Amended Returns Due to DOMA Case - What Needs to be Done

This blog is my blog so I make the rules and get to decide when I'm going to break them.  One of the rules is that I don't talk about what the tax laws should or should not be.  The motto is "It is what it is. Deal with it."  So I observe, find humor, matter for reflection or practical implications.  When an ordained trumpet player gets a $195,000 "parsonage exclusion" on his second home, I might break the rule and express an opinion.  DOMA has enough people expressing opinions, so I'm sticking with the practical implications.  If you would like some passionately informed opinion check out Gay and Lesbian Advocates and Defenders and the Massachusetts Family Institute.  GLAD was managing the plaintiff side of Gill v OPM.  MFI says it will be seeking to pick up the defense ball that the Administration has abandoned.  Both organizations agree that the case is important.  Other than that they appear to differ.

What I'm thinking about is what Robin and Terry should do. Robin and Terry are a couple of indeterminate gender and marital status who were invented to help me deal with awkward pronoun problems.  For now they are of the same gender, live in Massachusetts and were legally married in Massachusetts in 2007.  If I was writing a novel, this is the church, where they were married, but that level of detail is really not necessary.  The administration's decision doesn't really change my opinion on what needs to be done.  It just increases the urgency a bit, since it makes it somewhat more likely that part of DOMA will be definitively declared unconstitutional.

Robin and Terry have been filing their federal returns as single, because they are law abiding.  I'm going to assume that they have foregone all the clever ideas I described in my post on the tax advantages of not being married for federal income tax purposes.  So there is a chance that if they were allowed to file a joint federal return their aggregate tax liability would be lower.  So can they just wait for the DOMA drama to resolve itself and then file amended returns?  Not exactly.  Any refund claim they make has to be filed before the statute of limitations expires for that year.  Putting aside extensions that means that 2007 is looming.  I'm not going to get into a fine tuned discussion of Emancipation Day and Patriots Day.  The statute expires in the middle of April and the IRS has to receive the claim before the statute expires (No timely mailed, timely filed rule for amended returns). So get this taken care of soon.

How can you tell if Robin and Terry will save money by filing a joint return ?  There is really only one way.  You have to do the return.  Someone might tell you that the wider their discrepancy in income, the more likely they are to benefit from a joint filing and conversely if their incomes are close DOMA is probably saving them income tax.  Computing federal income tax, however, involves a host of thresholds, percentage computation and special limitations.  To take a simple example.  Robin and Terry each make $200,000 per year in salary.  Robin is a brilliant stock picker.  Terry is, well, an idiot when it comes to investing.  Robin has $300,000 in capital gains.  Terry has a $500,000 capital loss carryover that promises to last out the new millennium if Terry should live so long.  On the separate returns there is a positive $300,000 on one return and a negative $3,000 on the other.  On a joint return there is just the negative $3,000.

Another example.  Robin makes $250,000 and Terry makes $75,000.  Terry has $40,000 in medical expenses while Robin has none.  Terry's medical deduction is $34,375.  That would be reduced to $15,625 on a joint return because of the higher 7.5% threshold.

One more example.  Robin makes $75,000 per year and Terry makes $300,000.  Robin owns some rental properties that amazingly lose money.  Robin actively participates in running the properties and deducts $25,000 of the losses, the other $10,000 being suspended.  On a joint return with Terry they would all be suspended unless, of course, Terry owned a real estate brokerage business.  Then they could all be currently deducted.

Then there is the alternative minimum tax.  Don't even get me started.

This particular problem does not require the conceptual thinking of a tax attorney or an algorithm designed by a software engineer.  It requires a seasoned tax preparer, preferably one with good software.

I don't think it is at all likely that DOMA being declared unconstitutional will affect the returns of people who filed as single, whose tax would be higher if they had been considered married.  CCA 201021050 ruled that registered domestic partners in community property states should each report half of their own and their partners income.  The ruling made amending returns for open years optional.  Presumably it would be the same for a DOMA change.  The optional money saving amended returns will only be available for open years, though.  Only those who file claims before the statute expires on each year will be able to benefit from those years.

The other consideration in filing joint returns, which I mentioned in last week's post on this issue is joint and several liability.  If Robin thinks that Terry may have omitted significant income, then Robin should not join in an amended return regardless of the apparent savings. 

So that's it for the practical aspect, which I must say seems to be largely neglected in the rest of the blogosphere.  I do have two reflections on the issue.  The first is that I think it is fascinating that someone with a very conservative view of the Constitution should really likely the Gill decision.  It is a states rights case.  It has always been up to the states to say who is or is not married and DOMA is a violation of that principle.  I'm still searching for the honest person that doesn't have the same opinion on Gill v OPM and Perry vs. Schwarzenegger, because of their strong belief in either states rights or federal supremacy.  I think that the Constitution is generally used by activists as a drunk uses a lamppost, more for support than illumination. 

The other observation, which may seem slightly mawkish, though I assure it is quite sincere, is that I feel very blessed that I live in a country where GLAD and MFI are fighting this battle with briefs and news releases.  As I noted they both seem to agree that what the court has to say is very important.  I don't think we are always as grateful for that type of agreement, as we should be.

Post Script

The Santa Clara Law Same Sex Tax Law Blog has posted something on the practical points of filing for a refund based on the DOMA decisions.

DOMA Unconstitutional - Practical Tips

In a quick bonus post yesterday I noted that the Obama administration has decided to no longer defend the Defense of Marriage Act against constitutional challenges.  As it turns out that was a bit of an overstatement. I usually don't write on things that "everybody else" is writing about, but the tax issues surrounding same sex couples have been one of my themes.  Also I offer a somewhat different perspective.  My general attitude toward tax law is "It is what it is.  Deal with it."

So here are some practical observations.  If you are intensely interested in the nuts and bolts of same sex tax issues, I recommend you follow Santa Clara Law - Same Sex Tax.  That blog may be a little West Coast focused, but I recommend it regardless.  In Massachusetts the exciting decision in 2010, was Gill v OPM.  The case which had several plaintiffs was managed by Gay and Lesbian Advocates and Defenders.  Although GLAD's statement on the administration's decision is positive, it is less than celebratory, because the decision isn't quite as sweeping as some media reports make it out to be. There are two caveats.  The first is that the administration only said it will not defend DOMA in the Second Circuit where it would be subject to "strict scrutiny".  It is still possible that they may continue to defend in the First Circuit which covers Gill v OPM where the standard is "rational basis".  The holding in Gill was that the law did not have a "rational basis" (In other words, it doesn't even make good nonsense).  That question may be still up for grabs.  The other caveat is that the executive branch will continue to enforce DOMA until it is either repealed or declared definitively unconstitutional.  That means, I would think, that there will be no helpful guidance from the IRS.

The Mass Family Institute, which did not take a positive view of the administration's decision, did not focus on those nuances in its statement.  It did point out that either house of Congress could appoint counsel to defend DOMA and that the Institute, itself, will seek standing to defend it in Gill v OPM.  As noted by GLAD, though, the administration has not thrown in the towel on Gill, at least not yet.

The best overall coverage I have seen on the story has been from the Keen New Service.

So what should Robin and Terry do ?  (Robin and Terry are a couple of indeterminate gender and marital status who were invented to help me deal with awkward pronoun problems)  In today's manifestation they are of the same gender and married in Massachusetts in 2007.  In 2007, they each filed returns as single.  Robin is on Terry's health insurance and Terry's employer included the related costs as part of Terry's wages.  If Robin and Terry were my clients, I'd be looking at their 2007 returns right now and what they could do is wait for my call. I would rough out two pro-forma amended returns.  One would be a joint return of Robin and Terry.  The other would be Terry, married filing separately, with income reduced by the denied medical insurance exclusion.  The chance that the latter would produce a meaningful refund strikes me as improbable,  but it would be pretty easy to do.   I would tell them that they should extend their 2010 returns.  This won't be sorted out by September (Yes I know the extended due date is in October, but I don't like being a "Last Minute Louie", as my mother used to say), but we might know more by then.

