This week, Joe Kristan (CPA & Shareholder, Roth & Company (Des Moines, Iowa); Editor, Tax Update Blog) highlights the lesson of a recent Tax Court case: friends shouldn't let friends claim the business bad debt deduction:
You can have a friend, or you can have a bad debt.
With friends like this, who needs deductions? When you lose money on an investment, a business bad debt deduction for the loss is the best consolation. A business bad debt is an ordinary loss, fully deductible against any other taxable income. A “non-business” bad debt, in contrast, is a capital loss, deductible only against capital gains, plus (for most individuals) $3,000 of other income. If the investment isn’t a loan, the best you can hope for is a capital loss.
The best result is the hardest to get, as a Virginia financial advisor learned in Tax Court this week. The advisor had a friend, a Mr. Zinn, who ran a business negotiating reduced interest rates for credit card borrowers with high balances. The advisor got involved in the business, called CFS, as Judge Lauber explains:
In order to charge its fees to consumers’ credit cards, CFS needed to have “merchant accounts” with one or more banks. Because Mr. Zinn had very poor credit, neither he nor CFS could secure a merchant account with any bank. Mr. Zinn accordingly sought assistance from petitioner, who agreed to use his superior credit to help open merchant accounts on behalf of CFS.
The taxpayer set up a partnership, JC, with an associate to help open these merchant accounts.
Mr. Zinn’s business struggled, and he asked the advisor for help, meaning cash. The taxpayer’s girlfriend came through with $84,000. That’s when things get confusing. From Judge Lauber (I abbreviate the girlfriend’s name as “Ms. S”):
But she testified that she did not know whether this money went to petitioner, JC, or CFS. Her bank account statements evidence these transfers; but neither she nor petitioner could establish that the account numbers to which the funds were wired belonged to CFS. Ms. S clearly advanced these funds to petitioner or on his behalf, because petitioner’s father eventually provided Ms. S with enough money to make her whole. But there is no evidence, apart from petitioner’s testimony, that this $84,000 was actually received by CFS.
Things went downhill, and the taxpayer ended up claiming a business bad debt deduction on a (late-filed) 2009 tax return. The Tax Court wasn’t convinced that funds ever made it to Mr. Zinn’s business in the first place:
We did not find petitioner to be a particularly credible witness; and there is no evidence, apart from his testimony, that CFS actually received any portion of the $84,000.
But, says Judge Lauber, the deduction would not be a business bad debt even if he could prove the amount loaned. From the opinion (citations omitted):
There is no evidence to support petitioner’s contention that any funds he advanced to CFS gave rise to a bona fide loan. There was no promissory note, no fixed or determinable amount due, no specified interest rate, no principal due date, and no requirement of security. It seems obvious that no bank would have lent money to Mr. Zinn or CFS in 2009. Indeed, the reason that Mr. Zinn sought “merchant processing” assistance from petitioner was that his credit was too poor to enable him to open merchant accounts himself.
That made any advances look more of an equity investment or gift, rather than a loan. But even if it were a loan, there is a problem:
…even if petitioner could prove that his advances to CFS created bona fide indebtedness, he did not prove that the debt was a “business bad debt” qualifying for deduction under section 166(a)(1). A loss is deductible as a business bad debt only if the taxpayer is in a “business” and the debt in question is proximately related to that business. To determine whether a loss is proximately related to the taxpayer’s business, we evaluate his dominant motive for making the loan…
We find no evidentiary support for the proposition that his alleged loan to CFS was “a debt created or acquired * * * in connection with a trade or business” of lending money in which he was engaged during 2009. Nor was any alleged loan “incurred in the taxpayer’s trade or business,” namely, petitioner’s occupation as a financial adviser.
He wasn’t in the business of lending money, and the loan wasn’t part of the business he was engaged in. Bad facts.
We find that petitioner’s dominant motivation for advancing funds to CFS was personal, stemming from his longtime friendship with Mr. Zinn. He was fully aware that Mr. Zinn had very poor credit, and it is highly unlikely that he would have advanced funds under these circumstances unless Mr. Zinn had been a close personal friend. Because petitioner’s primary motivation for advancing funds was personal, we find that the advances, to the extent substantiated, were not proximately related to any business in which petitioner during 2009 was engaged.
Decision for IRS.
The Moral? It’s very hard for individuals to get bad debt deductions. If you aren’t in the business of lending money, or if you don’t lend money as part of the business your in (for example, selling merchandise on credit), any bad debts are probably non-business. If the creditor is a bad risk and a friend in the first place, you’ve got real problems. And don’t even get me started on whether you should loan your boyfriend’s bad credit risk buddy $84,000.
Cite: Scheurer v. Commissioner, T.C. Memo 2017-36 (Feb. 21, 2017).
Here’s the rest of this week’s Tax Roundup:
Monday, February 20, 2017
Annette Nellen, California proposal to use convert vacation home subsidy to low-income housing one. “AB 71 introduced in California for the 2016-2017 session, proposes to repeal the deduction for mortgage interest on a second home (usually a vacation home) and use the savings (and apparently other funds) for low-income housing.” California would do a lot more to help out low-income housing by making it less impossible for people to build there in the first place.
Hank Stern, Running out the clock (InsureBlog). “The fear of paying The ObamaTax is one of the most compelling reasons (and, for many folks, the only reason) to even consider buying an ObamaPlan. Now it appears that there’s even less bark in that dog…”
Jared Walczak, Washington Legislature Takes Up Formal Income Tax Ban (Tax Policy Blog).
Jessica Silbering-Meyer, Swiss Voters Reject Corporate Tax Reform III (Thomson Reuters Tax & Accounting Blog). “The June 5, 2015 version of CTR III included a proposed 'license box' regime for cantonal (but not federal) tax purposes, granting preferential treatment for revenue from patents and similar rights associated with research and development…” Good job, Swiss voters.
Jim Maule, So Who Should Pay Taxes for Police Protection? “As explained in this article and others, the governor of Pennsylvania has proposed that Pennsylvania towns relying on the state police for all policing in the town pay a $25 per-person tax for those services.”
Kay Bell, Watch out for the Dirty Dozen tax scams of 2017. Phishing and phone scams lead the list.
Kristine Tidgren, Polk County District Court Rejects Landowners’ Eminent Domain Challenge (Ag Docket). “The court also found th”t the Board had statutory authority to grant Dakota Access eminent domain over impacted parcels of agricultural land.”
Lew Taishoff, IMMUNITY 101. “And jive talking may give an unpleasant personal perception.”
Paul Neiffer, Watch Out for Excess Farm Loss Rules. “If you received a CCC loan this year and you have a farm loss greater than $300,000, you may not be able to deduct all of the loss.”
Peter Reilly, Conservative Judge Okays Huge Roth IRA Tax Shelter, Slams IRS Substance Over Form Attack.
Robert Goulder, Oh Cupid, Why No Love for Tax Reform? (Tax Analysts Blog)
Robert McClelland, Investors respond to changes in capital gains tax rates, but less than you think (TaxVox).
Stephen Olsen, Procedure Round Up(date): Regulations, Mount Up! & State Law SOL Issue When Suing Promoters. (Procedurally Taxing).
TaxGrrrl, Understanding Your Tax Forms 2017: Form W-2, Wage and Tax Statement
Tuesday, February 21, 2017
David Brunori, Rethinking Combined Reporting, the Worst Idea of the Year, and Unicorns in Kentucky (Thomson Reuters Tax & Accounting Blog, my emphasis):
For many years I believed that to make the corporate income tax work, states had to adopt combined reporting. I believed that separate accounting regimes left too many planning opportunities. Yes, I also thought that the corporate tax should be repealed. But, I thought if the corporate tax were to survive combined reporting was a necessity, especially given all the other problems with the tax.
I no longer believe combined reporting is a remedy for fixing the corporate income tax. In part, I do not believe there is a remedy; the corporate tax is unfixable. It should be repealed not mended. And, it turns out combined reporting doesn’t actually do much to strengthen the tax. My students and I have been studying the revenue effects of combined reporting. Does it lead to more money? The answer is: not really.
That’s a big change in thinking for Mr. Brunori. It is driven by research showing that combined reporting nets little revenue.
Jack Townsend, Further on Contempt Sanctions for Failure to Produce Foreign Documents.
Jason Dinesen, Things Tax Preparers Say: “S-Corp Reasonable Comp is 25% of Your Gross Income”.
Kay Bell, Looking for tax help in lots of online places. “However, instead of calling, be it today, tomorrow or any date, the IRS suggests that we use one of the tax agency’s other help options, like its app IRS2Go.”
Leandra Lederman, The Status of Judicial Anti-Abuse Doctrines if Code Section 7701(o) Were Repealed (Surly Subgroup). “In sum, it would be best for Congress not to repeal Code section 7701(o). But, if it did, although that statutory gloss on the economic substance doctrine would be gone, the judicial doctrine itself would not cease to exist.”
Lew Taishoff, IT’S THAT DAY AGAIN. “This is the day whereon two former Presidents of these United States are born again on a Monday. Wherefore, as Tax Court, and indeed the entire government, is closed, my keyboard is dumb.”
Marjorie Kornhauser, TaxJazz: The Tax Literacy Project (Procedurally Taxing). “Despite the fact that taxation is a critical component of both personal and national finances, financial literacy programs pay little or no attention to taxation.”
Roger McEowen, The Scope and Effect of the “Small Partnership Exception”.
Russ Fox, Online Gambling Addresses for 2017. Russ again performs a wonderful service by providing street addresses for offshore online gambling websites. The IRS considers accounts with such sites to be financial accounts subject to FBAR reporting, with nasty penalties for non-compliance. The form requires the street addresses for the accounts. You may not be surprised to find that offshore gambling sites aren’t always forthcoming with their street addresses. Russ also includes information required when the amounts also have to be reported on Form 8938.
Problem: Tax Policy Under an Anti-Policy President “We need the nation’s chief executive to think about, and accept the notion of ‘policy’ – and take advice and counsel from experts who know more than he does.” (Stuart Gibson, Tax Analysts Blog)
Problem solved: Actually, Robots Could Face IRS With Trump-Like Tax Savvy (Robert Wood)
News from the Profession. Australian Tax Lawyer Built an AI Tax Research Assistant That Will Never Get Sick of Your Questions (Caleb Newquist, Going Concern).
Wednesday, February 22, 2017
Accounting Today, Practitioners walk fine line on silent returns. The article addresses the dilemma facing preparers whose clients are subject to the ACA individual mandate penalty, now that the IRS has decided to accept returns without information on whether the taxpayer has qualifying insurance coverage.
Robert D. Flach doesn’t think there is a dilemma at all:
At this point, with the repeal of either the entire Affordable Care Act or at least the shared responsibility penalty eminent, and the fact that the IRS does not have the authority to collect any assessed penalty other than by offsetting future refunds, I feel the best course of action for a taxpayer, or a tax preparer, is to remain “silent” about health coverage when the taxpayer would be subject to this penalty, and not include a penalty assessment as part of the tax filing.
The Accounting Today article suggests taxpayers get clients to sign off on a CYA document before omitting the disclosure.
Andrew Mitchel, Caligula & Taxes.
Caleb Newquist, Tax Resistance Still a Great Way to Get the IRS’s Attention (Going Concern). And who doesn’t want a lot of attention from the IRS?
Jeremy Scott, The Unpopular Tax That Almost No One Pays (Tax Analysts Blog). “The estate tax now faces near certain extinction even though almost no one pays it, and very few even face the prospect of paying it.”
Jim Maule, Can Your Girlfriend’s Child Be Your Dependent?. It might make getting your wife’s signature on the joint return a little awkward.
Jon Baron, New Phishing Scheme Reiterates the Need for Stronger Data Security Within Accounting Firms (Thomson Reuters Tax & Accounting Blog). “Here’s how it works. The first phishing email comes in the form of a need for service with a message along the lines of, ‘I need a tax preparer to file my taxes.'”
Joseph Henchman, Scott Drenkard, Kansas Sends Tax Overhaul to Governor Brownback (Tax Policy Blog): "The Kansas pass-through carve-out has no place in a good tax code."
Kay Bell, Most taxpayers get failing tax knowledge grades. In fairness, most taxpayers have better things to do with their time.
Leslie Book, Preparer “Doctors” the Return Adding Phantom Income: Court Sustains Preparer Penalties (Procedurally Taxing). “As the Foxx case illustrates, the EITC creates the odd incentive for the creation of phantom income that could fuel a tax refund.”
Lew Taishoff, YOU SAID IT. “I’m inferring here, but it sounds like Marty was playing the sub S dodge.”
Paul Neiffer, A Lightning Strike. “Before today, the nearest I had come to getting hit by lightning was playing golf in Central Oregon about 20 years ago.”
Robert Wood, Dear IRS: Sorry, A Typo On My Taxes Dropped Some Zeros. It could happen to anyone…
Sam Brunson, Past Moratoria on Tax Guidance and Regulations(?) (Surly Subgroup). “It looks like there’s no history of entirely refusing to issue regulations and other guidance in the first month(s) of a new administration; at the same time, that early period of a new administration doesn’t issue a whole ton of new guidance.”
TaxGrrrl, IRS ‘Dirty Dozen’ Tax Scams For 2017 Include ID Theft & Bogus Refunds.
Thursday, February 23, 2017
Howard Gleckman, The Border Adjustable Tax Can’t Shrink The Trade Deficit and Produce Trillions In New Revenue (TaxVox).
Jason Dinesen, Does Coast Guard Retirement Pay Count Toward the Iowa Military Pension Exclusion?
Kansas City Star, Gov. Sam Brownback’s tax policies survive — barely — after Kansas Senate vote. The exclusion of pass-through income from income tax is a disaster, and Governor Brownback is sticking with it.
Kay Bell, What will your bar tax bill be on Margarita Day 2017?
Keith Fogg, Continued Developments in Private Debt Collection (Procedurally Taxing).
Lew Taishoff, UNCLEAN, UNCLEAN. “I’ve stated before that Tax Court gets more valuation cases than almost any other court. This case gives a look at how the process works. Takeaway- If your expert wants any piece of the action, walk away.”
Richard Phillips, The Border Adjustment Tax Creates More Problems Than It Solves (Tax Justice Blog).
Robert Wood, Trump Vows Estate Tax Repeal, But California Plans Its Own 40% Estate Tax. It’s only a proposal, and I doubt if even California legislators are that clueless.
Roger McEowen, Some Thoughts On Long-Term Care Insurance. “s purchased early and there is no pre-existing condition, and benefits are triggered early on, then it can turn out to be a good deal. But, a person could be better off simply setting aside funds every month in an investment account that is earmarked as being set aside to cover long-term care costs.
TaxProf, Snuggies Are Blankets, Not Garments, For Tax Purposes.
Friday, February 24, 2017
Howard Gleckman, In Praise of the Debate Over The Border Adjustable Tax (TaxVox). “Sure, there has been plenty of political posturing but for the most part, it has been exactly what tax policy debates ought to be: Serious and substantive.”
Kay Bell, Religious freedom is not a valid tax evasion defense. It would be handy, considering the holy zeal some clients have about their taxes.
Lew Taishoff, DESIGNATED EMPLOYEE. “IRS hit Alex and Mercedes with passthrough employment taxes for the wage shortfalls from their sub S.”
Meg Wiehe, State Rundown 2/23: Regressive Tax Proposals Multiplying (Tax Justice Blog)
Morgan Scarboro, A Proposal to Simplify Ohio’s Local Income Tax Compliance (Tax Policy Blog): "A few weeks ago, we covered Ohio Governor John Kasich’s budget proposal here. One provision that deserves additional attention is his plan to simplify municipal income tax collection, because the proposal is a thoughtful attempt to reduce compliance costs in Ohio’s worst-structured tax."
People are dying for this stuff. The IRS auction website tells of an exciting opportunity to buy the “Contents of Funeral Home to include furniture, caskets, office supplies, embalming room supplies/tables/slop system, embalming machines, pulpit items, Hammond Organ and more.” “Slop system?”
Robert D. Flach, NO SURPRISE TO ME. “No software package, or online filing service, is a substitute for knowledge of the Tax Code, and no tax software package, or online filing service, is a substitute for a competent, experienced tax professional!”
Russ Fox, FTB Not Appealing Swart Decision. “Last month a California appellate court ruled that California’s Franchise Tax Board was wrong in trying to assess an Iowa corporation with a 0.2% ownership in an LLC that invested in California the California minimum Franchise Tax. It was announced today that the FTB will not appeal the decision.” Good news.
TaxGrrrl, 10 Ways To (Mostly) Avoid A Tax Audit: "No one can promise you that you will never be audited. That’s because while most tax audits are targeted (more on that in a moment), a percentage – granted, a tiny percentage – of audits are random."
TaxProf, IRS Audit Rate Of Individuals (0.7%), Businesses (0.5%) Falls To 10+ Year Lows Due To Budget Cuts
Tyler Cowen, Is the border adjustment tax a good idea? (Marginal Revolution). It links to a Mercatus piece that says “…the preponderance of evidence seems to show that currencies don’t adjust as theory would predict.”