Larry's Tax Law

In this Part XII of my multi-part series on some of the not-so-obvious aspects of S corporations, I explore a consistent theme – taxpayers lose fights with taxing authorities when they fail to maintain adequate records.  Keeping adequate records is vitally important to S corporations and their shareholders or, for that matter, all taxpayers. 

Background 

Time and time again, taxpayers lose their battles with the IRS and other taxing authorities for the same reason – failure to maintain adequate records.  One of the greatest services that tax advisers can provide their clients is preaching the virtues of maintaining good records.

More than 25 years ago, effective January 1, 1997, Treasury issued what have been called the “Check-the-Box” regulations (the “Regulations”).¹  The Regulations ended decades of battles between taxpayers and the IRS over entity classification.  Further, the Regulations simplified entity classification and brought much needed certainty to most entity classification decisions.

Under the Regulations, a business entity with more than one owner is either classified for federal tax purposes as a corporation or a partnership.²  Likewise, a business entity with only one owner is either classified as a corporation or is disregarded for federal income tax purposes as being separate and apart from its owner.³ 

If a business entity is disregarded, its activities are generally treated for federal tax purposes as the activities of its owner.  There are five notable exceptions to that rule. 

As reported in my April 7, 2016, October 3, 2016 and October 27, 2016 blog posts, former U.S. Tax Court Judge Diane L. Kroupa and her then husband, Robert E. Fackler, were indicted on charges of tax fraud. Specifically, they were each charged with one count of conspiracy to defraud the United States, two counts of tax evasion, two counts of making and subscribing a false tax return, and one count of obstruction of an IRS audit. The indictment was the result of an investigation conducted by the Criminal Investigation Division of the Internal Revenue Service and the United States Postal Inspection Service.

As previously reported, former U.S. Tax Court judge Diane L. Kroupa and her now estranged husband, Robert E. Fackler, were indicted on charges of conspiracy to defraud the United States, tax evasion, making and subscribing a false tax return, and obstruction of an Internal Revenue Service audit. On September 23, 2016, Mr. Fackler pleaded guilty to attempting to evade more than $400,000 in federal taxes. He also signed a plea agreement wherein he sets out in some detail a long-term scheme, which he proclaims was masterminded by Ms. Kroupa to evade taxes.

Effective October 1, 2016, the Internal Revenue Service (“IRS”) changed its approach to conducting appeals conferences. The changes were likely adopted by the government under the guise of efficiency and cost savings. With that said, the changes probably will result in increased negative taxpayer perception of the IRS administrative process, and a significant reduction in prompt and fair resolution of matters at the conference level.

In a nutshell, the major change adopted by the IRS, subject to limited exceptions, is that the government will conduct all appeals conferences by telephone (or a virtual conference, if available). IRM § 8.6.1.4.1. An in-person conference generally will only be allowed if the appeals conferee (i.e., the “Appeals Technical Employee” or “ATE”) and the Appeals Team Manager (“ATM”) concur that it is appropriate and reasonable. As such, they must agree:

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.