If an amended 2007 return would produce a significant refund, they should consider filing it.  Let me emphasize - Consider filing it.  Despite the bad advice of a legion of divorce attorneys, the decision to file a joint return is not a simple numbers exercise.  Filing jointly, as I have pointed out, involves the acceptance of joint and several liability.  If Robin thinks that Terry may have omitted to report substantial income then Robin should not join in an amended return.

Assuming that an amended return is a good idea, the other practical tip is to not delay too long.  Here is why.  For returns that are required to be filed there is a "timely mailed, timely filed" rule.  The Service noted however in CCA 201052003 that an amended return is not a return that is "required" so the 2007 amended return needs to be received by the IRS before the statute expires for 2007.  Please don't get into an argument about how Emancipation Day and Patriots Day might play into that determination.  Get it to them sometime in March.

For later years, the thing to do is to wait and see.

POSTSCRIPT

The government followed up with a withdrawal in Gill v OPM, but the release on it from GLAD indicates some ambiguity in the statement.  This in no way affects my advice on getting amended returns in to preserve rights.

Time For Robin and Terry To Amend

This is a bonus post.  In October, I wrote a post on whether Massachusetts same sex couples who are married should consider filing amended returns.  It was follow-up to a slightly longer treatment I had done on Gill v OPM which had held that portions of the Defense of Marriage Act were unconstitutional.  DOMA has two major effects.  The first is that states that do not allow same sex marriage for their own residents do not have to recognize the validity of marriages performed in other states.  The second is that for all purposes of federal law marriage is defined as being between one man and one woman.  Gill was about the second piece of DOMA.  It was an action by several people who had been denied a variety of federal benefits by DOMA including the right to file an amended return.The effect of Gill was suspended pending appeal.

  Robin and Terry are a mythical couple of indeterminate gender and marital status who were invented to help me deal with awkward pronoun problems.

The news is that President Obama has ordered the Justice Department to stop defending DOMA.  Here is a link to the New York Times story.

In his letter, Mr. Holder said the administration legal team had decided that gay people merited the protection of the “heightened scrutiny” test, and that under that standard, the Defense of Marriage Act was impossible to keep defending as constitutional

See my more extensive follow-up on this.

Through The Hoops

A lot of our time was spent training in January as we geared up for another tax season.  I'm going to share with you one of the little talks I always give.  I know you all love to see lots of Code references and the like, but I'm going to gloss over them.

A lot of people think that the complexity in the in the tax law comes from special tax breaks and deductions and we can enter into an era of simplicity by having some sort of flat tax with a low rate and minimal deductions.  What that viewpoint fails to recognize is that the taxation of income, as opposed to gross receipts, is inherently complex.  It may be that if you looked at the Code you would be able to pare it down substantially by eliminating provisions that encourage affordable housing or historic renovation or the like.  All that would not touch the inherent complexity.

You could view the history of tax reform since the mid seventies as largely a war against tax shelters.  If you look at your Form 1040 you will see that "Taxable Income" is on Line 43.  The really interesting number, though, is on Line 22 "Total Income". The numbers that go into making up Line 22 (Line 7 through Line 21) have an interesting feature.  Some of them can be negative numbers.  If you are in a very lucrative profession you might have a very big positive number on Line 7 (Wages, salaries, tips, etc.).  If that number drops unharmed down to Line 22  the various deductions that will start whittling it down are for the most part subject to a host of limitation and pretty much require a direct dollar for dollar cash outlay for each dollar of deduction.  Speaking in very broad generalities to seriously carve away at the Line 7 number as it hurtles towards line 43, you need a big negative number before you hit Line 22 (total income).  The most likely place for that big negative number is Line 17 (Rental real estate, royalties, partnerships, S corporations, trusts, etc.)   Other possibilities are Line 12 (Business income or (loss)) and Line 18 (Farm income or (loss)).  Much of the complication in tax rules can be viewed as trying to prevent you from legitimately putting in those negative numbers.

Of course all the rules that have been put in place to stop those negative numbers are generally applicable and have to be dealt with by people who really aren't trying to get away with anything.  Also, the rules have been put into place over a period of time.  When a set of rules was put into place to stop abuse and abuse continued, it was not replaced by a new set of rules.  It was supplemented by additional rules.  To make sense of this both for the purpose of planning and also to do returns correctly I have used the metaphor of a series of hoops to jump through.  In order to get that negative number onto your return the hoops must be jumped through in order.  If you don't get through the second hoop, it doesn't matter what a good job you do on the third.  The only flaw in the analogy is that the hoops are not necessarily pass fail.  A step might limit your loss, without eliminating it.  When that happens there is that much less to jump through the next hoop with.

You could write a book about each of the hoops (As a matter of fact multiple books have been written about them).  I will only discuss each of them very briefly.  The point of my lesson on this is that despite some relationships among them, they operate independently and as I noted above in order.  So, here are the five hoops:

                                               1. For Profit
                                               2. Allocation
                                               3. Basis
                                               4. At-risk
                                               5. Passive Activity Loss Rules

1. For Profit - The activity generating a deductible loss has to be an activity that you enter into with the expectation or at least the hope of making a profit.  This is a pass/fail hoop.  The IRS seems to think that anybody who loses money in any business having anything to do with horses is just doing it for fun.  The Tax Court is sometimes persuaded otherwise.  Complex foreign currency swapping transactions that have a remote chance of producing a stupendous return are an example of something the IRS seems to be able to win on. 

2.Allocation - Assuming that there is a loss being generated in an entity of some sort in a business that is trying to make a profit, does a share of that loss really go to you ? If we are talking about Schedule C or Schedule F, the question would be whether the business is really your business.  S corporations allocate loss on a per share per day method unless the shareholders agree to an interim closing of the books.  That's pretty straight forward.  Then we come to partnerships, which we will see as we progress, is where the real action is.  Partnership allocations have to have or be deemed to have "substantial economic effect".  This is governed by the infamous 704(b) regulations.  Just to give you a feel for them, I was going to reproduce the table of contents.  I thought better of it.  Trust me. The regulations get incorporated either directly or by reference into most partnership agreements.  There is a huge understanding gap between the drafters - attorneys who never look at tax returns and return preparers - CPA's who don't always read the agreements. 

3.Basis - If all you ever do is put money into a business, have losses, have income and take money out basis is simply the net of all those (Money in and profits are plus, money out and losses are minus).  It you contribute property or obtain an interest by gift or inheritance it gets more complicated.  This is the area where partnerships shine.  The thing that many people do not understand is that basis can never go below zero.  Never.  If there is a loss in excess of your basis that loss is suspended.  If you withdraw funds in excess of your basis you recognize gain.  The thing about partnerships though is that your share of the partnership's liabilities is included in your basis.  So you can have losses greater than the amount of money that you put in.  When this is referred to as "negative basis" what is really meant is that your share of the liabilities is greater than your basis.  The correct term is "minimum gain".  Minimum gain is the amount of gain that you would have to recognize if you abandoned your partnership interest, because, in that event, your share of the liabilities would be a deemed distribution to you. The one good thing about the nasty allocation rules is that generally a partnership will not allocate a loss to somebody who doesn't have basis to absorb it.  That happens all the time with S corporations.

4.At-risk - This is frequently confused with basis but it is a different concept.  Probably the best way to think of it is basis lite.  If you incur a liability that gives you basis but you are somehow insulated from loss, as is the case of a non-recourse liability, you are not at-risk for that amount.  If you are dealing with real estate, however, most conventional financing that is non recourse will be considered "qualified non-recourse" and exempt from the at-risk rules.

5. Passive Activity Loss Rules - Hoops 2 through 4 are somewhat interrelated. The final hoop is another whole system. The Passive Activity Loss rules (Code Section 469) were part of the Tax Reform Act of 1986 (Note that that act was epic in its scope such that we now have The Internal Revenue Code of 1986.  Previously it was 1954. )  The PAL rules require us to put our trade our business activities into buckets.  (There are some wonderful regs about how big the buckets can be and what can go into each of them).  Then the buckets are classified as to whether we materially participate in them.  Rental activities are per se passive.  There is a lot to these rules and by my lights they really did kill tax shelters, at least as I knew them in my youth.  Sometimes people will say that you can offset passive income with passive losses.  This is a dangerous thought trap.  Gains and loss retain their character so that the sale of a passive activity at a capital gain will release previously suspended ordinary losses.

