Larry's Tax Law

Following up on my summary of Congressman Dave Camp's discussion draft of the Tax Reform Act of 2014, I had the opportunity to discuss the subject with Colin O'Keefe of LXBN. In the brief interview, I describe some of the proposed tax provisions that will impact individual taxpayers and corporate taxpayers.

On March 3, 2014, the Internal Revenue Service published Announcement 2014-13 (“Announcement”).  The Announcement sets forth the disciplinary actions the Office of Professional Responsibility (“OPR”) recently took against practitioners.

The OPR is responsible for interpreting and applying the Treasury Regulations governing practice before the Internal Revenue Service (commonly known as “Circular 230”).  It has exclusive responsibility for overseeing practitioner conduct and implementing discipline.  For this purpose, practitioners include attorneys, certified public accountants, enrolled agents, enrolled actuaries, appraisers, and all other persons representing taxpayers before the Internal Revenue Service.

In essence, Circular 230 sets forth the “rules of the road” for tax practice before the Service.  Circular 230 cases generally revolve around a practitioner’s fitness to practice.

According to an article published by Kristi Eaton of the Associated Press (“AP”) on February 20, 2014, NBA star Kevin Durant filed a lawsuit against his former accountant, Joel Lynn Elliott, CPA, for alleged mistakes made in the preparation of income tax returns.  As a result of the mistakes, Durant alleges he will have to amend certain income tax returns, pay additional taxes, and possibly be subjected to penalties.

 The lawsuit, filed in California, where CPA Elliott practices accounting, alleges that the accountant made numerous errors in the preparation of Kevin Durant’s income tax returns, including deducting as business expenses the costs of personal travel and the costs of a personal chef.  According to the AP, the complaint provides with respect to the travel expenses:  “In preparing a client’s tax returns, a reasonable prudent accountant would have conducted a basic inquiry and sought documentation to confirm that each travel expense for which a deduction was recorded was truly business related.” 

As a general proposition, if a tax return preparer gives a client incorrect advice about the deductibility of certain expenses or mistakenly includes non-deductible expenses on the client’s tax return, what are the client’s damages? The taxes, the interest on the underpayment of taxes, the penalties and/or the cost to amend the tax return?   If the client ends up engaging a new preparer to amend his or her tax return, and pays the tax, interest on the underpayment of taxes and penalties, it seems logical the preparer could be liable for the cost of amending the returns and the penalties.  The client owes the tax; nothing the preparer did likely changes that conclusion.  Unless the client would have refrained from incurring the non-deductible expenses in the first place had he or she been given a correct recitation of the tax laws, how can the preparer be liable for the tax?   Interest is a bit trickier.  Since the client got the use of the money (from the time the taxes were originally due until actually paid), one can argue the preparer is not liable for the interest.  Assuming the preparer gave incorrect advice or mistakenly included non-deductible expenses on the client’s tax return, he or she will likely be liable for the cost of amending the tax return and the penalties.  Obviously, there may be facts that would cause a court to rule differently.

The Estate of Michael Jackson is battling it out with the IRS in a dispute over the value of the late pop star’s estate.  To borrow the titles from two of Michael Jackson’s hit songs, the Service is alleging the estate is “Bad” in that it substantially understated the value of the decedent’s assets, while the estate is telling the Service that it is wrong and it should simply “Beat It.” 

What is the battle about?  The answer is simple:  Lots of money!  The Service asserts the understatement results in the estate owing taxes of over $500 million more than actually reported on the estate’s tax return, plus almost $200 million in penalties.  If the Service is correct, the State of California will likely have its hand out, asking the estate for a significant amount of additional taxes, plus penalties.

According to the petition filed by the estate in the United States Tax Court, representatives of the estate placed a date of death value on the decedent’s property at a little over $7 million.  The IRS, on the other hand, asserts the value was closer to $1.125 billion dollars.  If the Service is correct, the estate was undervalued by more than 160 times.

