How I Saved A Client Over $20,000 And Got The IRS To Pay For It

It is always stressful to receive a notice from the IRS.  It is far more stressful if the IRS is assessing you over $20,000 for additional taxes and penalties.  This was the situation of one client who I assisted a few months ago.

Image from forbes.com

This individual, who for the sake of her privacy I will refer to as X, had always prepared her own tax returns as she only had a W-2, some interest and dividends, and the occasional stock sale.  However, in early 2015 she received a Notice from the IRS that she owed over $20,000 of additional taxes and penalties relating to her 2012 income tax return.

She initially tried to resolve the issue with the IRS herself, but unfortunately did not get any positive results.  She then talked to a CPA who referred her to me.

I quickly discovered that she inadvertently did not report several stock sales in 2012.  The IRS knew the amount of proceeds she received from the transactions because of 1099s that were filed, but they did not know her basis (what she paid for the stocks in the first place).  The IRS took the position that X had no basis in the stock, and that the proceeds were 100% taxable gain.  This of course was not the case.

I worked with X and her financial advisor, and we discovered that X's basis in the stock was greater than her proceeds (she sold the stock at a loss).  I presented this information to the IRS, and prepared amended tax returns for 2012 and all the years subsequent to claim her newly discovered capital losses.

When everything was done, not only did X no longer "owe" the IRS over $20,000, but they owed her money.

If you have received a Notice from the IRS and would like to discuss it, please feel free to send me an e-mail.

The IRS's New Repair Regulations: Part 3

In the last few posts, we have discussed the new IRS repair regulations and the first safe harbor to these new regulations, the de minimis safe harbor.

In this blog, we will discuss another safe harbor to the new IRS repair regulations, the small taxpayers safe harbor.

Under this safe harbor, a qualifying taxpayer may expense the repairs, maintenance, improvements, and similar activities in the year the expense is incurred, as long as certain conditions are met.

Who counts as a "small taxpayer"?

To be considered a small taxpayer, in this context, you must have annual gross receipts for the 3 preceding years of less than $10 million.

However, if you have been in business for less than 3 years, then you will determine your average annual gross receipts for the number of years, including any short taxable years, that you have been in the business.  For short taxable years, you must annualize the gross receipts.

What buildings are eligible?

In order for a building to qualify under this safe harbor, the original unadjusted basis (i.e., the purchase price of the building) basis must be $1 million or less.  In addition to commercial buildings, single family residences, and multi-family residences, the definition of building includes, condominiums, cooperatives, or leased buildings or leased portions of a building.

What other conditions have to be met?

The aggregate cost of all the repairs, maintenance, improvements, and similar activities cannot exceed the lesser of $10,000 or 2 percent (%) of the unadjusted basis of the building.

This test is applied on a building by building basis.

How are qualifying expenditures treated?

If a taxpayer meets all of the above-listed qualifications, then the amount he/she spends on repairs, maintenance, improvements and other similar activities are able to be deducted that year.

What happens when the expenditures are greater than the safe harbor amount?

Like I mentioned before, the aggregate cost of all the repairs, maintenance, improvements, and similar activities cannot exceed the lesser of $10,000 or 2% of the unadjusted basis of the building. If it does, even by $1, then this safe harbor cannot apply to any of the expenditures related to that building.

How does a taxpayer claim the protection of the de minimis safe harbor?

If a taxpayer wishes to take advantage of the de minimis safe harbor, they must file an election with the IRS by attaching a statement to their timely filed original federal tax return, including extensions, for the taxable year the safe harbor is being claimed.  The statement must include:

• The title "Sec. 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers";
• The taxpayer's name;
• The taxpayer's address;
• The taxpayers identification number; and
• A description of each eligible building property to which the taxpayer is applying the election.

If the taxpayer is a partnership or an S corporation, then the election must be made at the entity level.

Examples of the Small Taxpayer Safe Harbor

Example 1

Adam, a qualifying small taxpayer, owns an office building.  Adam has an unadjusted basis of $850,000 in the building and during 2014 incurs $9,000 of repair, maintenance, improvements, and related expenses.

The building has an unadjusted basis of less than $1 million, so it is a qualifying building.  Similarly, the aggregate expenses of $9,000 is less than $10,000 or 2% of the unadjusted basis of the property ($17,000).  Therefore, if Adam elects to make the safe harbor election for small taxpayers", he may deduct the entire $9,000 in 2014.

