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In Aivatzidis v. Commissioner, T.C. Summary Opinion 2013-105, the U.S. Tax Court concluded that a professional driver could deduct expenses based on mileage, but not for actual expenses. This case provides an example of why drivers should compute car and truck expenses based on mileage if they do not have sufficient records.
The facts and procedural history are as follows:
- Mr. Aivatzidis was a limousine driver.
- Mr. Aivatzidis timely filed a joint federal income tax return for 2009.
- He deducted $16,992 of business car and truck expenses and $5,567 as repair and maintenance expenses for his limousine driver business on his on Schedule C.
- He also deducted $20,099 of unreimbursed employee business expenses on Schedule A.
- The IRS audited Mr. Aivatzdis’ 2009 federal income tax return.
- The IRS accepted all of the business car and truck expenses ($16,992) and a portion of the reimbursed employee business expenses ($3,257), but none of the $5,567 repair and maintenance expenses.
The IRS accepted the business car and truck expenses as determined by Mr. Aivatzidis. These expenses were for the SUV that Mr. Aivatzidis used in his limo business. The IRS accepted the amount of this deduction as Mr. Aivatzidis computed the deduction based on mileage rather than actual expenses. The law allows taxpayers to use a standard mileage rate as established by the IRS in lieu of substantiating actual expenses for the business use of a passenger automobile.
The $5,567 vehicle repair expenses were for a town car in Mr. Aivatzidis’ limo business. The costs were to repair the town car after it was involved in two accidents. Mr. Aivatizidis did not compute the deduction for the town car based on mileage, as he did with the SUV. The court concluded that Mr. Aivatizidis did not provide any substantiation for any automobile repair or maintenance expense paid in 2009 or that he even owned the town car. As such, the court disallowed the vehicle repair expenses.
In Brown v. Commissioner, T.C. Memo. 2013-275, the U.S. Tax Court denied an insurance salesman’s bonus depreciation deduction for his private jet as it was not placed in service in the tax year. The case highlights the highly factual nature of determining when an asset is deemed to have been placed in service for tax depreciation purposes.
- The facts and procedural history are as follows:
- Mr. Brown was in the insurance business.
- He focused on selling life insurance policies worth more than $10 million, having sold several insurance policies worth $300 million.
- Mr. Brown had to constantly prospect for clients given the high-end market he focused on.
- Mr. Brown needed to be able to travel to multiple states in a single day.
- He was not able to use chartered airplanes as they were too unreliable.
- His first private jet was not satisfactory as it could not travel across the U.S. without refueling.
- Mr. Brown searched for an airplane that could travel longer distances without refueling.
- Mr. Brown signed a contract to buy a Challenger airplane in December of 2003, which required delivery of the jet that month.
- Mr. Brown made make it clear that he needed to have the airplane delivered in December of 2003 to take advantage of the favorable bonus depreciation tax rules.
- Mr. Brown also had several modifications made to the airplane, including replacing chairs with a conference table and replacing the standard 17-inch display screens with 20-inch screens so he could display power point presentations.
- Mr. Brown and the seller agreed that Mr. Brown would take delivery of the airplane before the end of the year and the plane would return to the seller on January 5 or 6 of the next year–which was the following month–to start the modifications.
- Mr. Brown signed the closing documents and accepted delivery of the Challenger on December 30th.
- Mr. Brown reported the airplane on his 2003 income tax returns and claimed almost $11.2 million of bonus depreciation for it.
Congress added the bonus depreciation rules to stimulate the economy. To qualify under these rules, the Challenger must have been both qualified property and qualified property that was acquired and placed in service that year.
The IRS disallowed the bonus depreciation deduction, asserting that the airplane was not placed in service in 2003.
Mr. Brown argued that he had not only taken delivery of the airplane in 2003, he had used it in his business. Mr. Brown testified in court to say that after fueling the plane around noon, a pilot certified to fly the Challenger flew Mr. Brown and his aviation attorney from Portland to Seattle, landing just before 1 p.m. He flew there to have a business lunch with a real-estate developer to whom he had sold a large insurance policy earlier in the year, and a couple that the developer wanted to introduce to him as potential clients.
Mr. Brown also introduced a letter from the real estate developer that seemed to confirm these details.
The IRS referred to these end-of-year trips as “tax trips,” suggesting that Mr. Brown and his tax attorneys had a plan to arrange the trips so Mr. Brown could qualify for the first year bonus depreciation deduction in 2003.