House Ways and Means Committee Chairman Dave Camp (R-Michigan) issued a discussion draft of the “Tax Reform Act of 2014” last week.  The proposed legislation spans almost 1,000 pages and contains some interesting provisions, including, without limitation, the following:

Individual Taxpayer Provisions

• • Consolidation and simplification of individual income tax brackets.  The current seven tax brackets would be consolidated into three brackets—namely, a 10% bracket, a 25% bracket and a 35% bracket.  High-income taxpayers would be subject to a phase-out of the tax benefit of the 10% bracket.  In addition, the special rate structure for net capital gains would be repealed.  In its place, non-corporate taxpayers could claim an above-the-line deduction of 40% of adjusted net capital gain.

• • Expand the standard deduction (to $22,000 for joint filers and $11,000 for individuals) and modification of available itemized deductions, including:

• • Repeal of the 2% floor on itemized deductions and the overall limitation on itemized deductions.

• • Reduce the itemized deduction for home mortgage interest to $500,000.

• • Repeal of the deduction for personal casualty losses.

• • Repeal of the deduction for unreimbursed medical expenses.

• • Repeal of the deduction for state and local taxes not paid in connection with business or investment.

• • Simplification of the rules surrounding charitable deductions.

• • Repeal of the exclusion for employee achievement awards.

• • Repeal of the deduction for moving expenses.

• • Reinstating the former provision allowing the cost of over-the-counter medications to be reimbursed through tax-favored health accounts.

• • Consolidation and simplification of tax benefits for higher education.  A single educational tax credit of up to $2,500 annually would be made available that could be used for up to 4 years; however, the current deductions for educational expenses and interest on student loans would be repealed.

• • Elimination of the income limitations on Roth IRAs and prohibiting new contributions to traditional IRAs and non-deductible traditional IRAs—effectively forcing all new IRA contributions to be Roth contributions.

• • Repeal of the exception to the 10% early withdrawal penalty for withdrawals from retirement plans and IRAs used to pay first-time home buyer expenses (capped at $10,000).

• • Elimination of the deduction by the payor for the payment of alimony and elimination of the inclusion in income by the recipient.

• • Repeal of the individual AMT.

• • IRC Section 1031 would be repealed.  Consequently, tax deferral from like-kind exchanges would no longer be permitted.

• • Simplification of rules surrounding in-service distributions, hardship withdrawals and required minimum distributions from retirement plans.

• • Encouraging Roth contributions in 401(k) plans by requiring all 401(k) plans to offer Roth accounts and requiring larger plans to treat all employee contributions as Roth contributions once an employee had contributed one-half of the annual contribution limit.

I Won the Gold Medal in Sochi. Awesome! Do I Owe Taxes on the Value of My Prize? 

As a general rule, in accordance with IRC § 61, the value of any prize or award a taxpayer receives is subject to taxation.  IRC §§ 74 and 117 provide limited exceptions to this general rule.

IRC § 74 specifically excludes from the income of the recipient certain employee achievement awards and certain prizes or awards transferred to charitable organizations prior to receipt.  IRC § 117 specifically excludes from the income of the recipient “qualified scholarship” proceeds.  These exceptions are subject to rigid qualifications. 

The value of prizes and awards which do not come within the parameters of these limited exceptions are subject to taxation.  Consequently, as we know, the winning ticketholder of the lottery is taxed on his or her winnings.  The recipient of the Nobel Prize is subject to taxation on the cash prize he or she receives.  Likewise, the value of the ring received by each of the members of the Seattle Seahawks this year for winning the Super Bowl is subject to taxation.  Also, the value of the rings received by each member of the Miami Heat for winning the NBA championship in 2012 and 2013 is subject to taxation.

On January 27, 2014, Judge Haines of the United States Tax Court issued a decision in Ydney Jay Hall v. Commissioner, TC Memo 2014-6.  This case illustrates that a taxpayer’s failure to retain adequate business records to substantiate income and expenses will lead to disastrous results. 

The taxpayer, Ydney Jay Hall, is a practicing attorney admitted to practice before the United States Tax Court.  His law practice income was reported on Schedule C of his Individual Income Tax Return.  Upon examination of Mr. Hall’s 2008 return, the Service asked to review his books and records relating to the law practice.  The Service, believing Mr. Hall did not fully respond to its request for information, summoned bank records.  With that information, it reconstructed his business income for the tax year.  The results of the audit reconstruction were not pretty. 

