IRS Marijuana Tax Audit

by Chris Moss CPA

Welcome to TaxView with Chris Moss CPA Tax Attorney

There are 23 States and the District of Columbia that have legalized Marijuana for medicinal use, with Colorado, Washington, Oregon and Alaska allowing legal recreational use as well.  Previous articles on Marijuana Income Tax Law and IRS or State Law for Medical Marijuana need updating due to IRS Marijuana Tax Audits the Government is sending over to California and Colorado in early 2016 . If you are in the retail, wholesale, growing, or distribution side of the Marijuana industry, you are going to be faced with an almost certain annual IRS Marijuana Tax Audits of your 2015 business and personal tax returns, so stay with us here on TaxView with Chris Moss CPA Tax Attorney to learn how to best protect your Marijuana business from adverse Government action when the IRS Marijuana Tax Audit hits your business

IRS Code Section 280E allows no income tax deduction for any trade or business dealing in Federal scheduled controlled substances, and herein lies the problem for anyone connected with the Marijuana industry. Even if your State has legalized Marijuana, Government enforcement of Section 280 still results in draconian amounts of tax owed by business owners after an IRS Marijuana Tax Audit.  That is until California Helping to Alleviate Medical Problems known as  CHAMP decided to fight back. After Champ was audited by an IRS Marijuana Tax Audit in 2002, the Government determined that all of CHAMP’s expenses including its Costs of Good Sold, were nondeductible under Section 280E in connection with the trafficking of a controlled substance. CHAMP appealed to US Tax Court in CHAMP v IRS US Tax Court (2007).

The IRS argued that all of CHAMP expenses were in connection with the illegal sale of drugs and therefore all expenses were nondeductible under Section 280E. Judge Laro disagreed as to Cost of Goods Sold. Citing the Senate Finance Committee report, the Court found that Cost of Goods Sold would be exempt from 280E in order “to preclude possible challenges on constitutional grounds.” Senate Finance Report S. Rept. 97-494 (Vol. 1).  In addition the Court allowed expenses for nonrelated Marijuana ancillary services for counseling and caregiving because the books and records were adequately able to separate out those expenses.  Both CHAMP and IRS had partial wins.

Because CHAMP did not appeal there was no higher Court precedent until Martin Olive and his infamous California Vapor Room got hit with an IRS Marijuana Tax Audit for 2004 and 2005 disallowing all his expenses.  Olive appealed to US Tax Court in Olive v IRS US Tax Court (2012).  Judge Kroupa easily distinguishes Vapor Room from CHAMP in that CHAMP was a service organization with 72% of its employees working exclusively with caregiving.  The Vapor Room business model stresses solely the sale and consumption through vaporization of marijuana.  The Court finds for the Government concluding that Section 280E disallows all Vapor Room expenses except for Cost of Goods Sold.

Judge Kroupa of the US Tax Court found Olive’s testimony and the testimony of the other witnesses on the Cost of Goods Sold to be “rehearsed, insincere and unreliable” and also found that the ledgers were not accurate due to Olive transacting his entire business in cash. The Court noted that Vapor Room grossed at least $1.9M in 2004 and $3.3M in2005. The Court estimated Cost of Goods Sold at 75.16% of sales for 2005 based on expert testimony of Dr Gieringer that the Cost of Goods Sold of medical marijuana dispensaries ranged from 70-85% of sales resulting in a tax bill of over $1.1M for 2005 alone.

Martin Olive appealed in Olive v IRS (9th Cir California) relying again on CHAMP. The Court found Olive’s reliance on CHAMP was misplaced. CHAMP had not only of medical marijuana business, but also ran an extensive counseling and caregiving service. This is not the case in Vapor Room were the sole business of Olive was to engage in selling medical marijuana. The Court concluded that if Congress now thinks that the policy embodied in 280E is unwise as applied to medical marijuana sold in conformance with California law it can change the statute. This Court cannot. IRS wins Olive loses.

The latest Court ruling regarding Marijuana is again from California where in 2011 various individuals including Pickard were criminally indicted under 21 U.S.C. §§ 846, 841(a)(1) accused of illegally conspiring to grow 1,000 marijuana plants. Pickard moved to dismiss in 2013 on various Constitutional grounds asking for an evidentiary hearing which the Court eventually granted.  Judge Mueller on April 17, 2015 denied Picard’s Motion to Dismiss and denied his Motion for Reconsideration on June 1, 2015.

Judge Mueller after careful consideration of the expert witness testimony presented at the evidentiary hearing, joined the chorus of other courts considering the same question, and concluded the issues raised by Picard are policy issues for Congress to revisit if it chooses. Judge Mueller in a brilliant conclusion opines:  “At some point in time, in some Court, the record may support granting such a Motion, but after having carefully considered the facts and the law as relevant to this case, the Court concludes that on the record in this case, this is not the Court and this is not the time.  US Dept. of Justice Wins, Pickard and others all lose.  It appears that Pickard not appealed to the US Court of Appeals for the 9th Circuit at this time.

So as we head to 2016 there is one thing certain. Unless you are all properly prepared, the IRS Marijuana Tax Audit will be devastating to all in the Marijuana industry. What can you do now? First, the only hope of deducting expenses other than your Cost of Goods Sold is to on advice and approval of your Tax Attorney make sure those unrelated expenses are perfectly recorded through a separate LLC with QuickBooks or similar accounting software creating your books and records.  Make sure your tax experts separate out revenue from those activities allocated accordingly and all cash deposits should be clearly separated in separate bank accounts if they are unrelated to Marijuana sales. Second, again on advice and approval of your Tax Attorney record all cash sales and report all income. If you cannot secure a bank willing to do business with your Marijuana cash business then create again with consent of your Tax Attorney a Management LLC to accept the cash with the offset to management fees. Finally you will most certainly be subject to annual IRS Marijuana Tax Audits, so make sure when you file your tax return you have your Tax Attorney who prepares your return ready to represent you on the IRS Marijuana Tax Audit, all the way up to the US Tax Court and Federal Appeals Court if necessary. In conclusion, it appears until Congress changes the law, it is not going to be as easy as you all thought years ago, but at least you have now a fighting chance of at least partially winning  the battle against the IRS Marijuana Tax Audit sure to come your way soon.