I have only very lightly touched on each of these areas.  The point of the post, though, is that you must remember that they are separate sets of rules that must be independently evaluated.

OK 2010 This is Really Goodbye

In  a previous post,  I explained the need for occasional purges of material that does not transform itself into a full length post.  Now I'll explain the Amazon ads.  All hope of them being a means of monetizing has vanished.  They are purely decorative.  The only thing my readers, who apparently now number in the scores (If you have trouble remembering what a score is here is a little trick.  Remember "Four score and seven years ago".  Now subtract the year of the Declaration of Independence from the year of the Battle of Gettysburg.  Then subtract seven.  Then divide by four.  Piece of cake.). do is come to the site.  I have a little gadget next to where I type the blog and I can search Amazon and then click to move the link and image into the blog.  I thought I would see what I got with Goodbye and up comes one of my favorite books.  It's very short and I read it from time to time to cheer myself up. 

As the title indicates this is the last of the 2010 material.  I would have gotten it in sooner, but it got pushed aside by two much more interesting recent developments.  One was about mercenaries and the other was about breasts.  So how was blog housekeeping going to compete? With no further fanfare here is the last of 2010:

Private Letter Ruling 201051024

This was a ruling on exempt status.  Exempt status ruling are a fairly rich source of tax humor, although it will be a while before somebody tops Free Fertility Foundation.  I'm not inclined to mock this particular effort, although it does provide a slighly heightened reading on my bs detector.

You were incorporated under the nonprofit laws of the state of M on x. According to your Articles of Incorporation your purpose is to advance the religious beliefs, cultural traditions and lifestyles of four N churches (the "churches") by providing loans and other assistance for real estate purchases and other farm and business related purchases to members of the churches; to encourage savings and thrift and continue to be committed to Christian principles of operation by providing investment and borrowing opportunities to enhance economic social and spiritual well being of the N Brotherhood; and to operate exclusively for charitable, religious or educational purposes.

Investors are limited to residents of M who are members of the churches. Eligible individuals meeting the minimum-investment requirement ($10,000), up to a maximum of 25 new investors annually (to comply with the requirements for exemption from the security laws of the state of M), will be accepted on a first-come, first-serve basis. 



You state that both your lending and borrowing activities will support your exempt purpose of advancing your religious beliefs, cultural traditions and lifestyles of the churches. You represent that central to your religious doctrine is a belief (i) in Biblical financial truths, including brotherly financial aid, responsibility for stability in family finances, the collective responsibility for all members of the church for each other's well being and personal stewardship and (ii) that deacons of your churches are called by God to oversee and, where applicable, alleviate the financial hardship of their church's members. You state that all of these principles lead to the rejection of laws that permit or facilitate the avoidance of responsibility, such as bankruptcy and insolvency laws.

Although you were initially funded by contributions from founding board members and received a church offering from each of the churches, you do not plan to engage in further fundraising activities. Your primary method of raising capital will be interest bearing loans from investors. Your sole source of income will be interest charged to borrowers. You plan to use the spread between the interest rates paid to investors and those charged to borrowers to pay all necessary future expenses.

The organization did not qualify for exempt status.

Articles 4(a) and (b) of your Articles of Incorporation states that you were formed to provide investment and borrowing opportunities. Providing investment and borrowing opportunities to members is not an exempt purpose described in section 501(c)(3).



Your primary purpose is to operate a trade or business, a lending institution which directly competes with commercial lending institutions. Your business practices are consistent with those of the industry in general. You will be funded by capital from investors. Your method of determining fees is similar to the method used by commercial lending institutions.

The minor mystery in this is what the organization expected to gain by its exempt status since it was planning on just breaking even and would not be getting charitable contributions.  It may be there was some state law benefit.  In my recent post on exempt organizations I note one that was trying to qualify so it could get a liquor license.  Presumably that was not the plan with this one.

I'm not much of a scriptural scholar, but I'd like to know where the stuff about bankruptcy comes from.  I think there is more in there about forgiving debts.

Humphrey E. Igberaese v. Commissioner, TC Memo 2010-284

This is really a run of the mill substantiation case. It concerns a host of deductions including charity.

Cash Charitable Contributions Igberaese asserts that he contributed $200 to his church in cash every week of the year, for a total of $10,400. He said that when he was in town, he would attend church and would personally donate the $200 to the church. He said that when he would be out of town, he would provide the cash to other church members in sealed envelopes to take to the church for him. He said he did not recall, even approximately, how often he provided the cash to other church members to donate for him. Nor did he remember the names of any of these members. He presented a printout of a computer spreadsheet consisting of the name of the church, the date of each contribution (each Sunday of the year), the amount of each contribution ($200), and the yearly total ($10,400). He testified that he made each entry around the time of that week's contribution.

Putting aside the formal substantiation requirements for charitable contributions, I'd advise people like Mr.Igberaeseke to work on their stories a little better.  I don't have personal acquaintance with tax court judges, but I believe I've learned a bit about them from reading their opinions for the last thirty years.  Among the things that I have surmised is that they are not idiots and that they live in the same world that I do.  Some of them probably go to church and will therefore know that people who drop cash in the collection plate mostly still think that George Washington is our holiest president.  If the ushers know who's face is on a C note, it is not from experience gained counting the collection

We do not find the evidence Igberaese introduced to be credible. As we discuss in connection with each deduction, Igberaese presented little beyond his own unpersuasive testimony and self-created documentation to corroborate his series of implausible deductions. Several of his explanations for the absence of further corroboration were also implausible.

We are similarly skeptical of Igberaese's documentary evidence, which shows little more than that he has written down his implausible assertions

Trout Ranch, LLC, et al. v. Commissioner, TC Memo 2010-283

This was a dueling expert case.  The Trout Ranch had donated a conservation easement.  The partnerships expert indicated that it was worth 2.1 million.  He based the valuation on other easements sold in the area. The Tax Court was not greatly impressed :

 In essence, in all three cases the conservation easements all but eliminated residential development. In stark contrast, the Trout Ranch CE restricted development from at least 40 residential lots to 22 lots (a reduction in potential development of 45 percent). We are simply not convinced that the value of a conservation easement that restricts development to at most one residential lot sheds any light on the value of a conservation easement that allows as many as 22 residential lots.

The Service had originally wanted to allow $485,000, but when it came to trial they decided to reduce that to 0.  I mean, what the heck, why not say the property was worth more with the easement and have them pick up income ?  The switch led to some fancy burden of proof discussion, which the Court indicated didn't matter because they were able to determine the true value.

The Tax Court came in at $560,000.  We know that is the right answer, because its what the Tax Court said.  The case is worth reading if you are interested in valuation issues.  It's not great for my purposes as I couldn't find any good quotes.

Richard A. Frimml, et ux. v. Commissioner, TC Summary Opinion 2010-176


My tentative title for this was "Paint Your Horses".  It is a hobby loss (Section 183) case.  The IRS seems to be firmly convinced that people take care of animals much larger than themselves that appear to defecate copiously for fun.  Go figure.  The couple was raising American Paint Horses.  The Tax Court ruled that they were in fact trying to make money.

Petitioners' knowledge at trial was extensive as it related to breeding and artificially inseminating Paint horses. Their knowledge included the genetics, the mechanics and the financial aspects of breeding.  Even the horses aren't having any fun.

The worst thing about people who win hobby loss cases around horse breeding is that the Tax Court gives them extra points for heartlessness.

Petitioners made many business decisions regarding the purchase, care and sale of a number of Paint horses for their horse activity. Petitioners paid extensive amounts to care for Special when he was injured. On the other hand, petitioners decided to put down a 2-year-old foal that hurt her leg in a fence accident because the cost to heal her exceeded the projected price in selling her.

In case you are wondering what was so special about "Special".

They have identified semen production by Special as a potential future source of revenue.

