (if you're, say, one of the 539 people with no AGI who took the credit) the normal range is a good way to get the IRS' attention.

It's a big file, so it will take a bit to download, but it's an interesting read if you've got time to kill (you know, like when you're on hold with the IRS).