Thanks for joining us on TaxView with Chris Moss CPA Tax Attorney

See you next time on TaxView

Kindest regards

Chris Moss CPA Tax Attorney

IRS Lease to Buy Audit

by Chris Moss CPA

Welcome to TaxView with Chris Moss CPA Tax Attorney

For any of you out there who have converted a commercial lease to a purchase your accountant has likely capitalized the cost to terminate the lease increasing your basis in the property buy out.  Most likely your business income tax return was also prepared based on these capitalized costs in accordance with IRS Code Section 167 or perhaps amortized underSection 197.  However, there is good news in recent Court rulings regarding Federal income tax rent deductions when you convert your lease to a purchase and pay large upfront lease termination fees that you can deduct in full in the year you paid those fees.  But watch out for the IRS Lease to Buy Audit sure to come your way requiring you to capitalize all those expenses in accordance with Code Section 167. So if you are leasing a building or warehouse with a lease to buy option in your future plans, and you want to take advantage of this new Court approved tax deduction when you exercise your lease to buy options, stay with us here on TaxView with Chris Moss CPA Tax Attorney to find out where lease to buy tax deductions are trending in 2015 and how to protect your expense in lieu of additional rent deductions from  being disallowed during an IRS Lease to Buy Audit.

IRS regulations require capitalization of all acquisition costs to purchase a building whether it be amortization underSection 197 Intangible, or depreciation under Section 167 and also require capitaliziation if the property you are purchasing is “subject to a lease”. So it would not surprise me if most accountants capitalize the cost of lease buy out conversion under IRS Code Section 167(c)(2).

But ABC Beverage Corporation which makes and distributes soft drinks and other non-alcoholic beverages at its bottling plant in Hazelwood, Missouri took a different approach.  On its 1997 tax return ABC claimed a business expense deduction of $6.25M which they claimed on their tax return was the buyout cost of the lease negotiated with the Landlord in lieu of additional rent over the term of the lease.  The Government audited ABC and commenced an IRS Lease to Buy Audit disallowing the enter $6.25M deduction sending ABC a bill for $2.5M in back taxes.  ABC paid the tax and then brought suit for refund in ABC Beverage vs United States 577 F Supp 2d 935 (WD Michigan 2008).

ABC’s argument to District Judge Paul Maloney was that their buy out was similar to 6th Circuit’s Opinion in Cleveland Allerton Hotel, Inc. v. Commissioner, 166 F.2d 805 (6th Cir. 1948).  In that case Cleveland had a lease with roughly 80 years left on the term. Cleveland purchased the building after negotiating a buy out with the Landlord and claimed a tax deduction as business rent expense claiming when the IRS audited that the deduction was not to purchase real estate but to be “relieve them of an important rental obligation” which could accurately be measured by the difference between the fair value of the real estate and what Cleveland paid to purchase the property.

The Government in Cleveland claimed under IRS Code Section 167 or in the alternative Section 197  the deduction should have been capitalized as part of the purchase price to acquire the property. But Circuit Judge Simons found for Cleveland opining that Cleveland is not a third person investor buying real estate, but rather had a liability in a lease it wished to extinguish and it simply paid liquidated damages to the Landlord for release from its long term lease not to buy the property but to allow the lease to be terminated. District Judge Maloney found for ABC as did Judge Simons rule for Cleveland, and the Government appealed to the 6th Circuit in ABC Beverage Corp. v. U.S., 113 AFTR 2d 2014-2536 (CA6 2014).

The Government’s main argument on appeal was that Section 167 required that property “subject to a lease” was required to be capitalized, further arguing that ABC should simply depreciate or amortize the deduction as required bySection 167 or Section 197.   The Government supported its position citing Woodward v Commissioner, 397 U.S. 572 (1970), Commissioner v Idaho Power Co., 418 U.S. 1 (1974), and INDOPCO, Inc. v Commissioner, 503 U.S. 79 (1992)and finally asking the 6th Circuit to overturn the out of date 65 year old Cleveland case.  But Circuit Judge Cole opines that the facts in all those cases are not controlling and therefore do not warrant the Court to overturn Cleveland.

Circuit Judge Cole after review of all the evidence found that the Cleveland and ABC expense was a cost to extinguish liability to the Landlord prior to the purchase of the property and Congress did not intend Section 167 to apply to these specific facts. Absent other indication from Congress, the Court ruled that property was not “acquired subject to a lease” if the purchase extinguished the lease.  ABC’s purchase was not acquired subject to a lease and therefore ABC wins, IRS loses.

OK now what does this say to all of you out there with lease to buy options?  First, your tax attorney needs to have the language inserted in the lease to buy option prior to executing your lease that any additional expense in lieu of continued rent will be tax deductible as what I would call additional rent to extinguish lease citing the ABC case law in the applicable lease paragraph allowing for the buy out to purchase the building.  Second, have your tax attorney include in your tax return his contemporaneously prepared opinion on why Section 167 does not apply to your specific facts and perhaps even include the applicable lease provision in the tax return prior to filing. Finally sit back and enjoy your new real estate purchase including your fully deductible additional rent to extinguish lease which has allowed you to substantially reduce your income tax.  You can now relax knowing you have contemporaneously created facts and Court rulings and Opinions supporting and bullet proofing your tax return to win the likely IRS Lease to Buy Audit coming your way soon.

Thank you for joining us on TaxView with Chris Moss CPA Tax Attorney

See you next time on TaxView

Kindest regards

Chris Moss CPA Tax Attorney

IRS Mortgage Interest Audit

by Chris Moss CPA


Welcome to TaxView with Chris Moss CPA Tax Attorney

Just about all of us at one point or another have deducted mortgage interest as an itemized deduction allowed under IRS Code Section 163 on Schedule A of your Form 1040 tax return. IRS Publication 936 and IRS Regulations 1.163 allow a married couple or single individual to deduct interest paid on debt no greater than $1.1M or $550K each filing separately. That is until Charles Sophy and Bruce Voss two unmarried joint owners of a home decided to file a tax return claiming $1.1 Million each or $2.2 Million total. So if you are not married and jointly own a home stay with us here on TaxView withChris Moss CPA Tax Attorney to find out how in 2015 it appears that you are now able to deduct interest paid on $2.2 Million and learn how to protect that deduction from an almost certain IRS Mortgage Interest Audit perhaps many years later.