This case is similar to that of Johnny L. Dennis TCM 2010-216 which I gave a brief mention.  Besides doing a cost benefit analysis on the vet bills, the other thing that they have in common was not riding the horses themselves.

U.S. v. RUTH, JR., Cite as 106 AFTR 2d 2010-7443

The decision itself is about criminal procedural issues which are not of great interest to me.  If you have an interest in such things check out Jack Townsend's blog.  I read cases like this because the story behind the story is often interesting.

The conduct at issue began while Ruth and Pilkey were incarcerated at the Federal Correctional Institution in Fort Dix, New Jersey. The defendants submitted tax returns to the IRS claiming refunds in the names of fellow inmates for wages never earned and giving addresses where the inmates never lived. These inmates fell into three groups: (1) those who were aware of the fraud, (2) those who were not aware of the fraud and had instead provided their personal information in order to receive legal assistance from Ruth and Pilkey, and (3) those who testified they did not know the defendants. Ruth and Pilkey were able to avoid having to submit W-2 forms by misrepresenting that fellow prisoners were working at companies that had gone bankrupt. As part of the scheme, defendants obtained employer identification numbers for these bankrupt companies. To avoid detection by prison authorities, defendants enclosed envelopes addressed to the IRS within large envelopes sent to collaborators outside of prison. Defendants had the tax returns sent to mail-forwarding services who would then deliver the returns to their collaborators.

I became interested in accounting in part from reading stories about epic frauds.  I doubt anybody will ever top Alfredo Reis.  Read the book about him if you don't believe me.  He convinced the British bank note printing company that printed the money issued by the Bank of Portugal that he worked for the bank and got them to print money for him.  He used the money to buy stock in the Bank of Portugal which was the only entity that could prosecute counterfeiting.  These fellow aren't in the same league, but given the adverse conditions they were working under (being in prison and all), they really achieved a lot.  Of course you might expect that the IRS computers would catch them eventually.  That's not exactly the way it turned out.

Defendants' scheme resulted in the IRS issuing refunds of tens of thousands of dollars. Eventually the IRS became suspicious of returns filed by persons in federal custody using the same type of form and listing the same employers and addresses. In May 2004, an inmate came forward who informed prison officials about the fraudulent tax scheme. Based on this information, prison officials searched the lockers of several inmates, including Ruth and Pilkey, and recovered records and material used to file the fraudulent tax returns.

So that is it for 2010.  Goodbye 2010.

Even More About Short Sales

I received a very gratifying email yesterday :

We are happily settled in our new home. Thank you for all your help.

The lady who sent it had been trying to purchase a home on a short sale where the seller was receiving a relocation grant.  The seller had an outstanding IRS lien.  The collection agent responsible for releasing the lien finally gave in after she sent him a copy of CCA 201102058 which she had learned about from my blog post.  What is really intriguing is this particular development seems not to have attracted any notice to speak of.  Check out this search.  It seems like, except for one broken link, I'm the only one who has written on this.

My friend, Stephen McWilliam, a Florida realtor has suggested to me that this may be because the HAFA relocation money is not really flowing yet, making the problem more of a theoretical one. Stephen is a really smart guy.  I have a pretty good aptitude for what I do and I have experience and focus.  It's always a little humbling to realize that other people I meet in business and am able to help would probably be better at what I do than I am.  Fortunately they chose other fields.  I think in economics this is referred to as "comparative advantage".  At any rate, Stephen mentioned something about the tax aspects of short sales that had never occurred to me.  Presumably when you are behind on your mortgage you owe both interest and principal.  When the short sale goes through for some transitory moment the money is yours even though your don't get to touch it.  If the bank applies the proceeds to interest, you should potentially be able to deduct that interest and should be looking for a Form 1098.  I usually try to tie my posts to specific pronouncements, but I haven't been able to find anything that addresses this head on.

This is separate from the issue of getting a Form 1099-C which may require you to recognize income on a short sale. 

Staying Out of the Dog House

CCA 201104037

This was a ruling about whether someone qualified as a "first time" home buyer.  The "first time" is really a misnomer because your home buying virginity is restored if you haven't owned a principal residence for three years.  I'm reproducing this one almost in full:

From: —————————— Sent: Tuesday, October 19, 2010 11:48:41 AM To: ——————————- Cc:


Here are the facts as we understand them. The taxpayer's residence was destroyed by a fire on ——————. On that date, the (destroyed) home ceased to be the taxpayer's principal residence.


In the latter part of 2008, the taxpayer began construction of a new home on the same property on which the destroyed home used to be located. The taxpayer occupied this new home on ——————.


During the period of ——————-through ——————, the taxpayer lived with his girlfriend, and sometimes at the homes of relatives and other friends. When the taxpayer began construction of the new residence in late 2008, he also lived in a storage shed / dwelling unit on the property where he was constructing his new home. The storage shed had a stove, refrigerator, bathroom, sleeping apparatus, and heat.

The taxpayer spent about 40% of his time in the storage shed / dwelling unit, and most of the rest of the 60% of his time living with his girlfriend.


Based on those facts, the storage shed / dwelling unit is a residence for purposes of section 121. Under Reg. section 1.121-1(e)(2), the term dwelling unit has the same meaning in section 280A(f)(1). Under Reg. section 1.280A-1, a dwelling unit includes a house, apartment, condominium, mobile home, boat, or similar property, which provides basic living accommodations such as sleeping space, toilet, and cooking facilities.

Although the storage shed / dwelling unit is a residence, it is not the taxpayer's principal residence because he did not spend the majority of his time there. Reg. section 1.121- 1(b) provides, in part, that if a taxpayer alternates between two properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer's principal residence.


Therefore, the taxpayer meets the definition of a first-time homebuyer because he has not owned a principal residence within the three years prior to the date of purchase of the new home (here, the occupancy date). In this case, the taxpayer may only include the cost of construction of the new home in calculating the credit.

They always leave out the details that interest me.  What were the key factors in whether the taxpayer was sleeping with his girl friend or in the shed?  Conceivably it was tied in with his work schedule in fixing up the house.  Of course the other possibility was that it was an index of the relationship quality.  So there it is.  A forgotten birthday, a few less flowers, some unkind remarks about her friends and the toilet seat left up a couple of times and we would have had a totally different tax result.

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Donee Gets Income Tax Deductions for Medical Expenses and Taxes

Judith F. Lang v. Commissioner, TC Memo 2010-286

From time to time I encounter confused people.  They might for example think that they can give $13,000 to each of their kids and deduct it.  That's not the way it works.  The $13,000 is the amount that you can give to as many individuals as you want to - including me by the way (I'll tell you where to mail the check) - without having a taxable gift (Under the new regime, you can have $5,000,000 in taxable gifts before you have to start paying gift tax).  Gift tax is the responsibility of the person making the gift.  Income tax is the responsibility of the person receiving taxable income, which does not include gifts.  So what happens if your aunt gives you $10,000,000 of low basis stock, but wants you to pay the gift tax for her ?  You and your aunt can give me a call and I'll work with you on it.  This post is about something that happens with the merely wealthy.

The annual exclusion is not the only exclusion from gift tax.  There is also an exclusion for gifts made for medical or educational purposes.  In order to qualify for the exclusion the donor must pay the bills directly.  So if you pay the medical bills of your adult children those payments are excluded for gift tax purposes (i.e. You can give the ne'er do wells who can't pay their own medical bills $13,000 in cash on top of that without eating into your $5,000,000.  They'll still probably resent you, but you'll need to find another blog to deal with those issues.)

Medical expenses are also deductible for income tax purposes, though.  What is supposed to happen for income tax purposes when your medical bills are paid by someone else ? Judith Lang had some heavy medical expenses and was behind on her real estate taxes.  Fortunately, she had a generous Mom :

Petitioner's mother, Frances Field (Mrs. Field), paid $24,559 directly to medical providers on account of petitioner's medical expenses and paid $5,508 directly to the city government on account of petitioner's real estate tax. Petitioner was not a minor, and Mrs. Field was not legally obligated to pay petitioner's expenses.