Example 2

Barry, a qualifying small taxpayer, is a real estate investor.  He owns 2 rental properties, House A and House B.  House A has an unadjusted basis of $350,000, and House B has an unadjusted basis of $400,000.  In 2014, Barry spends $8,000 in repair, maintenance, improvement, and related expenses on House A.  Similarly, he spends $7,000 in repair, maintenance, improvement, and related expenses on House B.

Both buildings have an unadjusted basis of less than $1 million, so they are both qualifying properties.

While Barry spend less than $10,000 on House A, the $8,000 he did spend is greater than 2% of the unadjusted basis of the property ($7,000) so he is not eligible to make the safe harbor election for small taxpayers for his House A expenditures.

However, Barry is able to make the safe harbor election for small taxpayers for House B.  Barry only spent $7,000 on House B in 2014, which is less than $10,000 and 2% of the unadjusted basis in teh property ($8,000).

If you have any questions about the small taxpayers safe harbor, or about the IRS's new repair regulations in general, please send me an e-mail.

The IRS's New Repair Regulations: Part 2

Anyone who owns a building or business equipment knows that occasionally it is necessary to have some work done to keep it in good condition.  In the last post, we discussed the IRS's new repair regulations and how the IRS is attempted to clarify when a business owner or investor is able to expense a repair and when you are required to capitalize an improvement.  I also explained why many taxpayers would prefer to have the work done classified as a repair.

There are 3 safe harbors listed in the Internal Revenue Code's Regulations that allow a taxpayer to treat the expenditure as a repair.  In this post, we will discuss the first of these, the de minimis safe harbor.

Taxpayers that have a procedure in place to claim property as an expense on its books and records may be entitled to expense either $500 or $5,000 per item depending on whether the company has an applicable financial statement.

What is an "applicable financial statement"?

According to the Internal Revenue Code's Regulation, an applicable financial statement is:

• A financial statement required to be filed with the Securities and Exchange Commission;
• A certified audited financial statement that is accompanied by the report of an independent certified public accountant; or
• A financial statement required to be provided to the federal or a state government or any federal or state agency.

What does the Internal Revenue Code mean by a procedure in place to claim property as an expense on its books or records?

At the beginning of the taxable year, a taxpayer must have a written accounting procedure in place specifying how certain expenditures will be treated.  Essentially, the procedure must specify that expenditures for less than a specified amount or that have an economic useful life of less than 12 months will be treated as an expense on the taxpayer's books.  However, the decision to implement this procedure must be made for non-tax reasons.  In other words, there has to be a rationale for this procedure other than classifying the expenditure as a repair for taxes.

When can taxpayers expense $5,000 per item as a repair?

A taxpayer may expense up to $5,000 per item if:

1. The taxpayer has an applicable financial statement;
2. The taxpayer has at the beginning of the taxable year a written accounting procedure treating as an expense for non-tax purposes amounts paid for property costing less than a specified dollar amount or with an economic useful life of 12 months or less;
3. The taxpayer treats the amount paid for the property as an expense on its applicable financial statement in accordance with its written accounting procedures; and
4. The amount paid for the property does not exceed $5,000 per item.

When can taxpayers expense $500 per items as a repair?

A taxpayer may expense up to $500 per item if:

1. The taxpayer does not have an applicable financial statement;
2. The taxpayer has at the beginning of the taxable year a written accounting procedure treating as an expense for non-tax purposes amounts paid for property costing less than a specified dollar amount or with an economic useful life of 12 months or less;
3. The taxpayer treats the amount paid for the property as an expense on its books and records in accordance with these accounting procedures; and
4. The amount paid for the property does not exceed $500 per item.

What counts as part of the cost of each item?

Taxpayers electing to apply the de minimis safe harbor must include as part of the cost per item all the additional costs (delivery fees, installation fees, etc.) if these additional costs are included on the same invoice as the tangible property.  However, if they are not included on the same invoice as the tangible property they are not required to be included as part of the cost of the item.

How does a taxpayer claim the protection of the de minimis safe harbor?

If a taxpayer wishes to take advantage of the de minimis safe harbor, they must be aware that it is not selectively applied but instead applies to all amounts paid during the taxable year for applicable property.