In 2002 Charles Sophy and Bruce Voss purchased a house in Beverly Hills California as joint tenants financed by $2.2 Million in debt. They filed a federal income tax return in 2006 and 2007 with all interest on over $2M in debt deducted onSchedule A of their personal 1040 Tax return.  The IRS commenced an IRS Mortgage Interest Audit and disallowed all interest on debt over $1.1M. Sophy and Bruce appealed to US Tax Court in Sophy v IRS US Tax Court (2012).

Sophy and Voss argued to the Court that Section 163 limitations were applied per taxpayer with respect to co-owners who are not married and therefore they should be allowed interest on debt up to $2.2M.  The Government argued that whether married or unmarried you still live in one house and get to use only one $1.1M limitation. Judge Cohen therefore had to decide whether or not the statutory limitation of Section 163 was properly applied on a per-residence or per-taxpayer basis where residence co-owners were as in the case of Sophy and Voss not married.

The Court reviewed the legislative history of Section 163 and concluded that because married couples filing separate returns had to split the exemption in half, so should unmarried couples.  Sophy and Voss countered that Congress intended to create a special rule for married couples, the marriage penalty if you will, which should not apply to unmarried couples. Congress was silent on unmarried couples and therefore the marriage penalty should not apply to them. The Court ultimately found for the Government concluding that that nothing in the legislative history of Section 163 suggests that Congress had any other intention than to view mortgage debt on a per-residence basis.  Therefore the per-taxpayer basis used by Sophy and Voss was overruled by the Court with a win for the IRS.

Sophy and Voss then appealed to the US Court of Appeals for the 9th Circuit in Pasadena California filing on August 7, 2015, in Voss c. Commissioner 796 F.3d 1051 (9th Cir. 2015).  An Amici Curiae brief was filed by Shannon Minter and Christopher Stoll of the National Center for Lesbian Rights and Sophy and Voss were represented by Sideman & Bancroft LLP of San Francisco and Hone Maxwell LLP of San Francisco. The Government was represented by Assistant Attorney Generals Keneally, Cohen and Schumann from the US Dept. of Justice Tax Division in Washington DC

Sophy and Voss continued to argue that the US Tax Court should be overruled because Section 163 debt limits apply to unmarried co-owners on a per-taxpayer basis.  Circuit Judge Jay Bybee acknowledges that Section 163 is specific with respect to a married couple but notes the IRS Code does not specify whether in the case of residence co-owners who are not married the debt is limited per residence or per taxpayer.  The gap in the Code is the source of the present controversy Judge Bybee opines.

The Court argues that because Voss and Sophy were unmarried they were required to file separate single tax returns not joint or married filing separately returns.  Knowing that married couples file as one person, either jointly or separately, Congress on many other occasions has provided half-sized deductions for married couples filing separately including a capital gain limitation of $3000 for married, $1500 for married filing separately.

If Congress, the Court reasons, wanted to go further and ensure that two or more unmarried taxpayers were treated as a single taxpayer for purposes of Section 163, then Congress could have done that with specific language in the Code. The Court gave as an example Section 36 of the Code the First Time Homebuyer credit where unlike the mortgage debt interest limitation in Section 163, First Time Homebuyer credit Section 36 says “Married filing separately each can take $4000 of the total $8000 credit AND if two or more individuals who are not married purchase a principal residence, the amount of the credit can not exceed $8000”. The Court concluded that a per-taxpayer reading of the statute debt limit provisions is most consistent with Section 163 and Treasury regulation 1.163 as a whole. The Court therefore reversedSophy v IRS US Tax Court (2012) and remanded back to the US Tax Court the job of determining in a manner consistent with the 9th Circuit Opinion the proper amount of qualified residence interest under Section 163. Voss Sophy win, IRS loses.

But there’s more: Circuit Judge Ikuta writes a blistering dissenting Opinion claiming that the majority opinion allows unmarried taxpayers who buy expensive residences to deduct twice the amount of interest than married spouses would be allowed to deduct. The Dissent shows how over the years the IRS has promulgated numerous regulations and rulings showing how exactly unmarried taxpayers who jointly own a home can apportion the interest on the $1.1 M debt limitation of Section 163. Voss and Sophy’ s approach should be rejected because due respect and deference should be given the US Treasury interpretation of the statute citing Christensen v Harris 529 US 576 (2000). The Dissent called the Majority “an absurd” marriage penalty with the better solution being to defer to the IRS reasonable interpretation of the statute. Therefore Judge Ikuta concluded in his Dissent that he would affirm the US Tax Court below.

What does all this mean to any of you purchasing a home with debt of over $1.1M? First, in my view, even if you don’t live in the 9th Circuit, if you are unmarried in 2015 and co-own a home together with a larger mortgage than $1.1M make sure you consult with a tax attorney before you file your 2015 income tax return.  It sure looks at least for now until the other Circuits chime in that you will have a good chance of supporting an interest deduction on debt of up to $2.2 million.  Second, have your tax attorney include in your tax return Voss c. Commissioner 796 F.3d 1051 (9th Cir. 2015) to support your position. Finally until Congress amends Section 163 and the other Circuits chime in, you should expect an IRS Mortgage Interest Audit within perhaps years after you file your tax return. With proper preparation and planning you will have an excellent chance to win an IRS Mortgage Interest Audit as did Voss and Sophy. Thank you for joining us onTaxView with Chris Moss CPA Tax Attorney.

See you next time on TaxView

Happy Thanksgiving 2015 from

Chris Moss CPA Tax Attorney

Welcome to TaxView with Chris Moss CPA Tax Attorney

Do any you have some land that you are thinking about selling in 2015 for a large capital gain under IRS Section 1221 to perhaps be offset against some stock losses in your brokerage account? Seems easy enough. But unfortunately the Government looks closely at your land sales when the IRS in many cases years later commences a Capital Gain to Ordinary Income Audit disallowing all your capital gain and converting those gains to ordinary income under IRS Section 61. When the audit is over, the IRS agent then explains to you that you owe a great deal of tax, interest and penalty now that your brokerage capital losses cannot offset ordinary income.  So how do you protect your capital gain from converting to ordinary income when the IRS comes knocking on your door? Stay with us here on TaxView with Chris Moss CPA Tax Attorney to find out how to bulletproof your capital gain from an IRS Capital Gain to Ordinary Income Audit.