Ms. Lang thought that she should be able to deduct these payments for income tax purposes:

It is petitioner's position that although Mrs. Field made the payments directly to petitioner's creditors, we should consider them to have in substance passed from Mrs. Field to petitioner and then to petitioner's creditors; therefore petitioner should be entitled to deduct the payments.

The IRS did not agree:

Respondent contends that the form of the transaction should apply and that because the money was paid directly from Mrs. Field to petitioner's creditors, petitioner may not claim the deductions.

The Tax Court noted that the IRS did not claim that Ms. Fields had deducted the medical expenses only that Ms. Lang was precluded from deducting them because she had not paid them.

The Tax Court ruled in favor of the taxpayer with respect to both the medical expenses and the real estate taxes.  With respect to the medical expenses they noted:

Although Mrs. Field and petitioner would not be subject to the gift tax,  the income tax treatment in this context is not controlled by the gift tax consequence.

Petitioner should be credited with having made the payments for purposes of the income tax deduction in question.



With respect to the real estate taxes the issue was even clearer:

Mrs. Field paid $5,508 directly to the city government in discharge of petitioner's obligation for real estate tax. Again applying substance over form, we treat petitioner as having received from her mother a gift of the $5,508 with which petitioner paid the city in satisfaction of her own real estate tax. Thus petitioner is entitled to a deduction under section 164 for that amount.


We note that there is no danger of a “double deduction” arising from our decision on this issue. See Rome I, Ltd. v. Commissioner, 96 T.C. 697, 704 (1991) (”Double deductions are impermissible *** absent a clear declaration of intent of Congress.”). Because the real estate tax was imposed upon petitioner, she is the only taxpayer who may deduct it; Mrs. Field may not. See sec. 1.164-1(a), Income Tax Regs.

This is a significant decision for some wealthy families where transfer tax concerns outweigh income tax concerns.  It would be a good idea to review the individual returns of family members who have benefited from gift tax excludable medical gifts.

If You Were Wondering _____ Don't Even Bother to Ask

Rev. Proc. 2011-7, 2011-1 IRB 233
Rev. Proc. 2011-3, 2011-1 IRB 111

If you are thinking about doing a transaction, but don't want to proceed before you are certain of its tax effects, you can apply to the IRS for a private letter ruling.  This has the collateral benefit of providing me material for my blog.  Even though private letter rulings apply only to the taxpayer who receive them and the IRS would just as soon they stayed, well, private, the Freedom of Information Act means they get published by Research Institute of America.  And that means that the one in a hundred of them that is really kind of interesting gets written about here.

You can't just ask the IRS anything, though.  And one of the things they do to start the year is to tell you all the questions they don't want to answer.  They do it in two revenue procedures one about foreign transactions and the other about domestic matters. Some things they won't rule on because they are "highly factual".  The rest of the things they say they won't rule on I kind of treat this like the list of things they ask you about before you can buy life insurance or give blood.  I pretty much haven't done them and now I know to cross them off my bucket list.  At any rate, here are a few of the things that you just shouldn't bother to ask.

Section 61.—Gross Income Defined.— Whether amounts voluntarily deferred by a taxpayer under a deferred—compensation plan maintained by an organization described in § 501 (other than a plan maintained by an eligible employer pursuant to the provisions of § 457) are currently includible in the taxpayer's gross income.



Section 61.—Gross Income Defined.— Whether a split-dollar life insurance arrangement is “materially modified” within the meaning of § 1.61-22(j)(2) of the Income Tax Regulations.

Split-dollar is one of those great ideas whose time has passed.

Section 83.—Property Transferred in Connection with Performance of Services.— Whether a restriction constitutes a substantial risk of forfeiture, if the employee is a controlling shareholder. Also, whether a transfer has occurred, if the amount paid for the property involves a nonrecourse obligation.


Section 107.—Rental Value of Parsonages.—Whether an individual is a “minister of the gospel” for Federal tax purposes. (Also , §§ 1402(a)(8), (c)(4) and (e), 3121(b)(8)(A), and 3401(a)(9)).

As I note in my most comprehensive post on the parsonage exclusion, I resent the IRS reticence in this area.  Rulings on who is or is not a "minister of the gospel" have as much potential for bizarre humour as those on exempt status such as the lady who was conveying the teachings of the Pleiadians or the fellow who started a foundation to distribute his own sperm.


 Section 121.—Exclusion of Gain from Sale of Principal Residence.— Whether property qualifies as the taxpayer's principal residence


This is an example of a "highly factual" question.


 Section 7701(b).—Definition of Resident Alien and Nonresident Alien.—Whether an alien individual is a nonresident of the United States, including whether the individual has met the requirements of the substantial presence test or exceptions to the substantial presence test. However, the Service may rule regarding the legal interpretation of a particular provision of § 7701(b) or the regulations thereunder.

This is probably an example of something that is highly factual.

 Whether a proposed transaction would subject a taxpayer to criminal penalties.

This is one of those situations where if you ask the question you probably already know the answer.



Section 893.—Compensation of Employees of Foreign Governments and International Organizations.—Whether wages, fees, or salary of an employee of a foreign government or of an international organization received as compensation for official services to such government or international organization is excluded from gross income and exempt from taxation and any underlying issue related to that determination.



Functional Currency.—Whether a currency is the functional currency of a qualified business unit.


I find this refusal regrettable.  In my very first post I speculated that the Linden dollar, the currency in Second Life, meets the definition of "functional currency" (Hard to believe that this blog started out even more frivolous than it is now). 

Any frivolous issue, as that term is defined in § 6.10 of Rev. Proc. 2011-1.

Those guys just don't have that much of a sense of humor.  You would think they would enjoy some frivolity.

Whether a taxpayer has a business purpose for a transaction or arrangement.

It's up to the courts to ultimately decide whether you were doing business or up to monkey business.

Situations where a taxpayer or a related party is domiciled or organized in a foreign jurisdiction with which the United States does not have an effective mechanism for obtaining tax information with respect to civil tax examinations and criminal tax investigations, which would preclude the Service from obtaining information located in such jurisdiction that is relevant to the analysis or examination of the tax issues involved in the ruling request.

If the promoter starts telling you how talkative bank employees are drawn and quartered, you probably don't want to do the deal anyway.

Section 163.—Interest.—The income tax consequences of transactions involving “shared appreciation mortgage” (SAM) loans in which a taxpayer, borrowing money to purchase real property, pays a fixed rate of interest on the mortgage loan below the prevailing market rate and will also pay the lender a percentage of the appreciation in value of the real property upon termination of the mortgage.

Just thinking about that one gives me a headache.

Section 170.—Charitable, Etc., Contributions and Gifts.—Whether a taxpayer who advances funds to a charitable organization and receives therefor a promissory note may deduct as contributions, in one taxable year or in each of several years, amounts forgiven by the taxpayer in each of several years by endorsement on the note.

This is an example where cutting some extra checks might help.

Section 213.—Medical, Dental, Etc., Expenses.—Whether a capital expenditure for an item that is ordinarily used for personal, living, or family purposes, such as a swimming pool, has as its primary purpose the medical care of the taxpayer or the taxpayer's spouse or dependent, or is related directly to such medical care.


My doctor made me do it.

Section 312.—Effect on Earnings and Profits.—The determination of the amount of earnings and profits of a corporation.

It would be nice if someone who wants to purge their earnings and profits could have certainty as to what they are, but you can't get a ruling.  I once did an earnings and profits analysis on a company that had been founded in 1919.  It was quite a project.  And no I'm not that old that I was doing it in 1925 or something.

Section 704(b)(2).—Partner's Distributive Share.—Whether the allocation to a partner under the partnership agreement of income, gain, loss, deduction, or credit (or an item thereof) has substantial economic effect.


Don't ask them.  They have already given you pages and pages of impenetrable regulations that attorneys transform into partnership agreements nobody can understand.

The results of transactions that lack a bona fide business purpose or have as their principal purpose the reduction of Federal taxes

You wouldn't want to do anything like that anyway.  Right ?

This is a small sample of the areas where they won't issue rulings.  There is a follow on list of areas where they will not ordinarily issue rulings.  I don't know if it would be shorter for them to make a list of things where they will issue rulings, but it seems almost possible.










