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Court Addresses IRS Audit Adjustments that are Really Accounting Method Changes
Given the potential for the adjustments to trigger extremely large tax liabilities, accounting method changes made by the IRS on audit can be doomsday scenarios for unwary taxpayers. In Nebeker v. Commissioner, T.C. Memo. 2016-155, the court addressed a common situation where the IRS makes an adjustment on audit that is an accounting method, but it does not follow the accounting method change rules.
The facts and procedural history in Nebeker are as follows:
- The taxpayer operated a Schedule C business that provided project management consulting primarily for aerospace and defense companies.
- The taxpayer employed a number of independent contractors who provided services to his clients.
- The taxpayer paid his independent contractors every two weeks for labor and travel expenses they incurred, regardless of whether the his clients had paid the invoices associated with the subcontractors’ labor and expenses. The taxpayer would then invoice and collect on the invoices at a later time.
- Beginning in 2004 and running through 2009, the taxpayer claimed the income tax deduction for outside labor associated with payments made to his contractors for the year in which the he received payment for the contractor expense, regardless of whether he paid the subcontractor in a prior year.
- So the taxpayer deducted $1,373,309 and $392,210 for 2006 and 2009, respectively, even though he only paid $1,087,551.72 and $180,665.62.
- The IRS audited the tax returns and proposed to disallow the difference between the amount deducted and paid in each year.
Accounting method changes are timing issues. They include changes in the overall plan of accounting for gross income or deductions or changes in the treatment of any material item used in such overall plan.
They usually require the taxpayer (or the IRS, if the IRS is making the change) to make a catch-up adjustment in the current year to account for the treatment of the item in prior years.
Accounting method changes can result in either favorable adjustments that result in a reduction of taxes in the current year or unfavorable adjustments that increase the amount of tax in the current year. The adjustments are usually quite large if they change the tax treatment for several years or for several decades.
For example, a taxpayer who changes their method of accounting for depreciation on a building that has been held for a number of years may be able to make a catch-up adjustment in the current year to account for depreciation that was not taken in the prior years. This can result in the taxpayer being entitled to a large depreciation deduction in the current year. This adjustment can reduce the taxpayer’s tax liability in the current year by allowing the missed depreciation deductions from the prior year to all be taken in the current year.
In Nebeker, the IRS only disallowed the taxpayer’s 2006 and 2009 deductions. It did not make a catch-up adjustment in 2006 to account for the same items in the 2004 and 2005 tax years.
The court concluded that the IRS’s audit adjustments were in fact an accounting method change. As noted by the court, this requires a catch-up adjustment in 2006. The court did not provide the facts to say with any certainty, but it would seem like this adjustment would essentially nullify the IRS’s adjustments in 2006 and 2009.
Duty of Consistency in Suit to Collect Unpaid Taxes
Many tax cases are won or lost based on tax procedure issues. The U.S. v. Holmes, Civil Action No. 4:15-cv-00626 (S.D. Texas 2016), case serves as a reminder of this. The case involved a lawsuit filed by the government in the eleventh hour and the duty of consistency doctrine.
The Holmes case involved an estate tax return filed for the 1997 tax year. The IRS assessed the tax in July of 2004. The IRS did not make any effort to collect the tax liability until 2013–nine years after the tax was assessed by the IRS.
The taxpayer submitted a Form 12153 to the IRS on October 5, 2013, to request a Collection Due Process (“CDP”) hearing. The IRS lost the CDP hearing request due to the federal government shutdown from October 1, 2013 to October 16, 2013. The taxpayer then sent a letter to the IRS on June 2, 2014, to withdraw its request for a CDP hearing. The government then brought suit to collect the tax on March 10, 2015–more than ten years after the tax was assessed by the IRS.
The dispute in the case was whether the IRS’s lawsuit was timely filed. The IRS generally has ten years from the date a tax is assessed to bring suit to try to collect the tax. This time period is extended when the IRS receives the taxpayer’s request for a CDP hearing. This extended time period ends when the IRS receives the taxpayer’s written request to withdraw the CDP hearing request or the IRS issues a Notice of Determination in the CDP hearing.