Selling land, real estate or stock always results in a capital gain right? Well not quite always as is currently trending in 2015 and as Greg and Melanie Boree discovered in Boree v IRS US Tax Court (2014). The facts are simple. Boree purchased 1,982 acres in Florida with a 1.8M loan from Perkins State Bank in 2002, plans were submitted to the County and various lots were sold during the next 5 years. However, in 2007 a new investor Adrian Development purchased 1067 acres for $9,600,000 from Boree.

Boree recorded all lot sales from 2005, 2006 and 2007 on his income tax form 1040 Schedule C as ordinary income but the sale in 2007 to Adrian as long term capital gain.  The IRS came visiting in 2011 and commenced a Capital Gain to Ordinary Income Audit, disallowing the entire capital gain resulting in a tax bill of almost $2M. Boree appealed to US Tax Court in Boree v IRS US Tax Court (2014).

Judge Foley cuts right to the core issue:  Was the $9.6M sale of land part of inventory of a business or was this sale unique, different from the other sales to be treated as a capital asset held for investment. The Court notes that sales of lots were made to customers in the normal course of business from 2002 to 2007 and were frequent and substantial with no distinction made in the books and records to treat the Adrian sale any differently, citing Slappey Drive Industrial Park v US 561 F.2d 572 (5th Cir 1977). Indeed the Court concluded there was no evidence presented contemporaneously by Boree in his 2007 tax return that the Adrian sale was being considered for tax purposes “segregated from the rest of the property” as property held for investment. IRS Wins Boree Loses.

Timothy and Deborah Phelan had a very different experience in Phelan v IRS US Tax Court (2004) when the IRS came knocking on their door for a Capital Gains to Ordinary income audit. The facts are very complex so I have simplified as best I could as follows: Phelan purchased 1050 acres in Colorado in 1994 with possible plans for development. There were various agreements with the County, municipal town and other developers but no sales to the public. In 1998, Phelan sold 45 acres were sold to Elite Development and Vision Development for $1.5M and recognized a 1998 capital gain on his personal tax return. The IRS commenced a Capital Gain to Ordinary Income Audit and converted the capital gain to Ordinary income claiming that Phelan was in the business of selling real estate. Phelan appealed to US Tax Court in Phelan v IRS US Tax Court (2004) claiming he had no employees nor did he engage in any business activities outside of holding and selling a limited number of parcels with the ultimate hope of appreciation of the value of the land.

Judge Gerber easily finds for Phelan because the facts showed that other than the 2 sales in 1998 there was no other activity. The Court concluded that during the 4 years that Phelan held the land, the property did in fact appreciate according to plan and the investment goals had indeed been achieved by Phelan. Phelan wins IRS Loses.

Our final case involves Frederic and Phyllis Allen who in 1999 sold 2.63 acres of undeveloped real estate in East Palo Alto to property developer Clarum Corporation. He reported the sale as an installment sale as per the sales agreement with Clarum and in 2004 Allen received the final installment of $63K from Clarum. Allen did not report this income on his 2004 tax return. On advice of tax professionals Allen amended his 2004 return in 2008 reporting the $63K as long term capital gain. The IRS audited Allen’s amended return and converted the capital gain to ordinary income after an IRS Capital Gain to Ordinary Income Audit. Allen bypassed US Tax Court by paying the tax and then suing for a refund in US Federal District Court for the Northern District of California in Allen v US No 3.2013cv02501.

Judge William Orrick opines that the evidence is compelling that Allen intended to develop the property when he purchased the property and that he undertook substantial efforts to develop the property during the time he owned it. Even Allen in his own deposition indicated to the Court that his original intent was to develop the property. While Allen then argues to the Court in that same deposition that his intent changed over time, the Court found that Allen presented no credible evidence to prove that his intent changed, citing Tibbals v US 362 F.2d 266 (Ct Cl 1966). The Tibbals Court held that a taxpayer’s purpose can change based on the facts the taxpayer presents to the Court but Judge Orrick in Allen concluded that because Allen provided no evidence that he had held the land for anything other than development the sale of the property therefore resulted in ordinary income. IRS Wins, Allen loses.

So for anyone out there planning to buy land, real estate or some other capital asset what can you do right now to protect your long term capital gain from ordinary income conversion when the IRS Capital Gain to Ordinary Income Audit commences years from now. First before you purchase your land have your tax attorney contemporaneously create the facts and evidence you will need to win an IRS Capital Gain to Ordinary Income Audit. Tibbal makes clear you need to prove to the Court that the purpose for which the property was acquired, the motive for selling it, the taxpayer's method of selling the land, taxpayer’s income from the sale of it compared with his other income, the extent of the improvements made to facilitate the sale of it, the frequency and continuity of sales, and the time and effort expended by taxpayer in promoting the sales in relation to his other activities all must be factually presented as evidence to the Court in order to win against an IRS Capital Gain to Ordinary Income Audit. Second, after you purchase your land, feel free to outsource development to developers creating written extemporaneous documentation of your intent to sell property to those developers at some point in time but only after the land appreciates in value. Finally make sure the same tax attorney who represented you on both the buy and sell side of the transaction prepares and files your tax return claiming capital gain treatment of the sale. When the IRS Capital Gain to Ordinary Income Audit commences years later your tax attorney will easily be able to present the facts to the Court you will need to win the audit, keep intact your long term Capital Gain, and prevent the Government from taxing you at much higher ordinary income rates.

Thank you for joining us on TaxView with Chris Moss CPA Tax Attorney.

See you next time on TaxView.

Kindest regards,

Chris Moss CPA Tax Attorney

IRS Bad Debt Audit

by Chris Moss CPA

Welcome to TaxView with Chris Moss CPA Tax Attorney

How many of you all have ever loaned money or property through your business and have not been paid back? Have you ever loaned money or property to a friend and have not been paid back? Did you all know you can deduct either on your business or personal tax return a bad debt either as a business bad debt under IRS Section 166(a) and 166(b) or a nonbusiness bad debt under IRS Section 166(d)? However, the Government looks closely at your bad debts perhaps years later disallowing all your deductions in and IRS Bad Debt Audit. So if you loaned out some money or property that you want to deduct in 2015 as a bad debt, stay with us here on TaxView with Chris Moss CPA Tax Attorney to find out how to keep those bad debt deductions from being disallowed years later during and IRS Bad Debt Audit.