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From Mercenaries to Mothers Milk

Announcement 2011-14

As yesterdays post compared with todays shows tax issues cover the gamut of human phenomena.  I don't make this stuff up though.  There is obviously selection on my part, but I work with the material that is thrown at me.

Normally I don't post on things that I pick up from other blogs.  I review original source material for items of interest either because of practical importance, humour or opportunity for reflection.  This particular item hit the news more quickly because a bunch of legislators are patting themselves on the back for persuading the IRS into reversing its position. To give credit where it is due, I first noticed this in Accounting and Tax Tips.  Although he didn't give a citation.  I found that in Accounting Today along with a link to the full text.  This is one of those very rare occasions where something gets into the blogosphere before it gets into Checkpoint.

The announcement which I reproduce below indicates that breast pumps and related supplies are deductible as medical expenses. Possibly of more practical significance it also makes them reimbursable under flexible spending arrangements.

The Internal Revenue Service has concluded that breast pumps and supplies that assist lactation are medical care under § 213(d) of the Internal Revenue Code because, like obstetric care, they are for the purpose of affecting a structure or function of the body of the lactating woman. Therefore, if the remaining requirements of § 213(a) are met (for example, the taxpayer’s total medical expenses exceed 7.5 percent of adjusted gross income), expenses paid for breast pumps and supplies that assist lactation are deductible medical expenses. Amounts reimbursed for these expenses under flexible spending arrangements, Archer medical savings accounts, health reimbursement arrangements, or health savings accounts are not income to the taxpayer.
The Service will revise Publication 502, Medical and Dental Expenses, to include this
information.


In INFO 2010-0173, the IRS had reached the opposite conclusion :

I am responding your letter of March 30, 2009, to Commissioner Douglas H. Schulman about the treatment of costs associated with breast pumps and related equipment. You recommend that the Service allow the costs of breast pumps and related equipment to be reimbursable under a tax favored health care flexible spending account (FSA).

In general, funds from an FSA are to be used for medical care. The Internal Revenue Code defines medical care to include the diagnosis, cure, mitigation, treatment or prevention of disease. Medical care includes medicine and drugs, but does not include goods or services that are merely beneficial to general health and do not mitigate or treat a disease. Under current law, therefore, the cost of purchasing or renting a breast pump and related equipment would not come within the definition of a medical care expense for FSA purposes, even though the mother's usage of the breast pump may have the health benefits mentioned in your letter.

It is not within the authority of the Internal Revenue Service to classify breastfeeding equipment as medical care in contravention of current law. A change to the Internal Revenue Code must be made by Congress.

Since "everybody else" is writing about this, I would normally pass it by except that one of my earliest blog posts was on a lactation issue that I thought the IRS had gotten wrong.  It had a very clever title, so you should click the link just to find out.  The IRS had disallowed a deduction for infant formula by a woman who had had a double mastectomy.  So the tax geek response to the stories about this announcement is "Well does that mean the Service will revisit its holding in PLR 200941003 ?"

IRS Memo Muddies the Water for Blackwater Employee

Nathaniel J. Holmes v. Commissioner, TC Memo 2011-26

I have probably over used Dr. Johnson's observation that "Every man thinks meanly of himself for not having been a soldier or been to sea.", but I quote it again to account for my odd fascination with the combat pay exclusion.  From a logical tax policy viewpoint, it doesn't make a lot of sense.  Presumably you could figure out the tax effect it has, gross that number up and increase the bonus pay for being in a combat zone thereby simplifying the Code with no significant net effect on either the deficit or military compensation.  Somehow that seems emotionally unsatisfying, though.

You would think, however, that this is not something that could give rise to tax litigation since the people issuing your W-2 should know whether you qualify for the exclusion or not.  No such luck.  There is a regulation, for example, that if you are not assigned to a combat zone, but you go there for your own amusement while on leave from a non-combat zone you are not entitled to the exclusion.  Maybe they needed that rule because the night life in Saigon was so exciting.  Then we have cases like that of Charles Gasche.  He was a pilot for Braniff airlines transporting US military personnel to Vietnam.  He was issued a special card :

The purpose of this identification card was to accord plaintiff the privileges of the rank of major in the United States Air Force under "all applicable treaties, agreements and the established practice of nations" in the event of his capture by hostile forces in Vietnam.


That was just what you needed when you were checking into the Hanoi Hilton in 1968.

At any rate First Officer Gasche never needed the card that said he should be treated like a major and he was getting paid by Braniff, so he was not entitled to the combat pay exclusion.  There are quite a few similar examples.

The case of Nathan J. Holmes might be distinguishable from the airline pilots delivering the troops to Saigon in that he appears to have been performing actual combat duties.  Nonetheless he was not being paid directly by the Department of Defense and was not a member of the armed services.  He worked for a company called Blackwater.  Perhaps you have heard of them.

 Mr. Holmes did not get the exclusion.  A blogger who writes on military contractor issues groused a little about it in his post on the case noting that there is talk of subjecting contractors to the Uniform Code of Military Justice, but no prospect of them getting the favorable tax treatment granted to member of the military.  For a little perspective on that, Mr. Holmes was trying to exclude $98,400 for 2005.  In 2005 the maximum pay for an enlisted member of the military was $6,300 per month, which sets the limit for what officers are entitled to exclude (Along with the couple of hundred bucks a month they get for being in a combat zone).Enlisted personnel in a combat zone exclude their entire income, such as it is.  So Mr. Holmes was trying to exclude more than anybody in the official armed services was entitled to exclude.

The interesting part of the case is actually how it was that Mr. Holmes was not assessed a penalty.  He was relying on a copy of a memo.

While in Iraq, petitioner was given a memorandum issued by Robert L. Hunt, the Acting Deputy Director, Compliance Field Operations, Internal Revenue Service (IRS). This memorandum discussed the appropriate steps for civilian personnel to take when engaged in an IRS examination and collection activity involving a taxpayer deployed to a Qualified Combat Zone. Petitioner did not remember who gave the memorandum to him.



This memorandum was an internal memorandum written to give the Commissioner's employees field guidance for examination and collection activity involving taxpayers in Iraq. The memorandum, titled “Memorandum for Acting Deputy Director, Compliance Field Operations”, was issued by the Internal Revenue Service Small Business/Self- Employment Division on June 28, 2004. The memorandum states that civilian or military personnel who are in direct support of a combat zone military initiative and physically located in the combat area are entitled to the exclusion. It also states that time spent in a combat zone by an individual serving in support of the Armed Forces will be disregarded with respect to “certain acts required under the Internal Revenue Code.” It goes on to state that “This change in procedure will be reflected in the next revision of the IRM, which is in the process of being written
Petitioner satisfies all the criteria found in the memorandum. He was serving in Iraq alongside the military, provided security to Government officials, and aided in giving air support, medical aid, and emergency response assistance. Petitioner had no background in tax law and was given this memorandum written by an IRS employee while serving in Iraq. We believe that receiving this memorandum while serving in Iraq could give someone reasonable cause to believe that his payments from Blackwater were excluded from gross income. Therefore, petitioner is not liable for the addition to tax under section 6651(a)(1).


Respondent also determined a section 6651(a)(2) addition to tax. Section 6651(a)(2) imposes an addition to tax for failure to pay the amount shown as tax on a return on or before the due date prescribed unless the taxpayer can establish such failure was due to reasonable cause and not willful neglect. The amount of the addition is equal to 0.5 percent of the amount shown as tax on the tax return but not paid, with an additional 0.5 percent each month or fraction thereof during which the failure to pay continues (up to a maximum of 25 percent). See Cabirac v. Commissioner, 120 T.C. 163, 170 n.12 (2003). For the reasons stated above, we find that petitioner had reasonable cause and is not liable for the section 6651(a)(2) addition to tax.


I have been assiduously hunting for this magical memo.  Feral Jundi, the blogger I previously mentioned, posted this.  It appears to be the first page of the memo. I don't know whether that is the entire memo or not.   In 2007 a firm called Palazzo posted a warning about the memo indicating that it was being misinterpreted.