Since the IRS lost the October 5, 2013 CDP hearing request, the taxpayer argued that the request was not received by the IRS until the taxpayer re-submitted the prior request to the IRS on May 2, 2014. So the taxpayer was arguing that the CDP hearing request only extended the ten year time to file suit by one month–from May to June of 2014. This would mean that the government’s time for filing suit expired in 2014 and the lawsuit was not timely filed.
The court did not agree. It applied the consistency doctrine, which it described as follows:
The elements of the duty of consistency are: (1) a representation or report by the taxpayer; (2) on which the Commission has relied; and (3) an attempt by the taxpayer after the statute of limitations has run to change the previous representation or to recharacterize the situation in such a way as to harm the Commissioner.” Herrington v. C.I.R., 854 F.2d 755, 758 (5th Cir. 1988). “If this test is met, the Commissioner may act as if the previous representation, on which he relied, continued to be true, even if it is not. The taxpayer is estopped to assert the contrary.” Id.
The court dismissed the taxpayer’s argument that the duty of consistency only applies to situations where a taxpayer adopts a factual representation for one tax year and adopts a different factual representation for a different tax year. The court said that the duty of consistency doctrine applies in cases where a taxpayer has taken one position, garnering a tax benefit over many years, and attempts to change its position to garner another benefit.
The court said that the taxpayer had “garnered the benefit of avoiding the tax deficiency for many years, and now change their factual representation in an attempt to garner a judicial shield of protection from liability.”
The court noted that the taxpayer had “aggressively demanded a CDP hearing” with the IRS by writing a letter to the IRS that noted that its original CDP hearing request had in fact been received by the IRS timely. According to the court, the IRS relied on this letter and treated the hearing as a CDP hearing. Thus, the court concluded that the taxpayers were precluded from arguing that the CDP hearing request was not received by the IRS timely. This lead the court to the conclusion that the time the government had to file suit was extended by the CDP hearing request and this extension was sufficient to make the lawsuit filing timely.
This case serves as a reminder that taxpayers should be wary of filing CDP hearing requests when the ten collection statute is about to expire. When they do submit these requests, if they are not going to litigate the CDP hearing if it is not successful, taxpayers should be ready to submit a written request to the IRS to withdraw the CDP hearing as soon as they have a sufficient basis to believe that the outcome will not be favorable. This will help minimize the time that the collection statute is extended.
Checkout the Facts Needed to Abate Penalties Based on Reasonable Cause
Taxpayers often contest penalties by arguing that their failures were due to reasonable cause. Many of these penalty abatement requests are resolved at the administrative level. The cases that end up being litigated typically do not have the best facts and, as a result, the case law in this area is not favorable to taxpayers. This is what makes the Rogers v. Commissioner, T.C. Memo. 2016-152, case noteworthy.
The court in Rogers concluded that failure to file and pay penalties should not be imposed because the taxpayer’s failures were due to reasonable cause. The court described the facts as follows:
Petitioner’s life was in a state of upheaval after the second fire [in her apartment] and through the period when the return was due. She was barred from reoccupying her apartment and, during the times relevant to the 2009 return, she was living under conditions she found to be dehumanizing at a YWCA; later, she experienced bouts of depression, a fall from a subway platform in 2009, and a skull fracture. She was subject to continuous monitoring and psychiatric examination while hospitalized. She did not resume conduct of the business she had operated from her apartment.
Even a cursory review of the prior case law shows that these facts alone are not sufficient to establish reasonable cause.
While these facts are not sufficient standing on their own, they may be sufficient when coupled with a legitimate argument explaining that the taxpayer did not have a tax filing or payment obligation.
In Rogers, the taxpayer believed that she was entitled to a casualty loss deduction in 2009 that the loss was sufficiently large that she would not have to file a tax return or owe a tax liability in 2009.
The deduction in question related to the fire in her apartment. The general rule is that taxpayers are entitled to the casualty loss deduction in the year it is incurred, unless there is a reasonable prospect of recovery or reimbursement for the loss in a later year. If there is a reasonable prospect of recovery in a later year, the loss is not deductible until the later year.