The tax court had this to say about Mr. Brown’s testimony and letter:
[W]e sense something doesn’t smell quite right with the whole Seattle visit. First, Brown’s testimony didn’t jibe with the flight logs he submitted at audit. Although Brown said his lunch meeting lasted between 90 minutes and two hours, the flight logs show that the Challenger was on the ground in Seattle for only 66 minutes. With respect to the timeframe, we find the flights logs submitted at audit more credible than Brown’s testimony.
We also give zero credence to the letter. Brown acknowledged that the letter was neither contemporaneous nor even prepared by Mastro. He admitted his CFO/CPA, Gary Fitzgerald, drafted the letter sometime much later and had Mastro sign it. Although at one point Brown said he thought he had told Fitzgerald to write the letter “several months” after year end, we find more credible his later testimony that one of Fitzgerald’s jobs is to write letters on behalf of Brown’s business associates “to get the substantiation for deductions when the IRS requests them.” (Emphasis added.) We therefore find that Fitzgerald didn’t write this letter until at least 2006 when the IRS began auditing Brown’s return for the 2003 tax year. We do not take it seriously as proof of anything but a reason to question Brown’s credibility.
And that leaves us with only Brown’s uncorroborated testimony about his lunch in Seattle. Brown didn’t produce a lunch bill, and neither Mastro nor the unknown couple testified on his behalf. We also find noteworthy that Schneider–who was on board the Challenger from Portland to Seattle (but not on any of the other flights discussed below)–worked at a law firm just outside of Seattle. We therefore find it more likely than not that there was no business lunch in Seattle.
In considering the issue, the court rejected the IRS’s argument that the airplane was in construction as the modifications were not complete, such that it was not fit for commercial flight.
The court concluded that the airplane was not ready and available for its specifically assigned functions for Mr. Brown, as Mr. Brown had testified that they were required for his business.
The court also noted that: “Just because a taxpayer uses an asset in his business sometime during the course of a year doesn’t necessarily mean that he placed it in service that year. Consumers Power tells us instead that the asset needs to be available on a regular basis for its specifically assigned function.”
Because the airplane did not meet this standard, the court concluded that the airplane was not placed in service in 2003 and it denied Mr. Brown’s bonus depreciation deduction.
In Zumo v. Commissioner, T.C. Summary Opinion 2013-66, the U.S. Tax Court concluded that the IRS was correct in rejecting an offer in compromise based on doubt as to collectibility. The case provides a good overview of the IRS collection process and how the IRS evaluates offers in compromise.
The facts and procedural history are as follows:
- Dr. Zumo was a neurologist.
- The income from his practice has been declining because of a reduction in both patient volume and medical insurance reimbursements.
- Dr. Zumo owned their primary residence and thirteen rental properties.
- Dr. Zumo’s residence was severely damaged by fire and the rental properties did not yield significant net income.
- Dr. Zumo also owned a liquor store which was operated from the first floor of the property in which he resided and he received royalties from a book he wrote.
- Dr. Zumo was married and had a two children.
- Dr. Zumo filed federal income tax returns for tax years 2007, 2008, 2009, and 2010, but did not pay the tax reported on these returns.
- The tax totaled nearly $67,000 and the penalties totaled nearly $11,000.
- The IRS mailed Dr. Zumo a Letter 3172, Notice of Federal Tax Lien Filing and Your Right to a Hearing Under IRC 6320, advising him that the IRS was going to file a notice of Federal tax lien on October 12, 2011, to collect unpaid liabilities for taxable years 2007, 2008, 2009, and 2010.
- Dr. Zumo submitted a Form 12153, Request for a Collection Due Process or Equivalent Hearing (section 6330 hearing), and a Form 656, Offer in Compromise, for 2007, 2008, 2009, and 2010 based on doubt as to full collectibility of the taxes. He offered $10,000 to settle his tax obligations.
- The offer was evaluated by the IRS Office of Appeals.
Dr. Zumo submitted a Form 433-A, Collection Statement for Wage Earners and Self-Employed Individuals, which reflected $9,000 of monthly income $8,850 of monthly living expenses, leaving $150 of disposable monthly income.
Appeals accepted the $9,000 in monthly income, but determined that Dr. Zumo’s allowable monthly expenses were $6,276, leaving a disposable monthly income of $2,724. Appeals reached this conclusion by:
- Increasing Dr. Zumo’s housing expense by $550, as Dr. Zumo had reported $900 and the national standard expense for a four-person family was $1,450 per month.
- Reducing Dr. Zumo’s expenses for two automobiles, public transportation, out-of-pocket healthcare expenses, and total healthcare expenses.
