By: Martin M. Shenkman, CPA, MBA, JD
Fox has a great new show that could be the paradigm for future IRS audits. Forget IRS agents and field audits-when your number is up…onto the show you go. You will be strapped to a lie detector and asked a series of questions by an IRS polygraph expert. You want your refund? You must pass through the gauntlet of piercing questions. To give you a taste of what you’ll be facing we have asked a hypothetical client some tough questions on their tax filings. Would you pass muster? What if we strap your favorite CPA into the chair after you?
The time has come for you to face your tax moment of truth. For the first $10,000 of your refund, you have to answer six questions:
Do you have anyone working in your home on whom you have not paid payroll taxes? Have you been maintaining the proper records? Fess up honey! The fact that so many people ignore these rules does not relieve you of the responsibility. Even if you’re not Zoe Baird looking to be Attorney General, these rules apply to you. If you have someone working in your home on a regular basis, they must complete U.S. Immigration Services Form I-9 Employment Eligibility Verification. The employee must submit appropriate documents proving eligibility to be employed. You are required to withhold Social Security and Medicare taxes from her pay at 7.65%, match those amounts, and remit it all to the IRS. Federal unemployment taxes, FUTA, and perhaps state taxes may all be due. Do not overlook worker’s compensation insurance.
Have you ever used your Lexus SC 08 coupe convertible “business” car for personal matters? Your family business purchased the car for you to use in your capacity of being an employee of the business. You are required to substantiate the business versus personal use of an employer-provided car by maintaining adequate written or computer records, or by providing other sufficient evidence. IRC Sec. 274(d). Automobile use not substantiated by adequate records, or other sufficient corroborating evidence, is considered personal use. Temp. Reg. 1.274-5T(e). Your business must retain summaries of your (and every employee’s) records. Your records must substantiate the amount, date, and time of use. An exception exists if your business adopts a policy that prohibits anything more than de minimis personal use. Temp. Reg. 1.274-6T. Of course every one of those spins by the golf course was to play with business contacts only.
Are all those medical expenses you reported really qualified tax deductions? Have you snuck in a few things that are really not legit? Not every “medical” type expense is deductible. The costs of elective cosmetic surgery are not deductible. Fees for teeth whitening are not deductible. While payments for psychiatric treatment of sexual disorders is deductible, marriage counseling costs are not. A weight loss program can be deductible if to relieve a disease (did you get your doctor’s note?). Rev. Rul. 2002-19. Smoking prevention programs are deductible, but nicotine patches and gum purchased at your local drug store are not. Rev. Rul. 99-28. You cannot deduct the rent on your Boca apartment just because Dr. Feelgood told you to spend winter in Florida. Payments for home help and care are only deductible to the extent that they are nursing costs. Improvements made to your home for medical reasons are only deductible to the extent that they did not add to the value of your property.
Did all your trust beneficiaries sign their Crummey notices? Signing them 10 years later when you finally show up for the “annual” meeting your estate planner told you was essential does not count. Were they signed on time? Many types of trusts are intended to receive gifts each year, in order to qualify for the annual gift tax exclusion. To do so, beneficiaries often have to be granted the right to withdraw the value of any gifts to them, following the gifts being made by you to the trust. To demonstrate that the beneficiaries knew of the gift and their right to withdraw, they should generally sign a written acknowledgement sent to them by the trustee. These acknowledgements are often called annual demand or Crummey power notices (Crummey, after a court case that sanctioned the technique). These are commonly included in insurance trusts. And while you are still hooked up to the polygraph, please confirm that there was never an understanding between you and your kids that they would never exercise their Crummey powers.
Have you deducted interest on your home mortgage when it really didn’t qualify? First of all, it has to be your debt. Helping out Ma and Pa by paying the mortgage on their homestead, while noble indeed, is not deductible by you. Interest only qualifies for the home mortgage interest deduction if it is on your principal residence or one other vacation home (one pied–à–terre only). Interest is only deductible on up to a $1 million home mortgage used to acquire, construct or improve the residence. If you refinanced and paid off the $450,000 remaining balance on the $1 million mortgage used to purchase your house with a new $1 million loan, only interest on $450,000 of that new loan qualifies to be deducted. Unless you have used the new funds to improve your house, you lose your deduction. You can also deduct interest on up to $100,000 of a home equity line, regardless of what it was used for. If you have a $400,000 equity line outstanding that you used to pay for a wedding and new boat, you can only deduct 1/4th of the interest. Think about this one during the commercial break.
Has your business claimed any deductions for entertainment expenses that weren't real, or properly documented? We will assume for purposes of your answer that everyone you have ever spoken to is a potential customer for your commercial floor solvents. Before answering, consider that no expense for entertainment or recreation is deductible unless it meets one of two tests. The expense has to be “directly related” to the active conduct of your business. Alternatively, the expense can be “associated” with your business if it precedes or follows a substantial bona fide business discussion. This would include your meaningful conversation about floor solvents following Giants David Tyree’s amazing SB XLII catch. In a recent case, the taxpayers claimed business deductions for meal and entertainment expenses pertaining to a real estate finder/consultant business. The only corroboration the taxpayer had was a few receipts, credit card statements, and self-prepared non-contemporaneous spreadsheets none of which met the tax requirements for substantiation and adequate records. Mila Alemasov, et vir. v. Comr., (2007) TC Memo 2007-130. Have you done the paperwork right?
Are you the only taxpayer that would have made it past Level 1? Sure you did. Keep going.
Have you made gifts of more than $12,000 in any year to a child or grandchild and not reported it to the IRS? Every taxpayer of modest wealth is aware of the right to make annual gifts to any number of people they wish. These gifts can aggregate $12,000 per year without triggering the requirement to file a gift tax return. Qualified payments for tuition and medical expenses are not counted in coming up with the total. But every other gift is. Lots of parents and grandparents use $12,000 annual gifts as stocking stuffers (sure beats a pair of Dr. Scholls Massaging Gel Insoles). But did you also add up the new car, birthday present, graduation gift, and all the others throughout the year? It is not a $12,000 check on top of the gifts; it is the value of the whole package.
So you formed a family limited partnership (FLP) and transferred significant wealth to it. You have claimed substantial discounts on the value of the FLP interests given to your children, and expect them to claim large discounts on the remaining FLP interests included in your estate. So please confirm that you do not have an implied agreement with your children, who are the other partners, that you can have access to the assets in the FLP whenever you wish. In Estate of Lillie Rosen, et al. v. Comr., TC Memo 2006-115, the Court held that the FLP was to be ignored for estate valuation purposes because there was an implied agreement between the partners that the decedent had access to partnership assets whenever she needed. IRC Sec. 2036(a)(1). The Rosen court said “Decedent will have retained an interest in the transferred assets to the extent that the assets were transferred with an understanding or agreement, express or implied, that the possession or enjoyment of, or the right to the income from, the assets would be for decedent's pecuniary benefit.” So let us have it on the table and save the tortuous delving into miniscule facts. Did you have a deal with the kids to give you money whenever you want from your FLP?
We humored you with a couple of questions from Level 2, but let us be honest, how far did you really get on “Taxpayer’s Moment of Truth”?
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