The taxpayer in Rogers explained that she believed that she was not entitled to deduct the loss in 2007–when the loss was sustained–as she had an ongoing claim with the insurance company for the loss. The taxpayer thought the loss was deductible in the year in which she finally settled her claim for the loss with the insurance company in 2009. The court does not address all of the facts related to this underlying issue, but the taxpayer may very well have been correct that the loss was allowable in 2009 and not in 2007.
Given this uncertainty as to the timing of the loss, the court factored this in with the facts surrounding her life circumstances to conclude that she acted with reasonable cause.
This holding is consistent with our experience in working penalty abatement claims at the administrative level. The IRS generally does allow penalty abatement requests for failure to file and pay penalties when there are circumstances, even those that are less extreme than those in the Rogers case, when the circumstances are coupled with a legitimate explanation as to why it was reasonable for the taxpayer to not have timely filed or paid. This extra explanation is often what differentiates a penalty abatement request that will be allowed by the IRS and one that will not.
The Start-Up Expense Limitation: Starting a Business in Retirement
There are several occupations where highly skilled individuals are forced to retire due to mandatory retirement provisions. These individuals often use their skills to start new businesses during retirement. The court addressed this situation in Tizard v. Commissioner, T.C. Summary 2016-42. The case provides an example of how to avoid having business losses from the first year disallowed as start-up expenses.
Facts & Procedural History
The facts and procedural history are as follows:
- The taxpayer was an accomplished pilot.
- She served as a pilot in the U.S. Air Force and a commercial pilot for United for several years.
- United requires pilots to retire at age 65.
- The taxpayer began looking for opportunities to earn additional income in retirement.
- She decided to purchase a military training aircraft and start an aviation business in Arizona.
- She purchased a Slingsby T-67C “Firefly” military training aircraft for $52,000 in late 2010.
- The taxpayer reported her United wages and a $$13,295 loss for her airline business.
- The IRS conducted an audit and concluded that the taxpayer’s $$13,295 loss was not allowable because she was not engaged in a trade or business in 2010.
Start-Up or Pre-Opening Expenses
Ordinary and necessary business expenses are generally deductible. Section 195 provides an exception for start-up or pre-opening expenses. Start-up business activities include:
- investigating the creation or acquisition of an active trade or business,
- creating an active trade or business, or
- any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.
Factors Indicating a Trade or Business Had Started
There are a number of factors that the courts consider in determining whether a trade or business has started for tax purposes.
One of the primary factors that tends to indicate that a business had not yet started is whether the business earned any revenues. This is the best evidence that the business was no longer a start-up.
In Tizard, the taxpayer’s business did not earn any revenues in 2010.
Advertising and Solicitations
Absent revenues, it is helpful if the business was holding itself out to the public as an ongoing business. This could include advertisements, active solicitations, etc. Taxpayers who are able to make this showing are generally successful in persuading the IRS or the courts that the start-up rules do not apply.
In Tizard, the taxpayer was only able to point to a conversation she had with the person who sold her her plane (who suggested that he may hire her) and a Facebook page with a photograph of her plane and no mention of her service offerings.
Evidence of a Business Plan
Absent this type of proof, it can also be helpful if there are other indications that the expenses were not incurred for a hobby. This would include evidence that there was some business plan and a reasonable prospect that the business could actually earn a profit. The court cases are mixed for taxpayers who are able to make this showing.
The taxpayer in Tizard was able to make these showings. She had a business plan. She was also able to articulate a seemingly reasonable plan for how her business could earn a profit. The court concluded that this evidence was not sufficient to convince the court to conclude that a business had started in 2010.
Start-Up Expense Election
Taxpayers can also make an election to deduct up to $5,000 of start-up expenses in the current year and to deduct the remaining expenses over a 180-month period. This election has to be made on a timely-filed tax return.
Had the taxpayer made this election in Tizard, she would have been able to deduct most of her start-up loss in the first year. This would have allowed the loss to offset her wages from her job as a pilot for United before she retired.
Military Tax Rights under the SCRA
Judicial and administrative proceedings are temporarily suspended for those serving in the United States military. This includes a temporary hold on IRS collection actions. These laws are not provided in the Tax Code. Rather, they are set out in the Servicemembers Civil Relief Act or SCRA.