Everyone I know working overseas in a combat zone probably has seen this memo. Let me tell you once and for all this memo does not apply to civilian contractors working in combat zones. This memo was released for a very small group of Coalition Provisional Authority Personnel and the only thing it did was allow them additional time to file their tax returns. It did not provide a full Combat Zone tax exclusion. There is no such thing. It did not waive their 330 day overseas requirement. This still must be met every twelve months. The only exclusion of income must be earned by meeting the presence test or in some instances the bona fide residence test.

Apparently civilian contractors rather than writing "Kilroy was here" on all available blank walls spent their time photocopying an internal IRS memo that "proved" that their income was excludable.  Perhaps Mr. Holmes couldn't remember who gave him the memo, because he got it from more than one person.  Oddly enough, the tax court found his reliance on the memo reasonable.  It will be interesting to see if there will be a string of these cases in the next few months.

How to Keep Out of The Penalty Box - RTFI

Rev. Proc. 2011-13, 2011-3 IRB, 12/28/2010

Early in each year the IRS will issue two Revenue Procedures.  One I call "Don't Even Bother to Ask", which outlines the areas in which they will not rule.  That one may be out by now, but I haven't looked for it.  The other which I discuss in this post, I call "How to Stay Out of The Penalty Box". 

The way to avoid penalties is to have adequate disclosure.  This ruling tells you what constitutes adequate disclosure in a variety of areas.  The most common theme in the Rev Proc is probably RTFI (READ THE INSTRUCTIONS).  Of course since everybody except Robert Flach uses software (and he's not taking any new 1040 clients), there isn't quite as much instruction reading going on as there might have been in the past.  Of course, even back in the manual days there was a lot of reliance on good old SALY (Same as Last Year).  Here are some of the highlights of Rev. Proc. 2011-13, which is really a must read for serious preparers.

.05. In general, this revenue procedure provides guidance for determining when disclosure by return is adequate for purposes of section 6662(d)(2)(B)(ii) and section 6694(a)(2)(B). For purposes of this revenue procedure, the taxpayer must furnish all required information in accordance with the applicable forms and instructions, and the money amounts entered on these forms must be verifiable.

(2) The money amounts entered on the forms must be verifiable, and the information on the return must be disclosed in the manner described below. For purposes of this revenue procedure, a number is verifiable if, on audit, the taxpayer can prove the origin of the amount (even if that number is not ultimately accepted by the Internal Revenue Service) and the taxpayer can show good faith in entering that number on the applicable form.

(4) When the amount of an item is shown on a line that does not have a preprinted description identifying that item (such as on an unnamed line under an “ Other Expense” category) the taxpayer must clearly identify the item by including the description on that line. For example, to disclose a bad debt for a sole proprietorship, the words “ bad debt” must be written or typed on the line of Schedule C that shows the amount of the bad debt. Also, for Schedule M-3 (Form 1120), Part II, line 25, Other income (loss) items with differences, or Part III, line 35, Other expense/deduction items with differences, the entry must provide descriptive language; for example, “Cost of non-compete agreement deductible not capitalizable.” If space limitations on a form do not allow for an adequate description, the description must be continued on an attachment.

(1) Form 1040, Schedule A, Itemized Deductions:


(a) Medical and Dental Expenses: Complete lines 1 through 4, supplying all required information.


(b) Taxes: Complete lines 5 through 9, supplying all required information. Line 8 must list each type of tax and the amount paid.

(2) Certain Trade or Business Expenses (including, for purposes of this section, the following six expenses as they relate to the rental of property):


(a) Casualty and Theft Losses: The procedure outlined in section 4.02(1)(e) must be followed.


(b) Legal Expenses: The amount claimed must be stated. This section does not apply, however, to amounts properly characterized as capital expenditures, personal expenses, or non-deductible lobbying or political expenditures, including amounts that are required to be (or that are) amortized over a period of years.


(c) Specific Bad Debt Charge-off: The amount written off must be stated.


(d) Reasonableness of Officers' Compensation: Form 1120, Schedule E, Compensation of Officers , must be completed when required by its instructions. The time devoted to business must be expressed as a percentage as opposed to “part” or “as needed.” This section does not apply to “golden parachute” payments, as defined under section 280G. This section will not apply to the extent that remuneration paid or incurred exceeds the employee-remuneration deduction limitations under section 162(m), if applicable.


(e) Repair Expenses: The amount claimed must be stated. This section does not apply, however, to any repair expenses properly characterized as capital expenditures or personal expenses.

(f) Taxes (other than foreign taxes): The amount claimed must be stated.

(3) Differences in book and income tax reporting.


Note: An item reported on a line with a pre-printed description, shown on an attached schedule or “ itemized” on Schedule M-1, may represent the aggregate amount of several transactions producing that item (i.e., a group of similar items, such as amounts paid or incurred for supplies by a taxpayer engaged in business). In some instances, a potentially controversial item may involve a portion of the aggregate amount disclosed on the schedule. The Service will not be reasonably apprised of a potential controversy by the aggregate amount disclosed. In these instances, the taxpayer must use Form 8275 or Form 8275-R regarding that portion of the item.

Combining unlike items, whether on Schedule M-1 or Schedule M-3 (or on an attachment when directed by the instructions), will not constitute an adequate disclosure.

That's just the highlights.  As I said above serious preparers should read the original.

Saying Goodbye to 2010

I know that you haven't been wondering how I do my blog, but I am going to tell you anyway.  I look at every federal court tax decision and an alphabet soup of IRS pronouncements (PLR, CCA, PMTA etc) as they are released by the Research Institute of America.  A small percentage of them strike me as interesting for one reason or the other (practical utility, humor, cause for reflection).  Those I copy into a draft post, which I will then labor over as the spirit moves me.  Having the full text in my draft post allows me to easily paste quotes into the body of my post.  The effect of this method is to leave me with a collection of draft posts.  Sometimes when I look at them I wonder why I thought they were interesting in the first place.  I've committed to a Monday Wednesday Friday schedule.  If something seems of immediate interest, I will put it up as a bonus post.  The side effect of this process is the accumulation of material that doesn't quite turn into a full length post.  Rather than consign it to the dustbin (You might be surprised at the number of developments than nobody would write about if I didn't), I will group a bunch of them together.  So in this post and maybe a subsequent one I will clean out anything left over from last year.  The only thing the items have in common is that they came out in the waning days of 2010.  If you can detect a theme, congratulations.

TAX PRACTICE MANAGEMENT, INC. v. COMMISSIONER OF INTERNAL REVENUE JOSEPH ANTHONY D'ERRICO v. COMMISSIONER OF INTERNAL REVENUE, TC Memo 2010-266

This was a fairly run of the mill substantiation case although the numbers were respectable (over 200k in deficiencies).  The fact that it was a tax preparation business added a touch of irony.  The most interesting feature was an airplane.  It was purchased in December.  Mr. D'Errico took it on a test flight which allowed him to visit some clients.  He then leased it out, because he was to busy to fly around during tax season.  He sold his tax business before he got to use the airplane to visit clients.  He, of course, took a 179 deduction in the year of acquisition.  The tax court didn't buy it.

TPM has not demonstrated that the airplane was acquired with the requisite intent or motive of making a profit. Other than D'Errico's self-serving testimony, TPM has not presented any evidence that it contemplated using the airplane for purposes of TPM's management or marketing operations. Further, the airplane leasing agreement specifically provides that TPM entered into the agreement with the intention of generating revenue to offset the airplane's operating costs.

Private Letter Ruling 201048025

This was a fairly convoluted like-kind exchange that was allowed.  As far as I could make out an entity swapped with a related party, which then acquired property.  The key to the whole thing seemed to be that as a group there was no net increase in cash.

Related Party intends to reinvest an amount equal to the total sale price of the Related Party Relinquished Properties less exchange costs. In the event that Related Party acquires replacement properties having a value less than 100 percent of the value of the Related Party Relinquished Properties, the difference will result in the Related Party recognizing gain arising from the exchange in the full amount of such difference, but the amount of gain so recognized will not exceed x% of the gain realized by Related Party on its transfer of the Related Party Relinquished Properties.