Taxpayers must file an election with the IRS by attaching a statement to their timely filed original federal tax return, including extensions, for the taxable year the safe harbor is being claimed.  The statement must include:

• The title "Sec. 1.263(a)-1(f) de minimis safe harbor election";
• The taxpayer's name;
• The taxpayer's address;
• The taxpayer's ID number;
• A statement that the taxpayer is making the de minimis safe harbor election under Section 1.263(a)-1(f).

If you have any questions about the de minimis safe harbor election or about the IRS's new repair regulations in general, please send me an e-mail.

The IRS's New Repair Regulations: Part 1

Anyone who owns a house knows that it will periodically require work to keep it in good condition.  This work can often end up being very expensive.

The IRS allows business owners and investors to deduct as a business/investment expense the full cost of this work if it determines that it is an ordinary repair.  However, if the IRS determines that the work amounts to an improvement or that it extends the useful life of the property, it will not allow an immediate deduction and instead requires the work to be capitalized.

This has caused a lot of controversy between the IRS and taxpayers trying to determine what qualifies as an ordinary repair and maintenance and what is an improvement that must be capitalized.

Recently, the IRS issued new regulations to attempt to clarify the issue.  If you are a business owner or an investor who owns any property that occasionally requires repairs, you need to know about the IRS's new repair regulations that took effect on January 1, 2014.

As a general rule, you are required to capitalize:

• The cost of purchasing new property (e.g. buildings or equipment);
• The cost of making permanent improvements to buildings; or
• The cost of restoring property that has already been fully or partially depreciated to its original condition (essentially extending the useful life of the property).

What do you mean by capitalizing the cost?

As I mentioned before, if an expenditure is deemed to be an ordinary repair then the full cost of the repair may be expensed in the year that the cost is incurred.  However, if it is not deemed to be a repair it has to be capitalized.

If a cost is capitalized, it is transformed from being an expense into being a depreciable asset.  This asset is then depreciated (expensed) over the useful life of the asset.  The useful life of the asset is determined based upon what the asset is.  For example, a residential building is depreciated over 27.5 years while an "improvement" is depreciated over 15 years and office furniture is depreciated over 7 years.

Most people would prefer to deduct the entire cost of the work required to keep their property in good condition right away instead of over a number of years, so most taxpayers would prefer to have the work classified as a repair.

There are 3 safe harbors with the Internal Revenue Code Regulations that, if met, allow a taxpayer to treat their expenditures as repairs.  These safe harbors are:

1. The de minimis safe harbor;
2. The small taxpayer safe harbor; and
3. The routine maintenance safe harbor.

These safe harbors will be the subject of my next several blog posts.

If you have any questions about the IRS's new repair regulations, please send me an e-mail.

Self-Directed IRAs

Did you know it is possible to hold real estate and business entities through an IRA?  You can if your IRA's custodian is open to having "nontraditional" investments.

What is a Self-Directed IRA?

A self-directed IRA is simply an IRA whose custodian permits a wide array of investments beyond bonds and securities and provides for maximum control by the account holder.  Self-directed IRAs can include any investment, other than life insurance and collectibles, that are not specifically prohibited by federal law.

As with all other IRAs, self-directed IRAs must comply with various rules and regulations, including a rule against "prohibited transactions".

What is a Prohibited Transaction?

There are several types of transactions that the federal government have determined to be improper if conducted with the IRA account holder, his or her beneficiaries, or any disqualified person.

Disqualified Persons

The Internal Revenue Code defines disqualified persons as:

1. A fiduciary of the plan (an IRA owner who exercises discretionary control over an IRA's investments is a fiduciary);
2. A person providing services to the plan;
3. An employer whose employees are covered by the plan;
4. An employee organization whose members are covered by the plan;
5. A direct or indirect owner of 50% or more of any entity that is described in numbers 3 or 4 above.
6. A family member of any of the above;
7. A corporation, partnership, trust, or estate that is more than 50% owned directed or indirectly by any person described in numbers 1 through 5 above;
8. An officer, director, 10% or more shareholder, or highly compensated employee (earning 10% or more of the employer's yearly wages) of a person described in numbers 3, 4, 5, or 7 above;
9. A 10% or more partner or joint venture of a person described in numbers 3,4, 5, or 7 above; or
10. Any disqualified person who is a disqualified person with respect to any plan to which a multiemployer plan trust is permitted to make payments under Section 4223 of ERISA.

