Taxpayers beware! Much of the $80 billion in new funding for the Internal Revenue Service will be used to scrutinize your tax return. Result: Hundreds of taxpayers end up challenging IRS decisions against them in US Tax Court. Bottom Line Personal asked leading accountants Edward Mendlowitz and Maryann Reyes to highlight cases in past years that can help you avoid problems and save money…
You Are Responsible for Reporting Income
Case study: Lionel and Molly LaRochelle moved to Florida in 2016, but continued to own their home in Washington, DC. In 2017, Mr. LaRochelle, a general manager of a real estate partnership, took a $238,000 distribution from a traditional IRA—but never received a Form 1099-R reporting the retirement-benefits distribution because his IRA custodian mistakenly mailed it to his Washington, DC, address. When the LaRochelles did not report the $238,000 on their returns, the IRS sent them a notice of underpayment and a penalty for $9,075. The couple argued that they didn’t deserve the penalty since the mistake wasn’t theirs.
IRS position: The LaRochelles were responsible for reporting all taxable income. Penalties for underpayment of taxes are issued if the underpayment is “substantial,” meaning that it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return.
Tax Court ruling: Even if there was a mistake, the LaRochelles do not get relief from the IRS penalty. Non-receipt of Form 1099 does not excuse the failure to report amounts that the taxpayer actually knew he/she received. The Court also noted that the LaRochelles did not make a good-faith effort to assess their proper tax liability. Example: They did not disclose the $238,000 to the accountant who prepared their tax returns.
Lesson: Non-receipt of a Form 1099 is so common that the IRS offers penalty abatement for first-time transgressors under certain circumstances. If you are current on tax payments, have a reasonable cause for the error and a good-faith belief that you had not committed an error, the IRS will forgive the penalty for the inaccuracy. Example: You are a freelance writer with a dozen client companies. One fails to mail out your Form 1099 for a small amount, so you report income improperly on your tax return. Note: You can’t get an abatement for underpayment, which is a separate penalty, for merely not receiving a Form 1099.
Ignorance Is Not Bliss When It Comes to Taxes
Case study: Om Soni was a successful businessman in New York who had been married to his wife, Anjali, a homemaker, for decades. She regularly deferred all financial matters, including tax returns, to her husband and trusted him to handle them. For tax year 2004, Mr. Soni had an outside accounting firm prepare the joint return. He reviewed and signed it. Mrs. Soni did not look at the return, and the couple’s adult son signed his mother’s name. The IRS audited the return and mailed a Notice of Deficiency of $642,629, plus another $157,000 in penalties. The Sonis argued that the joint return was invalid because Ms. Soni had not reviewed the return, signed it or authorized anyone to sign for her.
IRS position: Mrs. Soni was not absolved of the joint liability derived from the tax return. She knew her husband was filing their taxes. She historically had left the financial decisions, including tax returns, to him. She gave her tacit consent even without her signature.
Tax Court ruling: Mr. and Mrs. Soni were liable for the additional taxes and penalties. The doctrine of tacit consent holds that if the facts and circumstances show that a non-signing spouse “intended to file and be bound by the particular return in question,” he/she can still meet the criteria for a valid joint return. Mrs. Soni knew she had to pay taxes with her husband, and she received letters from the IRS at her home addressed to her and her husband. Another deciding factor for the Court was the history of one spouse’s trust in the other—the Sonis had filed joint returns for the prior five years, and Mrs. Soni never objected to filing jointly.
Lesson: Sticking one’s head in the sand doesn’t absolve a spouse from liability on a joint tax return. Lack of action—with knowledge—constitutes consent.
It’s Not a Gift Until the Check Clears
Case study: A 94-year-old Pennsylvania surgeon, Dr. William E. Demuth, sought to reduce his large estate for tax purposes by writing checks from his account with an investment-management firm and sending the money as gifts to family members. On September 6, 2015, 11 checks ranging from $14,000 to $240,000—a total of $464,000—were mailed out through the US Postal Service. Dr. Demuth died on September 11. Four of the checks had been deposited by recipients before his death, seven afterward. But only one, for $28,000, had actually cleared by the date of his death. When Dr. Demuth’s son, acting as his father’s executor, filed an estate-tax return with the IRS, he excluded $464,000 from the value of his father’s estate, the total amount for all 11 checks.
IRS position: The value of the estate was understated by the amount of 10 checks (totaling $436,000).
Tax Court ruling: In Pennsylvania and most states, a gift is not considered complete until the donor has “parted with dominion and control as to leave him no power to change its disposition.” Dr. Demuth’s investment-management firm had not accepted, certified or made final payment on any of the 10 checks upon his death. Therefore, he could have issued a stop payment on any of them or closed down his account before they were cashed. Note: Because of technical errors in the IRS attorneys’ filings, the Court ultimately ruled that three of the 10 checks should not be included in Dr Demuth’s taxable estate.
Lesson: In some matters, such as tax returns, your returns are considered filed on time as long as the envelope is postmarked and deposited in the mail by the due date each April. Not so with gift-giving. A lot of older folks still feel most comfortable and secure writing paper checks even though it’s become a very inefficient way to transfer money in the digital age. If timeliness and efficiency matter in issuing a gift, ask your adviser, bank and/or brokerage firm about alternative ways to move your money.
Keep Tax Records Longer Than Three Years
Case study: Betty Amos was an entrepreneur who ran 15 Fuddruckers restaurants in Florida and Tennessee in the 1990s. Her declining business fortunes in 1999 and 2000 caused her to start shutting down her restaurants and produced significant net operating losses (NOLs), which she listed on her tax returns and proceeded to carry forward for nearly 15 years. (Congress permits taxpayers to carry NOLs back five years and forward indefinitely). On her 2014 and 2015 returns, Amos reported about $100,000 of annual IRA income against which she claimed more than $4 million of NOLs. The IRS disallowed the NOL carryforwards. Ms. Amos, who was an accountant, objected, claiming that the IRS had allowed similar deductions in prior years.
IRS position: Even if the IRS did not take issue with a taxpayer’s NOLs until year 15, the taxpayer still needs to keep related records back to year one.
Tax Court ruling: Ms. Amos produced her old 1999 returns showing her NOLs but no longer had underlying documents to substantiate them. The Court found that a taxpayer who is claiming a loss stemming from a prior tax year needs to be prepared to substantiate the entitlement to that loss in the year it originated. The Court wrote, “it beggars belief that she would be unaware…[of] her responsibility to demonstrate her entitlement to the deductions she claimed.”
Lesson: A tax case is considered closed three years after a return has been filed. IRS guidelines suggest that you keep records up to seven years if you file a claim for a loss for worthless securities or a bad-debt deduction. But if an event in a given year could have tax repercussions years later, be prepared to keep tax records and supporting evidence indefinitely. Example: A taxpayer who buys a home in year one and sells it 10 years later should keep records of all transactions, such as capital improvements, that affect the cost-basis of the home during all 10 years.