If somebody has studied this ruling and could post a comment I'd really appreciate it.

Edward Daoud, et ux. v. Commissioner, TC Memo 2010-282

This was also a substantiation case.  It was notable for two reasons.  The first was the introduction:

The Daouds owned two Wienerschnitzel franchises in Southern California, both of which gobbled up unusually large amounts of money. These expenses grabbed the Commissioner's attention and during his audit of the Daouds' 2000 and 2001 returns, he found that they had reported a large loss on kitchen equipment they never owned, and lacked substantiation for many of the other deductions that they claimed. The Commissioner determined a large deficiency for each year, and wants to add fraud or at least accuracy-related penalties. We make our way through the resulting menu of possibilities to determine the correct taxes and penalties.

You don't read a lot of stories about Tax Court judges shooting themselves, so you know that they have to have a sense of humor.  Sometimes it comes through.

The story of the unallowed loss on the kitchen equipment is one that Robert Flach, The Wandering Tax Pro will love.  (Mr. Flach still prepares returns by hand rather than use expensive and unreliable software):

Mr. Daoud conceded that he and his wife were not entitled to the loss on the sale of kitchen equipment, but he tried to explain why he reported a loss for equipment he had neither bought nor sold. He testified that he was unsure how the $110,015 loss got on his return, but he speculated that the bid was mixed up with all the other paperwork on his desk, which caused him to enter it into Turbo Tax by mistake. He also testified that the date he recorded on the Form 4797, Sales of Business Property, as the date that he sold the equipment was simply one that he chose at random after Turbo Tax prompted him to enter a date. He went on to explain that he gave the altered document to the revenue agent "out of panic."

The Turbotax made me do it defense was unavailing:

This case is a good example of why we allow the Commissioner to prove fraudulent intent using circumstantial evidence and the taxpayer's entire course of conduct. Mr. Daoud claims that he reported the loss by mistake, and he asks us to believe that he first learned about it when the revenue agent brought it to his attention. We do not believe him--Mr. Daoud's credibility suffered during trial. His testimony was often suspect, and the records he provided have proven not to be what he said they were on many subjects.

The judge elaborated on the credibility theme.  He didn't yell "Pants on fire", but it was close.

Private Letter Ruling 201051025

In my more paternalistic moments, there is a provision of the tax law that I would keep secret from some people.  One of the ways that you can avoid a 10% penalty on early withdrawal from you IRA is by committing to a series of distributions.  I just turned 59, myself, and I am looking forward to my 1/2 birthday so I wouldn't need to consider something like that myself.  And of course I'm glad my younger self never thought about it.  Nonetheless, there might be circumstances where it makes sense.  The ruling was about someone who adopted that course then managed to screw it up.  The IRS was forgiving.

1. The failure to distribute the entire required distribution amount for Year 6, and a proposed makeup distribution for Year 7 will not be considered a modification of a series of substantially equal periodic payments and will not be subject to the 10 percent additional tax imposed on premature distributions under section 72(t)(1) of the Code.
2. The fact that the amount of the annual payment computed pursuant to section 72(t)(2)(A)(iv) of the Code was paid in a single sum in Year 1 and in monthly distributions in Year 2 through Year 7 will not be considered a modification of a series of periodic payments and will not be subject to the 10 percent additional tax imposed on premature distributions under section 72(t)(1) of the Code.

That is not a complete wrap on 2010, but it will do for now.

Non-Custodial Parents - You Need the Freaking Form 8332

Michael F. Wesner v. Commissioner, TC Summary Opinion 2011-5

Here is some advice for the about to be divorced.  I will preface it with a cautionary note.  It is a minority opinion and the simplest thing is probably to just go with the flow of however your attorney is handing things.  There are two issues that I think they often get wrong, though.  The first is filing a joint return in the final year of the marriage.  It is usually assumed that this is a simple numbers exercise of comparing the total tax of two married filing separate (or head of household) returns and a single joint return.  I have more posts on this subject than just this one, but it will give you the gist of why this is not a good approach.  It ignores the joint and several liability created by a joint return.  That is not the topic of this post though.

The other is the dependency deduction.  The most common solution to this overrated problem is for the couple to divide up the dependency deductions and in the case of a single child take it in alternate years.  Here is my advice on that.  If you are the non-custodial parent and you can get any concession at all in exchange for giving up the dependency deduction entirely, give it up. The case of Michael Wesner is a good illustration of this point, although as you can see here, by no means, the only one.

This was the Court order relative to the child support and dependency deduction :If *** [petitioner] has paid in full all current support and court ordered arrearage payments due for the calendar year by December 31, *** , the Federal tax exemption for the minor child(ren) shall be allocated as follows: *** [petitioner] to claim 2006 & 2007. *** [Ms. Tokar] to claim 2008. Three year pattern to continue. [Ms. Tokar] shall execute the necessary Internal Revenue Service forms to transfer the exemption(s) consistent with the order. Note: The exemptions are not allocated unless the current support obligation is greater than $1,200 per year. Petitioner was also obligated to pay 60 percent of the minor child's unreimbursed medical and dental expenses. In addition to future child support, petitioner was also ordered to pay past care and support of $9,160 for April 1, 2003, through June 30, 2006, at the rate of $76 per month.



Mr. Wesner followed through on his obligations and accordingly thought he was entitled to the dependency deduction.  Things were difficult though.

Petitioner approached Ms. Tokar, the custodial parent, immediately after the entry of the court order and arranged an appointment with her to execute the Internal Revenue Service forms (tax forms) as ordered by the divorce court. Ms. Tokar did not appear at the appointed time and failed to execute the tax forms. After petitioner's attempt to obtain Ms. Tokar's signature failed, he sought enforcement of the court order by service of legal process but he did not know her mailing address. He requested Ms. Tokar's address from the agency to which he made the support payments, and it refused to provide her address. Accordingly, at the time his 2007 income tax return was due, petitioner did not have the required consent form executed by Ms. Tokar; and his income tax return was filed without the form or any other documentation supporting his claim for the dependency exemption deduction.

After more than 6 months of trying to obtain Ms. Tokar's address, petitioner hired a process server during August 2009 to find and serve her. By the time the matter came before the divorce court it was too late for Ms. Tokar to sign the tax forms.


It seems like the IRS or the Tax Court should have cut Mr. Wesner a break.  No such luck.

“The custodial parent signs a written declaration *** that such custodial parent will not claim such child as a dependent *** and *** the noncustodial parent attaches such written declaration to the noncustodial parent's return for the taxable year.”

No such document was executed and/or attached to petitioner's 2007 income tax return and, accordingly, petitioner does not meet the requirements of the statutory exception and is not entitled to claim the minor child as a dependent. This is so even though a State court with jurisdiction over the parties to a divorce proceeding ordered that petitioner was entitled to the dependency exemption deduction for 2007 and even though the custodial parent had been ordered but failed to execute the consent form required by the Federal statute. The consent form requirement is in absolute terms and is unambiguous.

In this case Mr. Wesner did get some relief from the divorce court :

The divorce court, finding that petitioner had made support payments for 2007 and had qualified under the court order for the dependency exemption deduction, credited $2,559 against petitioner's future support payments beginning September 1, 2009. The income tax deficiency respondent determined for 2007 was $2,559.

Presumably, he is still out the interest on the deficiency.

Here is the problem.  The divorce court has a lot of power over you and your ex-spouse, but it takes time, energy and money to get it to use that power to enforce its orders.  The divorce court has no power over the IRS.  The divorce court can order that the dependency deduction be released or, as in many innocent spouse cases, that your ex-spouse is liable for an income tax deficiency, but its determinations are not binding on the IRS.

Here is another way to look at the dependency deduction that might be applicable to those more prosperous than Mr. Wesner, who was working down a child support arrearage of $9,160 at the rate of $76 per month.  If you and your ex-spouse are on the older side and are both prosperous enough that the estate plan of bouncing your last check is improbable (i.e. you are both going to be leaving money to the same kids), does a couple of thousand dollars one way or the other matter at all ?  That is an attitude that probably has limited applicability, but it does have the potential of cutting your stress level.