- Disallowing Dr. Zuma’s $500 reported child care expenses given that Dr. Zuma’s wife was a stay-at-home parent.
Appeals also determined that Dr. Zumo had overstated the fair market values of his assets. Appeals ultimately determined that the aggregate fair market value of the assets was $1,000,881 and the assets had an “appeals equity value” of $36,500. Appeals equity value is an asset’s fair market value reduced by 20% of its fair market value and then reduced again by all encumbrances.
Appeals rejected Dr. Zumo’s offer-in-compromise, determining that the tax collection potential was more than the $10,000 petitioner proposed and that he could satisfy his income tax obligations by paying monthly installments.
The IRS offered Dr. Zumo the option of paying either installments of $700 per month over a period of 72 months or installments of $550 per month over the remaining collection period. These amounts are significantly less than the $77,000 tax and penalties that were owed (and this does not even factor in any interest that would be due).
Dr. Zumo tentatively agreed to the $700 a month terms, but eventually declined the offer after the IRS refused to remove the federal tax lien so he could refinance his rental properties. Dr. Zumo then petitioned the U.S. Tax Court, which sustained the IRS’s position. Thus, Dr. Zumo was back to the start of the IRS collections process. Presumably he entered into another installment agreement with the IRS, paid the taxes by selling his properties or with other income or assets, or submitted another offer in compromise.
In AM 20133301F, the IRS addressed the validity of a closing agreement that was not submitted to the Joint Committee on Taxation or JCT for review prior to signing the agreement.
- The facts in the ruling were as follows:
- The taxpayer was an insurance company whose tax returns were being audited by the IRS.
- The IRS and taxpayer asked the IRS Office of Appeals (“Appeals”) to settle an issue related to the taxpayer’s reserves.
- The taxpayer and Appeals reached a settlement agreement and formalized the agreement via a closing agreement.
- The Appeals team manager and team case leader and the taxpayer signed the closing agreement and did not submit the agreement for review by the JCT.
- The taxpayer also filed a tentative carryback claim and the IRS made adjustments for the audit year, which, when combined the the settlement agreement, resulted in a tax refund in excess of $2 million.
- Both the IRS and the taxpayer desired to keep the closing agreement in place, but questioned whether the agreement was valid.
The question addressed in the IRS memo is whether the closing agreement is valid even though it was not reviewed by the JCT.
The IRS is required to provide a report to the JCT for any refund in excess of $2 million to Subchapter C corporations prior to paying the refund. This requirement is set out in the tax code. This report helps ensure that Congress is aware of what large refunds are being issued and why they are being issued.
On the other hand, Appeals has the authority to sign closing agreements. This is authorized in the delegation orders that govern how the IRS operates.
In considering these rules, the IRS determined that:
In our opinion, the closing agreement was within the Appeals Officer’s settlement jurisdiction and his signature is therefore valid to bind the Service to that agreement. In accordance with the above citations, an Appeals Team Case Leader has authority delegated to him to sign closing agreements in settlements reached in a fast-track mediation. Although the settlement at issue here was statutorily required to be submitted to the JC for its review prior to signing the closing agreement, the failure of the ATCL to submit the agreement for review by the JC does not strip the ATCL of signing authority.
Thus, the IRS concluded that it would not issue the refund in question before the JCT reviewed the closing agreement.
The IRS released a memo to implement policy changes for how the IRS Office of Appeals (Appeals) handles cases. The memo describes these changes as the Appeals Judicial Approach Culture (AJAC) project. These policies do not really break new ground, but they address a few key issues that are often in dispute in appeals cases.
One such issue is whether Appeals can raise new issues. Currently, prior to this memo, the rule is that appeals officers do not raise new issues unless they are material and they have manager approval. As a practical matter, most appeals officers simply make it their policy not to raise new issues under the current rules. This is supported by the Appeals mission to be independent and impartial.
Most appeals officers believe this to be the rule. However, there are a few appeals officers who do not view the rule as being mandatory in all cases. This normally comes up when the appeals officer has a strong feeling that the taxpayer should not prevail given the facts, circumstances, or law and needs a basis to support his or her action in the case.
The memo changes this by making it clear that appeals officers are not to raise new issues. Similarly, it goes on to say that appeals will not re-open issues that the IRS audit function and the taxpayer had previously agreed to.
It is important to note that this rule does not apply to issues raised by taxpayers. Taxpayers are free to raise new issues. Also, the memo generally does not apply to collection cases in Appeals.
The new procedures are effective July 18.