The IRS issued a deficiency notice to the taxpayer, asserting he had underreported his income by $76,681 for the tax year.  In addition, the Service disallowed deductions for travel and other expenses listed on Schedule C totaling $63,542 as the taxpayer did not maintain any books or records for his business activities and failed to provide proof he actually paid the expenses (e.g., receipts, invoices, cancelled checks or other evidence of payment).   To put salt on the wound, the Service assessed an accuracy related penalty against the taxpayer.

Mr. Hall filed a petition in the United States Tax Court challenging the notice of deficiency and the assessment of taxes and penalty.  He represented himself in the case.

On December 17, 2013, the United States District Court for the Northern District of Georgia issued its decision in United States v. Morris Legal Group, LLC, 113 AFTR 2d, 2014-XXXX (D.C. Georgia).  Gilbert Greenburg, a disbarred attorney, was employed as the office manager of Morris Legal Group, LLC, a law firm in Atlanta, Georgia.  He helped set up and manage the law firm’s personal injury practice.  Interestingly, Mr. Greenburg had no written agreement with the law firm relative to the amount of compensation he was entitled to receive.  Rather, he wrote himself payroll checks from time to time based upon the level of the firm’s profits.  His compensation generally ranged from $4,000 to $8,000 per month. 

Mr. Greenburg owed the IRS over $100,000 in unpaid income taxes, interest and penalties.  On May 26, 2011, the IRS sent the law firm a Notice of Levy and formally requested it surrender Mr. Greenburg’s wages until the levy was released.  Morris Legal Group, LLC appears to have ignored the levy and continued paying Mr. Greenburg compensation.

Is a full time gambler in the trade or business of gambling?  If the answer is yes, two results follow (one result which is good and one result which is not so good):  (1) the gambler is able to deduct under Section 162 of the Code all of the ordinary, necessary and reasonable expenses incurred in carrying on the business; and (2) the net income of the gambler, if any, is subject to self-employment tax under Section 1401 of the Code.

In 1987, the United States Supreme Court was presented with the issue of whether a full time gambler was engaged in the trade or business of gambling.  Commissioner v. Groetzinger, 480 US 23 (1987).  Justice Blackmun issued the court’s opinion.  The Supreme Court thoroughly reviewed the history of the phrase “trade or business” in the context of the Internal Revenue Code.  The court stated: “[T]o be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income profit.  A sporadic activity, a hobby, or an amusement diversion does not qualify.”   Whether a taxpayer is engaged in a trade or business is a question of facts and circumstances.

In Groetzinger, evidence revealed the taxpayer spent substantial amounts of time preparing for and actually gambling.  He had been gambling for a long period of time; the activity was not sporadic.  It was continuous.  Mr. Groetzinger had no other “profession or type of employment.”  He engaged in gambling with the intent to make a profit.  The court ultimately concluded, gambling may constitute a trade or business, and based upon the facts presented, Mr. Groetzinger was engaged in the trade or business of gambling.

Mr. Groetzinger won the battle in that his victory allowed him to deduct is ordinary, necessary and reasonable expenses associated with his gambling activities.  He lost the war in part because his net income (if any) would now be subjected to self employment taxes.  The result was likely unsuspected by the taxpayer.

Within a few hours after my January 17, 2014 blog post, as we suspected, President Barack Obama signed the Consolidated Appropriations Act, 2014 (“2014 Act”) into law.  Now, at least until September 30, 2014, our federal government may operate without interruption.

Each year, our government must pass bills that appropriate funds for all discretionary spending.  In most years, a bill is passed by each of the twelve subcommittees in the House Committee on Appropriations and each of the twelve subcommittees in the Senate Committee on Appropriations.

When Congress cannot pass separate bills, it rolls the bills into one omnibus bill like the 2014 Act.  This has become the norm rather than the exception over the past several years.  You may be asking yourself why would Congress roll the bills into one single act rather than pass several smaller bills which will be easier for our lawmakers to review and debate.  There may be many reasons, including:

• • Too much party disagreement to pass individual specific bills;

• • Too many issues pending before lawmakers to deal with several pieces of legislation;

• • Time constraints that may prevent dealing with appropriations in a piece meal fashion; and/or

• • The desire to bury in a single massive act some controversial spending provisions.