Bad Debts are not so bad when you get to write them off on your tax return. But what if you get audited as did Fred Cooper in Cooper v IRS US Tax Court (2015). The facts are simple:  Cooper liked to make large sporadic loans to friends and business acquaintances. One of these loans was for almost $1M to Wolper Construction commencing in 2005 and due to be paid back in 2007. Wolper filed Chapter 11 in 2008 and eventually Chapter 7 in 2009. On advice of professional tax advisors Cooper amended his 2008 tax return in 2010 and deducted $750,000 bad debt deduction against ordinary income. The IRS audited years later in 2013 and disallowed the entire bad debt deduction for 2008.  Cooper appealed to US Tax Court in Cooper vs IRS TC Memo 2015-191.

Judge Buch notes that Section 166 allows taxpayers to deduct any debt that becomes worthless within the taxable year. To be entitled to the deduction the taxpayer must show a bona fide debt based on a debtor-creditor relationship citing IRS Regulation 1.166-1(c). Business debts and nonbusiness debts are treated differently under Section 166.  Nonbusiness debts are defined as debts not connected in connection with a trade or business. Unlike Business Bad Debts that are deducted directly against income, nonbusiness bad debts are short term capital losses with a maximum deduction of $3000 per year if there are no offsetting capital gains. Whether or not the debt is business or nonbusiness is a question of fact citing Rollins v Commissioner 276 F.2d 368 (4th Cir 1960). The business bad debt must be “proximately related” to the conduct of the trade or business, citing Litwin v US 983 F.2d 997 (10th Cir 1993).

Cooper argued before the Court that he was in the business of lending and therefore the deduction was a business bad debt. The Government argued otherwise citing that the facts do not support Cooper’s argument. The Court agreed with the IRS finding that there were five facts that showed Cooper was not a lender: 1. Cooper made only 12 loans over a six year period from 2005-2010. 2. Cooper only would lend money to friends and acquaintances. 3. Cooper did not use formal lending practices with no credit checks or collateral verification and there were no written promissory notes for 7 of the 12 loans. 4. Cooper did not publicly hold himself out to be a lender and 5. Cooper did not keep adequate contemporaneous business records. Many of the records given to the Court were constructed after the fact and were not considered credible.

The Court then went on to find that the nonbusiness bad debt was not wholly worthless in the year Cooper claimed the deduction in 2008. Cooper unfortunately was unable to show identifiable events to the Court that formed the basis of Cooper abandoning any hope of recovery citing Aston v Commissioner 109 US Tax Court 400 (1997). The facts unique to Cooper showed Cooper never claimed the debt to the US Bankruptcy Court, that Cooper listed the loan on his personal financial statement in 2009 as an asset, and that Cooper never sent Wolper a form 1099-C, cancellation of debt, nor was the IRS ever sent the 1096 form reporting the cancellation of the debt to Wolper. The Court therefore concluded that based on the facts, Cooper’s nonbusiness bad debt was not wholly worthless and therefore the deduction could not be sustained. IRS wins Cooper loses.

Our next case, Shaw v IRS US Tax Court (2013)  also has simple facts. June Shaw had a large capital gain of over $1M in 2009 from the sale of an apartment building in 2008. In the same year as this gain, the facts show that in 2009 June Shaw loaned on a very short term basis over $800K to a company owned by her brother Kenneth Shaw. June Shaw was unable to get her loan paid back by her brother Kenneth in 2009 so she deducted this $800K as a capital loss bad debt against the $1M capital gain.  The IRS audited years later and disallowed the entire bad debt deduction claiming there was no bona fide worthless bad debt to deduct. June Shaw appealed to US Tax Court in Shaw v IRS Tax Court 2013-170.

Judge Lauber opines that Section 166(a)(1) allows a deduction for any bona fide debt that becomes worthless within the taxable year. A bona fide debt is a debt that arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed sum of money, citing Section 1.166-1(c) of the IRS regulations. Transactions between family are subject to special extra scrutiny citing Caligiuri v Commissioner 549 F.2d 1155(8th Cir 1977). The Court observed that June Shaw provided no evidence that she checked out the credit worthiness of the company nor that she request assets be given to collateralize the loan. The facts showed further that June Shaw extended an unsecured line of credit that no third party lender would have approved. Finally that Court noted that June Shaw made no serious effort to obtain repayment nor did she send a letter demanding payment.  Finally she never filed a law suit against the company. The Court easily concluded that the loan was not a bona fide loan and therefore not deductible under Section 166.  IRS Wins June Shaw loses.

So how can you best create the facts you need to deduct a bad debt and sustain the deduction under Section 166 during an IRS bad debt audit years later?  First, before you lend anyone any money or property make sure you have a written legal promissory note with real terms of repayment.  Check their credit scores and make sure you get collateral on the loan.  Obtain financials and a PFS from the borrower, just like a bank would ask for.  Second, if you think the debt is going bad, retain a collection company to collect the debt and consider bringing legal action.  About a year later if all else fails, then and only then can you claim on a tax return that you are deducting a bona fide bad debt that is wholly worthless and noncollectable.  Finally, have your tax attorney attest to the steps you have taken to collect the debt and insert her contemporaneous statement into your tax return before you file.  You will be glad you protected your bad debt deduction from Government adverse action when the IRS come knocking on your door years later to commence an IRS Bad Debt Audit.

Thanks for joining us on TaxView with Chris Moss CPA Tax Attorney

See you next time on TaxView

Kindest regards

Chris Moss CPA Tax Attorney

IRS Legal Fees Audit

by Chris Moss CPA

Welcome to TaxView with Chris Moss CPA Tax Attorney

If any of you have incurred legal fees in 2015 perhaps you should consider a Legal Fees Tax Deduction?  You are entitled to deduct civil or even criminal legal fees under Section 162(a) paid to an attorney in connection with your business. You can also deduct legal fees paid to an attorney as a miscellaneous itemized deduction under Section 67 if you bring legal action against your employer. Finally, you can deduct legal fees under Section 212 if you paid an attorney in connection with the production or collection of income or the maintenance of property held for the production of income. But the Government is aggressively reviewing your legal fee deductions in many cases years later during an IRS Legal Fees Audit, hoping to disallow much of your legal fees deductions.  So stay with us here on TaxView with Chris Moss CPA Tax Attorney where you will learn how to deduct legal fees in 2015 by protecting those deductions with bullet proof evidence you will need years later to successfully defend your deductions during an IRS Legal Fees Audit.