In Heinbockel v. Commissioner, T.C. Memo. 2013-125, the U.S. Tax Court considered a routine substantiation case and disallowed business expense deductions for a fashion clothing retailer. This case presents an opportunity to consider how to present routine substantiation cases to the IRS and to the courts.
The facts and procedural history are as follows:
- Mrs. Heinbockel was in the fashion industry.
- She was an accomplished model from her late teens to her late twenties.
- She started in business as an LA sales rep for Pierre Fabre, a French pharmaceutical company with a cosmetics line.
In 1997-1998, she got married and bought a home in San Luis Obispo.
- Mrs. Heinbockel was well aware that her new home was far away from the big cities that she enjoyed, but she sensed an opportunity in the dearth of quality clothing that she saw there.
- Mrs. Heinbockel created Lydia’s World (also known as Lydia’s Personal Shopping Services) offering designer lines with a personal touch to “very upscale women.”
- She would buy (or obtain on consignment) clothes from about a dozen internationally known designers, and bring those collections to trunk shows that she advertised in email invites.
- She had no storefront, but started with three trunk shows a year that lasted a week or two each (spring, fall, and holiday), and soon the business expanded into an “all-year-round, all-the-time business” where she would hold trunk shows at various times throughout the year in many of her clients’ homes.
- During any given in-home show, Mrs. Heinbockel would spend a few hours with “two or three girlfriends” personally outfitting them, while treating them to champagne and appetizers.
- Mrs. Heinbockel ability to market her brands to a loyal customer base brought in gross sales of between $65,000 and $135,000 during 2005 through 2007.
The business expense deductions for Lyndia’s World were at issue in the case. The court described the issue as follows: “The disputes over some of the expenses are nothing more than routine substantiation.” The court went on to disallow the taxpayer’s business deductions.
The IRS proposes adjustments in tens of thousands of audits just like this one. The U.S. Tax Court has considered hundreds, if not thousands, of cases just like this one. Many of the cases with this issue are not decided in the taxpayer’s favor.
The raises the question as to how “routine substantiation” issues can be presented persuasively, with the aim of being one of the few cases in which the deductions are allowed on audit or in court. This article provides a few pointers.
Focus on presenting the case in a different or novel way
From the IRS audit and the court’s perspective, generally, much of the work of the government is this type of repetitive ho-hum work that just has to be done. Routine substantiation tax cases fall into this category.
To make the case interesting or at least more challenging for the government to dispose of unfavorably on audit or in court, the issue should be presented as different or novel. There are a number of ways to do this.
For example, you may be able to find recent court case opinions (preferably from the same court and judge) that have less favorable or pro-government facts. The less favorable or pro-government position the better. Then you can use those cases as the basis for arguing that your records, facts, etc. are better than the other cases and, as such, your deductions should be allowed.
Another example would be finding a way to categorize or describe the expense that is different while still being a correct description. For example, a dress that is purchased and worn for work but could also be worn outside of work, might be described as a uniform, a prototype, inventory, etc. Thus, the argument for this uniform, prototype, inventory, etc. was sufficiently different than the dresses in the other cases in which the court had previously disallowed the expense deductions.
Focus on presenting the records
With substantiation cases, it is important to focus on the records and what was known at the time the expense was incurred and what the records actually say.
This is particularly important when presenting testimonial evidence where the records are incomplete. The focus should be on what was known at the time. The testimonial evidence should be corroborated by records.
It should not be presented the other way around–i.e, that you found some record that is not entirely sufficient (as it is incomplete in some way) and it jogs your memory. This presentation is not as strong. It raises doubts as to whether the records are sufficient and whether your memory is correct.
When presenting documentary evidence, the details matter. Pointing out that dates, transaction codes that have some meaning (even if they are cryptic and require explanation), or the order or completeness of the records helps. These details are often overlooked or forgotten if not pointed out. This also entails finding and submitting the best records possible.
For example, a monthly credit card statement is different than the online version of the same record from the credit card company website that auto categorizes expenses, as these categories add a contemporaneous description in the record. This detailed credit card records with descriptions can be categorized as being more than merely presenting a monthly credit card statement. They are detailed credit card records with contemporaneous descriptions. Similarly, a single monthly bank statement is not just a bank statement when it is presented for every month in the tax year–it is a complete set of bank records.
These facts and descriptions should be pointed out every time the records are described–even though repeating this may be awkward or seem forced.
We help clients in Westminster, Colorado with state and federal tax planning, tax controversy, and tax return matters. Our goal is to reduce the confusion, time, and stress associated with IRS and state tax matters.
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