Prohibited Transactions

There are several types of transactions that are prohibited if done between the self-directed IRA and a disqualified person.  Here are a few examples (this is by no means a comprehensive list):

• Selling property to or from the IRA;
• Lending money to or borrowing money from the IRA;
• Receiving unreasonable compensation for managing the IRA;
• Using the IRA as security for a loan; or
• Buying property for personal use with IRA funds.

What are the consequences if there is a prohibited transaction?

The penalties for engaging in a prohibited transaction are severe!  The Internal Revenue provides that if any prohibited transaction occurs, the account is no longer an IRA and it will be treated as if the assets within the account were distributed on the first day of the taxable year in which the prohibited transaction occurs.  This will trigger a 10% early withdrawal penalty, tax on the constructive distribution, and often an accuracy-related penalty for each of the tax years affected.

Let's look at an example.

In 2010, Mark decided to roll over all $2,000,000 from his 401(k) plan to a self-directed IRA.  On July 1, 2011, the IRA purchased a rental property for $400,000 and left the remaining assets invested in securities. The IRA then hired Mark to manage the property and agreed to pay him 10% of the total rents received. Mark managed the property until late 2013 when the IRA sold it for $450,000.  For the years 2011 through 2013, Mark reported his "management fee" as income, but did not report any of the rental income or the gain on the sale of the property because he knew that income earned by an IRA is tax-deferred.

In 2014, Mark received a notice from the IRS informing him that he was being audited for the tax years 2011, 2012, and 2013.  After its audit, the IRS concluded that the IRA's hiring of Mark and providing him compensation were prohibited transactions.  As a result, there was a deemed distribution of all of the IRA's assets on January 1, 2011 (not only the $400,000 used to purchase the rental property).  Mark was assessed the following penalties:

• Tax on $2,000,000+ deemed distributed to him on January 1, 2011 (plus penalties and interest);
• 10% early withdrawal penalty on the $2,000,000+ deemed distributed;
• 20% accuracy related penalty in 2011;
• Tax on the 2011, 2012, and 2013 rental income (plus penalties and interest)
• Tax on any interest, dividends, and capital gains from securities in 2011, 2012, and 2013 (plus penalties and interest);
• Tax on the capital gains from the sale of the rental property in 2013 (plus penalties and interest); and
• 20% accuracy related penalty in 2013.

It is not my intent to discourage anyone from using a self-directed IRA as an investment vehicle.  However, it is very important to understand that it can be very easy for someone to engage in a prohibited transaction and incur very severe penalties as a result.  Therefore, if you are thinking about utilizing a self-directed IRA, talk to a tax professional to ensure that everything is done properly.

If you have any questions about self-directed IRAs, please do not hesitate to contact me.

As always, I appreciate you leaving your feedback in the comments section below.

How does the Government Shutdown affect Taxes?

As I am sure you already have heard, as of October 1st, 2013, the federal government has "shut down" until a budget can be passed.  As you have been seeing on the news, this means that among other things national parks are closed and nearly 800,000 federal employees are on furlough.  But how does the government shutdown affect your taxes?

For individuals who have filed a tax extension, they must still file their tax returns by October 15th.

 

The IRS will only be processing tax returns that are filed electronically.  Any tax returns that are mailed to the IRS will not be deemed late, as long as they are still mailed by October 15th, but will not be processed until after the government shutdown ends.

 

The IRS will not be issuing any tax refunds.  Sorry, but this means that if the federal government owes you money you will not receive it until after the government shutdown ends.  I would expect that there will be delays even after the government is back to operating normally because it will take the IRS some time to process all of the tax returns.

 

Most customer service assistance will not be available.  There will not be any live telephone assistance and the IRS walk-in taxpayer assistance centers will be closed.  However, most automated telephone applications will still work.

 

IRS audits are on hold.  The IRS's auditors have been furloughed, so any meetings related to IRS audits, collections, or appeals have been cancelled.  If you are currently involved in an IRS audit, you should assume that it will resume once the government shutdown ends, but you have some extra time now to prepare for it.

 

Automated IRS notices will continue to be mailed.  This means that despite the government shutdown you may receive a notice from the IRS.  However, the IRS will not be working on any paper correspondence during this time.  If you receive an IRS notice, talk to your CPA about it just like you normally would.

 

If you would like to talk privately about how the government shutdown will affect your tax situation, please do not hesitate to send me an email.

 

What are your thoughts about the tax consequences of the government shutdown?  Please leave your comments below.