Military Tax Rights Under the SCRA
Section 570 of the SCRA addresses state and federal income taxes. Specifically, it addresses the collection of income taxes, the time for collecting income taxes, and the accrual of penalties and interest.
IRS and State Tax Collections
With respect to the collection of these taxes by the IRS or state governments, the act says that:
Upon notice to the Internal Revenue Service or the tax authority of a State or a political subdivision of a State, the collection of income tax on the income of a servicemember falling due before or during military service shall be deferred for a period not more than 180 days after termination of or release from military service, if a servicemember’s ability to pay such income tax is materially affected by military service.
The term “materially affected” means that the taxpayer’s current monthly income (military income) is less than the monthly income immediately prior to active duty. Their ability to pay the balance due is deemed to be “materially affected” by reason of active military status.
IRS and State Tax Collection Statutes
With respect to the time to for the IRS and state governments to collect tax, the act provides that:
The running of a statute of limitations against the collection of tax deferred under this section, by seizure or otherwise, shall be suspended for the period of military service of the servicemember and for an additional period of 270 days thereafter.
IRS and State Tax Penalties and Interest
With respect to the accrual of interest and penalties, the act says that:
No penalty or interest shall accrue for the period of deferment by reason of nonpayment on any amount of tax deferred under this section.
Thus to sum up the rights under the SCRA, upon application by the taxpayer, collection may be deferred during the taxpayer’s period of military service and up to 180 days afterward. Interest and penalties do not accrue during this period. The running of a statute of limitations against the collection of tax is suspended for the period of military service plus 270 days thereafter.
It should also be noted that if the taxpayer is not eligible for deferment, he is entitled to a reduction in the interest rate to 6% (unless the applicable interest rate is below 6%) on the tax liabilities arising before he entered military service.
Who Does the SCRA Cover?
The SCRA does not cover everyone who is associated with the military. The SCRA only covers:
- active duty members of the Army, Navy, Air Force, Marine Corps, or Coast Guard,
- members of the National Guard who are under a call to active duty for more than thirty consecutive days,and
- commissioned officer of the Public Health Service or the National Oceanic and Atmospheric Administration on active service.
It also covers these servicemembers who are absent from duty on account of sickness, wounds, leave, or other lawful cause.
Quotes: The IRS Does Not Have to Be Consistent
Mortgage Interest Deductions for Unmarried Couples
In Voss v. Commissioner, 796 F.3d 1051 (9th Cir. 2015), the court addressed the rule that limits the deductibility of interest on home mortgages and home equity loans. This rule limits the amount of interest that can be deducted on mortgages in excess of $1 million and home equity loans in excess of $100 thousand.
In Voss, the issue was whether these limitations were applied on a property-by-property basis or on a taxpayer-by-taxpayer basis. The taxpayer was not married. His domestic partner, was a co-owner of the property and was jointly and severally liable for the mortgage debt on the property at issue in the case.
The IRS conducted an audit and concluded that the limitations applied on a property-by-property basis. The U.S. Tax Court agreed with the IRS. So according to IRS and the U.S. Tax Court, the taxpayer and his domestic partner were not able to both deduct the full amount of interest.
On appeal, the Ninth Circuit Court of Appeals concluded that the limit applies on a taxpayer-by-taxpayer basis. According to the Ninth Circuit Court of Appeals, since Voss and his domestic partner were not married, they were separate taxpayers and were each entitled to deduct the full amount of interest for the same property.
It was not clear whether the IRS would continue to challenge this issue, particularly for taxpayers who are not within the Ninth Circuit’s jurisdiction. The IRS recently issued AOD 2016-13 to put taxpayers on notice that it will follow the Ninth Circuit’s decision in Voss. So taxpayers can now rely on Voss.
It should be noted that Voss does not apply to married taxpayers that file separate tax returns. The limitation rule cuts the amount of the allowable home mortgage interest deduction in half for married taxpayers who file separate tax returns. The Ninth Circuit relied on this reduced amount–or the absence of a similar reduction for unmarried co-owners of property–in reaching its decision in Voss.