The Moment of IRS Truth

Summary:

Fox has a great new show that could be the paradigm
for future IRS audits. Forget IRS agents and field audits, when your number’s
up…onto the show you go. You’ll be strapped to a lie detector and asked a
series of questions by an IRS polygraph expert. You want your refund, you have
to pass through the gauntlet of piercing questions. To give you a taste of what
you’ll be facing we’ve 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? For estates, the IRS will use its Ouija board
version.

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:

Question
#1:

Do you have anyone working in your home on whom you haven’t paid payroll
taxes?   What about maintaining
the proper records? Fess up honey! The fact that so many people ignore these
rules doesn’t 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. Don’t overlook worker’s compensation insurance.

Question
#2:

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’re 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.

Question
#3:

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. Stop
smoking programs are deductible, but stop smoking 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 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.

Question
#4:

Did all your trust beneficiaries sign their Crummey powers? Signing them 10
years later when you finally show up for the “annual” meeting your estate
planner told you was essential doesn’t count. Were they signed on time? Many
types of trusts are intended to receive gifts each year, 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’re
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.

Question
#5:

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’ve 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 1/4^th of the interest. Think about this one during the
commercial break.

Question
#6:

Has your business claimed any deductions for entertainment expenses that
weren’t both real and properly documented? We’ll assume for purposes of your
answer that everyone you’ve 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.

Question
#7:

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 aren’t 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’s
not a $12,000 check on top of the gifts, it’s the value of the whole package.

Question
#8:

So you formed a family limited partnership (FLP) and transferred
significant wealth to it. You’ve 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’s 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 when you need from your FLP?

We
humored you with a couple of questions from Level 2, but let’s be honest, how
far did you really get on “Taxpayer’s Moment of Truth”?