The first and most important evidence you need is contemporaneously prepared legal invoices by your attorney detailing the kind of legal work you paid for as Parker Company found out in Parker v IRS US Tax Court (2012). The Parker business claimed $630,000 in legal fees paid to attorneys in 2003 in relation to the arbitration and the shareholder derivative suit. The IRS audited six years later in 2009 and disallowed all legal fees. Parker appealed to US Tax Court in Parker v IRS US Tax Court (2012) arguing the legal fees were ordinary and necessary trade or business expenses to defend shareholder derivative suits. However, the Court concluded that Parker could not substantiate most of the claimed legal fees. A ledger and two cancelled checks provided by Parker was not good enough.  The Court allowed only $55K and disallowed $575,000.  IRS Wins Parker Loses.

In addition to having the proper contemporaneously prepared legal invoices, make sure you know what IRS Code Section you are able to legally deduct your legal fees as Gary Lee Colvin found out in Colvin v US Tax Court (2004).  Colvin paid an attorney in connection with State Court litigation against his primary residence homeowners association and paid the same attorney to sue his former employer to recover lost wages, however the attorney he paid never provided detailed invoices showing the kind of legal work he was paid for. Colvin deducted one total legal fee on his Schedule C business in 1997 and 1998. The IRS audited and disallowed all legal fees arguing that the legal fees were not ordinary and necessary business expenses and there was insufficient legal invoices to sustain the deduction. Colvin appealed to US Tax Court in Colvin v IRS US Tax Court (2004) arguing the legal fees were deductible under Section 212 to protect the production and collection of income. Special Trial Judge Dean easily finds for the Government noting that Colvin may not under Section 212 deduct legal fees that are personal expenses to protect his primary home as per Section 1.212-1(h). The Court concedes that legal fees to sue his former employer for lost wages would have been deductible but because there were no contemporaneously prepared legal invoices documented the nature of the legal work performed no deduction could be allowed.  IRS wins Colvin loses.

Our next case Chaplin v IRS US Tax Court (2007), involves a professional fiduciary Philip Chaplin who worked for Rice Heard & Bigelow Inc (Rice) and was elected to the Board of Directors of Rice in 1987.  Chaplin acted as a fiduciary for clients from 1988-1994, was provided a Rice credit card and was paid as an employee of Rice as per his employment agreement. Unfortunately Rice terminated Chaplin in 1994 and eventually in 1997 Chaplin filed suit against Rice alleging breach of contract and wrongful termination.  The case settled in 2002 and Chaplin was paid $1.5M.  Chaplin deducted legal fees on his 2001 tax return as an offset to the $1.5M.  In 2005 the IRS audited Chaplin’s 2001 tax return and denied his legal fee deduction claiming that the legal fees were not deductible from adjusted gross income as business legal fees but rather unreimbursed employee expense legal fees under Code Section 67 to be deducted as miscellaneous itemized deductions subject to the 2% floor limitation.  Chaplin appealed to US Tax Court in Chaplin v IRS US Tax Court (2007)Judge Haines easily finds for the Government concluding that Chaplin was clearly an employee not an independent contractor.  IRS Wins Chaplin loses.

Our next case Brenner v IRS US Tax Court (2001) introduces us to Andrew Brenner employee of Nomura Securities from 1987 to his termination in May of 1996.  Brenner sued Nomura and eventually settled in 1998 for $1.9M. In 1997, Brenner deducted $215,354 worth of legal fees as a miscellaneous itemized deduction under Section 67. But in 1999 he filed an amended return  on advice of his accountants claiming his legal fees were part of his company corporate plan under IRS Section 62 and Regulations 1.62, which allowed that his legal fees be directly deducted as an offset to his $1.9 settlement income.  The IRS audited and disallowed the adjusted the legal fees back to what they were on his original return claiming that Nomura was Brenner’s employer.  Brenner appealed to US Tax Court in Brenner v IRS US Tax Court (2001)and Judge Halpern easily found for the Government because no lawyer’s bill was ever submitted to Nomura, and no itemization of specific bills or invoices was ever substantiated under Section 162-2(e)(3). Because Brenner did not provide the required documents  to comply with Section 1.62-(2)(e)(3), Brenner’s only recourse was to deduct the legal fees under Section 67 as a miscellaneous itemized unreimbursed employee business expense on Schedule A of the original return as filed.  IRS Wins Brenner Loses.

Our final case is Butler v IRS US Tax Court (1997).  The facts are simple.  Butler purchased a farm in California and became involved with various law suits over water rights to protect and defend the title to his farm.  Butler deducted his legal fees in 1991 1992 and 1993 under Section 162.  The IRS audited disallowing all legal fees claiming the farm was not engaged in for profit within the meaning of Section 183, and therefore not deductible or in the alternative under Section 263 the legal fees were capital in nature to protect the title to the property and were also not deductible.  Butler appealed to US Tax Court in Butler v IRS US Tax Court (1997).  Butler claimed that at the legal fees where business expenses under Section 162 or in the alternative itemized deductions under Section 212 to protect is investment in the farm.   Judge Gerger finds easily for the Government because Butler did not work the farm full time and that Butler lacked a profit motive.  Therefore under Section 183 no legal fees could be deducted either under Section 162 or in the alternativeSection 212.  IRS Wins Butler loses.

As you can see, the US Tax Court does not allow legal fees to be deducted on your tax return unless you have well document legal invoices, a business connection under Section 162, unreimbursed employer expense under Section 67, or a clearly set up contemporaneous set of facts and evidence to prove the legal fees you paid  to an attorney protected  your income producing investment under Section 212.  So how can you win an IRS Legal Fee Audit?  First make sure you legal invoices are all specific enough to connect the legal service provided to the appropriate Code Section eitherCode Section 162, Section 67 or Section 212.  Second make sure you retain a tax attorney to create contemporaneous documentation to insert into your tax return before you file to make sure the Government has disclosure of under what Section of the IRS Code you are claiming your legal fee deduction. Finally obtain from your trial attorney before you pay them their opinion on whether or not their legal fee is tax deductible.  If they don’t know, perhaps they can retain a tax attorney to give her opinion prior to commencing litigation.  You will be glad you did years later when the Government comes knocking on your door to commence an IRS Legal Fee Audit.

