Main Menu
Posts in Tax Procedure.

DiplomaEarlier this week, United States Tax Court Judge Richard T. Morrison ruled, in the case of Emmanuel A. Santos v. Commissioner, T.C. Memo 2016-100 (May 17, 2016), that the government will not pay the cost of a taxpayer obtaining a law degree.

Case Background

This is a pro se case. While the record was not very clear, the taxpayer, Emmanuel A. Santos, claimed he earned a degree in accounting from Indiana University in 1988. Thereafter, he began a career as a tax return preparer. In 1996, he obtained a master’s degree in taxation. Eventually, Mr. Santos expanded his tax return preparer practice to include accounting and financial planning services.

Mr. Santos attended a law school in California, graduating in 2011. He was admitted to the California Bar Association and the United States Tax Court in 2014. In 2015, Mr. Santos and his father started Santos & Santos Law Offices LLP, a law firm offering attorney, tax planning, accounting and financial planning services.

On his 2010 federal income tax return, Mr. Santos deducted, in addition to various expenses, including laundry costs, $20,275 for law school tuition and fees. On audit, many of these deductions were denied.

After likely losing at the IRS Office of Appeals, Mr. Santos headed to the United States Tax Court. The sole issue in dispute was whether the deduction of $20,275 for law school tuition and fees was allowable under Code § 162 as an ordinary and necessary business expense.

When Educational Expenses Are Considered Deductible (and When They Are Nondeductible)

Treas. Reg. § 1.162-5(a) is clear—educational expenses that either: (i) maintain or improve skills required by the taxpayer in his or her current employment; or (ii) are required by the taxpayer’s employer (or applicable law) as a condition to continued employment or rate of compensation, are deductible. On the other hand, certain types of educational expenses are expressly nondeductible, including expenses for education that qualify the taxpayer for a new trade or business. Treas. Reg. § 1.162-5(b)(1) provides examples of these nondeductible educational expenses. One of the examples set forth in the regulations specifically references a taxpayer practicing accounting who pursues a law degree. The costs of attending law school are nondeductible because the course of study qualifies the taxpayer for a new trade or business. The law degree is not required to continue practicing accounting.

Previous Tax Court Holdings

Judge Morrison cited numerous cases where the courts have held, consistent with the Treasury Regulations, a law degree qualifies a taxpayer for a new trade or business, and thus the cost of the degree is a nondeductible educational expense. This is true, even if the degree improves the taxpayer’s accounting and tax skills, and the taxpayer remains practicing accounting (i.e., never practices law). See e.g., Taubman v. Commissioner, 60 T.C. 814 (1973).

Despite the clear language of the Treasury Regulations and the numerous cases supporting the government’s position, Mr. Santos brought his case to the United States Tax Court. He appears to have argued that the holdings in the cases where the court relied upon the Treasury Regulations are incorrect because the regulations are invalid. Mr. Santos’s argument, at first blush, appeared intriguing to me. By gosh, I recently won an Oregon Tax Court case invalidating a long-existing administrative rule (which is akin to Treasury Regulations).

Shortly after Treasury promulgated Treasury Regulation § 1.162-5, the United States Tax Court ruled that it was valid. The Ninth Circuit Court of Appeals affirmed the tax court’s conclusion. See Weiszmann v. Commissioner, 52 T.C. 1106 (1969), aff’d 443 F.2d 29 (9th Cir. 1971).

Giving It the Old College Try 

Mr. Santos argued that the court in Weiszmann employed the wrong standard to examine the validity of the regulation at issue. Unfortunately for him, the tax court quickly dismissed the argument without much discussion. Then, Mr. Santos asserted that Treasury failed to adequately respond to public comments before finalizing the regulations at issue, thus making the regulations invalid. Unfortunately, Mr. Santos did not raise that issue until after the trial had concluded. Consequently, the trial court record contained no evidence upon which the tax court could even evaluate his assertion. While his argument was creative and certainly intriguing, it never gained any traction. If he had offered evidence on the issue at trial, the tax court’s opinion would have been a much more interesting read. Who knows if any evidence exists to support his assertion of invalidity – Mr. Santos lost!

Lesson Learned

The clear take-away from this case is that: educational expenses are generally only deductible if they are incurred to maintain or improve the skills required for current employment or to retain current employment or current compensation. The costs of education required to prepare for a new trade or business are generally nondeductible.

The outcome of these cases is generally dependent upon the facts and circumstances. For example, if Mr. Santos had been a practicing tax lawyer (i.e., had already obtained his J.D. degree, had already passed the bar examination and was practicing as a tax lawyer), the costs of obtaining his LL.M. (taxation) may have been deductible.

Many nuances exist in this area of tax law. