The taxpayer advocate's annual report to Congress was recently released and one of the more useful parts of the report is its rundown of issues that taxpayers and the Internal Revenue Service most frequently end up fighting out in court. This list of top litigation provides a useful window into the IRS' focus– especially in regards to individuals and small business owners. Here are some of the issues and how you can stay on the right side—or beat—the IRS.
Trade or business expenses. For individuals the problem continues to be having good books and records to support the deduction of expenses – especially for travel and entertainment expenses. The advocate noted that “taxpayers represented by counsel fared noticeably better than their pro se counterparts” (meaning taxpayers who represented themselves, as provided for by U.S. Tax Court procedures.) Taxpayers with representation received full or partial relief in 58 percent of litigated cases vs. just 34 percent for pro se taxpayers. Good to see that law degree is helpful.
A number of cases in this area also get into the question of whether the taxpayer is deducting expenses (and claiming losses) for a legitimate “for profit” activity. As a general rule, I've found the IRS takes a dim view of businesses that involve animals – horse training, cat raising, etc. If you aren't making a profit in your animal business, be ready for an IRS letter, particularly if you are claiming a loss from the activity and deducting as a business expense your subscription to “Cat Fancy” or “Horse and Hound” magazines, as well as the cost of kitty litter, oats, etc. Don't be surprised if the IRS deems your animal fancy a hobby. (For more advice on what you can and can't do, see Ten Tips On Deducting Your Hobby, here
Gross income – What counts as income
. Damage awards top the list here. While payments due to physical injury or sickness are not subject to tax, other damage payments are (ex. payments for emotional distress). The effort to avoid this issue should start by having a tax attorney involved with the final settlement agreement. Always a big help if you ensure that a settlement makes clear what the payments are for. (If you're involved in litigation, be sure to read the advice on taxation of damages here.
Discharge of indebtedness is the second issue in the area of gross income – particularly treatment of discharge of indebtedness for a principal residence is something that I've seen a good bit of with so many taxpayers suffering in the housing collapse.
Accuracy Related Penalties – Section 6662. In our litigation work, this penalty certainly is a favorite of the IRS. We have found, as the advocate report highlights, that taxpayers have good success in having this penalty set aside by showing that the taxpayer had adequate records and made a reasonable attempt to comply with the requirements of the law.
It is not a helpful story if the taxpayer points to an empty shoe box as holding the justification for the position taken on a return. As the advocate report notes, citing Treasury regulations, it is helpful if the taxpayer can show reliance on a tax professional – so long as the taxpayer provided all necessary information to the tax preparer; the preparer was competent; and, reliance was reasonable.
Claiming that the tax software screwed it up – was not embraced by the tax court in the case Anyika v Commissioner. Back to claiming the dog ate it.
Liens and Summons. In general, lots of taxpayers are litigating and most of them are losing. My suggestion is to move heaven and earth to keep a lien from being filed in the first place. It is the devil to make happen but it can be done.
Joint and Several Liability – Innocent Spouse. An antediluvian issue. The advocate's report does a good job of highlighting that a key factor for getting relief is whether the spouse claiming innocence knew, or should have known, of the tax deficiency. Under pressure, the IRS has been modifying its policies in this area some.
Charitable Deductions. This is a new one for the list of litigated issues. Congress and the IRS have cracked hard on taxpayers taking an expansive view of the value of certain charitable deductions. If you think your Yugo that goes only in reverse is worth 20k as an antique – think again. Good valuation is the key to success – and keeping your feet on the ground in what you claim especially in areas such as conservation easements.
Frivolous issues; failure to file; and, failure to pay. You still have a number of people claiming they don't owe taxes for a variety of reasons – including, that they are citizens of a state not subject to income tax (ie that their state is sovereign; compact or independent); that the IRS forms and notices violate the Paperwork Reduction Act; and, that only income earned from the U.S. government (not a private sector employer or investment) is subject to tax. Not a surprise these individuals are in court fighting (and losing) frivolous issues penalty; failure to file penalties and questions of gross income.
Of course the best way to win in court is never to end up there in the first place. So if you're audited, first, when the IRS is knocking on your door – this is not the time to be a spendthrift – get your tax professional involved early in the process as positioning is everything. Second, listen closely and understand fully the IRS' concerns. Third, provide the IRS documentation and legal support justifying your positions and addressing the IRS issues. Fourth, exercise your rights for review at IRS appeals and mediation. My colleague at alliantgroup John Dies, who has had great success in dealing with the IRS, reminds me that the IRS has of recent been much more open to alternative dispute resolution – something that can save you time and money.
Finally, I am a big believer that you need to be on offense when dealing with an IRS audit. The taxpayer should review the open year under exam closely and determine whether there are any additional tax savings available. This has meant that in some cases we've had clients who actually are OWED
money by the IRS from an audit. You can't beat that with a stick.
We have found working with hundreds of businesses and individuals that vigorous representation during exam and appeals right from the beginning will carry you a very long ways towards success – and keep you from being on the top ten litigation list.
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