Thanks for joining us on TaxView with Chris Moss CPA Tax Attorney

See you next time on TaxView

Kindest regards

Chris Moss CPA Tax Attorney

by Chris Moss CPA

IRS Clergy Parsonage Allowance

Welcome to TaxView with Chris Moss CPA Tax Attorney

The Clergy Tax Free Parsonage Allowance Exclusion under IRS Section 107(1) and 107(2) which has provided tax free rental exclusions to the preachers of the Gospel for almost 100 years has been saved by the 7th Circuit Court of Appealsin a dramatic reversal of Judge Barbara Crabb’s November 21, 2013 ruling in Wisconsin Federal District Court.  So if you are a minister or preacher of the Gospel and are planning to take advantage of the Parsonage Exclusion in 2015, stay tuned to TaxView with Chris Moss CPA Tax Attorney to hear about the exciting conclusion of the 7th Circuit’s November 13, 2014 Opinion in Freedom From Religion vs Jacob Lew, Sec of the Treasury and John Koskinen, Commissioner of the IRS, on Appeal from No.11-cv-06260 Freedom From Religion, Gaylor, and Barker vs Jacob Lew Secretary of the US Treasury (2013) Barbara B Crabb, Wisconsin District Judge presiding.

Recapping from a previous TaxView, Tax Free Housing Allowance for Clergy, by Chris Moss CPA Tax Attorney, let’s first look at what Section 107 is all about. Simply stated if you are a preacher of the Gospel you get to exclude from your income the fair rental value of the home or what the church pays you for the home, whichever is less. Section 107(1)excludes the value of your housing provided by the Church. Section 107(2) excludes direct cash compensation paid to the preacher for housing that the preacher pays for. 

Further regulations added requirements that the Allowance be officially approved by the Vestry or similar church Board.  See IRS Ministers’ Compensation and IRS topic 417. Various tax court rulings, including US Tax Court Driscoll v IRS imply that Congress had viewed the relationship between a Church and its ministers in a similar manner as they viewed the relationship between an Employer and its Employees. Congress reasons that if Employees were exempted on housing provided for the convenience of their employer, then why not have the Clergy exempt on similar housing allowance income when they would travel to a new Church to preach the Gospel. Interestingly, while the US Tax Court has ruled for or against the clergy over the years for abuse of the Exclusion, the Court has never before challenged Section 107 on Constitutional grounds that is until now.

Judge Crabb’s Opinion argues that her invalidation of the Allowance on Constitutional grounds does not mean that the US Government is powerless to enact tax exemptions that benefit religion. Indeed Judge Crabb concludes that Congress can enact legislation for granting the Exclusion that would be based on secular rather than religious grounds.  Unfortunately until Congress acts Judge Crabb opines, the Allowance is an unconstitutional violation of the separation of Church and State as found in the US Constitution.

However the 7th Circuit Judges Flaum, Rovner and Hamilton reversed Crabb in a most dramatic ruling, not deciding the case on the merits but rather on procedural grounds.  Judge Joel Flaum gave his Opinion that the Plaintiffs, Freedom From Religion, Gaylor and Barker, “lacked standing” before the Federal Court system to challenge Code Section 107(2).  The Court did not therefore reach the issue of the Constitutionally of the parsonage exemption.

The facts upon which this reversal were based were relatively simple in that Freedom From Religion’s co-Presidents Annie Gaylor and Dan Barker received a portion of their salary in the form of a housing allowance which was taxable to Gaylor and Barker.  Gaylor, Barker and Freedom From Religion brought suit in the Western District of Wisconsin claiming that Section 107 violated their First Amendment rights because it had given a tax benefit to preachers of the Gospel but not to them. The District Court agreed with Gaylor and Baker and ruled Section 107 unconstitutional. The Secretary of the Treasury and the IRS appealed to the 7th Circuit arguing that Gaylor and Barker did not have standing to bring the suit.

Gaylor and Barker argued before the 7th Circuit as they successfully argued before the District Court that they did indeed had standing because they were denied a tax exemption for their own employer provided housing allowance that was conditioned on them preaching the Gospel which of course they didn’t do.  The 7th Circuit reversed the District Court concluding that Barker and Gaylor were never denied the parsonage exemption because they never asked for it.

The 7th Circuit reasoned that without a request by Barker and Gaylor there could be no denial.  And absent any personal denial of the tax benefit, Gaylor and Barker’s claim amounted to nothing more than a generalized grievance about107(2)’s unconstitutionality, which does not support standing before the Federal Court system.  Citing Lujan v Defenders of Wildlife 504 US 555 (1992),   the Court agreed argued that a Plaintiff raising only a generally available grievance about government does not state a Constitutional Article III case or controversy.

But Gaylor and Barker argued further that they are in fact similarly situated to preachers of the Gospel receiving the107(2) exemption because they too receive a housing allowance from the company they work for.  The only reason they argue that they cannot take advantage of 107(2) is that they are not ministers of the Gospel but executives who are employed by Freedom From Religion. The 7th Circuit rejected this reasoning because there was still no injury to Gaylor and Barker since they had never tried to take advantage of 107(2).  The preachers of the Gospel actual had claimed the exemption, but Gaylor and Barker did not.  Being similarly situated is simply not enough to give standing opines Judge Flaum.

Finally, Gaylor and Barker argue as they did successfully before the District Court that for the 7th Circuit to require Gaylor and Barker to “claim the exemption” and wait for the IRS to deny their claim would serve no useful purpose and only delay the inevitable outcome in the case citing:  Freedom from Religion Foundation, Inc. v. Lew, 983 F. Supp. 2d 1051, 1055–56 (W.D. Wis. 2013).  The 7th Circuit however disagreed with District Court concluding that the US Constitution does not allow Federal Courts to hear suits filed by plaintiffs who lack standing, and standing is absent here with Gaylor and Barker because they have not been personally denied the parsonage allowance.  Finally, because the Plaintiffs did not have standing to challenge the parsonage exemption, the 7th Circuit, remanded the case back to Judge Grabb instructing her to dismiss the complaint for lack of jurisdiction,.

So what does this mean for all you Preachers of the Gospel out there? Since there has not yet been an Appeals Court ruling on the merits of this case, you can be sure there will be further attempts by Freedom From Religion type organizations to have the Parsonage Exemption ruled unconstituational.   Until then, please have your tax attorney continue to exclude your parsonage allowances from your taxable income under IRS Code 107 with written contemporaneous explanations included in your personal tax return before your file with reference to the ongoing Constitutional issues.  Finally as these cases ultimately wind their way up to US Supreme Court for a final Constitutional determination enjoy the tax free benefit under IRS Code Section 107(1) and 107(2) in my view you so rightfully deserve as  preachers of the Gospel.  God bless you all. Thanks for joining us on TaxView with Chris Moss CPA Tax Attorney

See you next time on TaxView

Kindest regards

Chris Moss CPA Tax Attorney

by Chris Moss CPA

Welcome to TaxView with Chris Moss CPA Tax Attorney

Many large public businesses have their corporate operations legally headquartered offshore.  For example Apple, General Electric, Pfizer, IBM, and Merck have offshore operations legally sheltering billions of dollars from US income taxation.   However, if any of you individuals or small business owners out there are ever approached with a too good to be true personal tax savings arrangement that involves offshore investing or business operations that result in you personally saving taxes on your From 1040 get a second opinion before you invest in and activate such a scheme.  Once the scheme is discovered by the Government action is immediate and devastating to the promoter of the shelter.  Unfortunately in many cases you the taxpayer/victim are accused of tax fraud as well resulting in severe civil fraud penalties in addition to all the additional income tax you owe.  So if you have money offshore right now or are thinking about a plan that purportedly legally allows you to send money offshore, please stay with us here on TaxView with Chris Moss CPA Tax Attorney to give you a fair warning that such schemes lead nowhere but to large civil fraud penalties and in some cases criminal Government tax investigations.

Big and small business have always been able to operate abroad and save taxes.  But owners of closely held businesses are not legally able to take advantage of these provisions.  In fact Americans are taxed on worldwide income regardless of whether or not the funds are deposited to a foreign bank in a tax free haven. Unfortunately there are many taxpayers out there who don’t know that these schemes are illegal, like Stanley and Ruth Alexander who were in US Tax Court over this very issue in Alexander vs IRS T.C. Memo 2013-203.

The facts are very complex in this 71 page Opinion.  Dr Alexander, a plastic surgeon, used offshore tax strategy to lease back his medical services to his professional Ohio practice.  Alexander met attorney Reiserer from Seattle who reviewed offshore employment leasing with Alexander.  There were numerous doctors who were well versed through seminars in the Bahamas about this strategy. Reiserer and a CPA Kritt “structured, implemented and managed” the offshore strategy for tax year 1996-2003 for Alexander.  In 2003 the IRS initiated a criminal investigation of Kritt.  Kritt was charged with criminal tax evasion, but Kritt was found not guilty by jury of any criminal misconduct.

As a result of the Kritt criminal investigation, Alexander and hundreds of other doctors were audited by the IRS for years 2000-2002 and were accused of substantial understatement of income and tax fraud.  Alexander appealed to US Tax Court in Alexander vs IRS US Tax Court (2013).  Alexander claimed the offshore strategy was to create retirement for his family.  The Government argued that the motivation was avoidance of tax as there was no meaningful economic substance to the strategy.  Judge Goeke on Page 45 of the Opinion opines Alexander relied on Krit and Riserer and Alexander had limited ability to understand the tax law.  As the case unfolds the Court seems to have sympathy for Alexander who “placed a great deal of reliance on Kritt”.  The Court concludes that Alexander did not possess the education that would allow him to know he should have reported additional income”. Page 50.  IRS loses on tax fraud, but IRS wins on understatement.

Our next case involves Dr Child in Child vs IRS T.C. Memo 2010-58.   The facts are relatively simple.  Dennis Evanson designed organized and promoted schemes to shelter income from taxation.  He was ultimately convicted of Federal income tax evasion by a jury in 2008.  All of Evanson’s tax evasion schemes used sham transactions to transfer clients’ untaxed income to offshore entities that Evanson created and controlled.  The funds were typically returned to his clients disguised as disbursements from fictitious loans to avoid taxation.

Dr Child was a highly compensated radiologist who met Evanson at a party.  Evanson helped Child and hundreds of over doctors create a tax evasion scheme which allowed a fictitious offshore insurance company to providing insurance coverage for Child. Premiums were paid and deducted on Child’s tax returns from 1997-2003.  The IRS audited not only disallowing over $280K of deductions but  claimed Child was guilty of tax fraud as the whole scheme was nothing but a tax avoidance sham transaction lacking any economic substance. Child appealed to US Tax Court in Child vs IRS US Tax Court (2010). Judge Kroupa concluded that indeed Child fraudulently intended to evade taxes and this was liable for additional fraud penalties under Section 6663 of the IRS Code which increases the penalty by 75% of the tax owed. IRS wins and Child loses on fraud under IRS Code Section 6663.

If you lose on Fraud you owe additional 75% of the tax owed, a lot of money for most of us.  So why did Child lose on Fraud but not Alexander?   The law says you commit tax fraud if “badges of fraud” are present:  you have inadequate records, you participate in the promoter’s scheme to mislead the Government, you give implausible explanations of behavior to conceal the fraud, you file false documents, and you fail to respond to subpoenas.  Finally you don’t cooperate with the Government. Judge Kroupa in Child argued that “most of the badges of fraud upon which this Court relies were present in Child”. Page 23.   Judge Goeke didn’t feel that way with Alexander and so Alexander did not have to pay the 75% fraud penalty.

In conclusion, if you are a small business owner who attends a seminar on offshore investing schemes, simply say no.  There is no legal tax strategy for individuals and small business owners to keep their offshore earnings from being reported on their personal tax return Form 1040.  Unless you are willing to give up your US Citizenship and leave the country there is simply no legal way to avoid paying personal income taxes by keeping your earnings offshore.  Work within the system to change the tax to perhaps a flat tax or national sales tax, but say no to offshore tax schemes.  You will be happy you did when the IRS comes knocking on your door for an offshore tax audit.

Thank you joining us on TaxView with Chris Moss CPA Tax Attorney.

See you next time on TaxView.

Kindest regards

Chris Moss CPA Tax Attorney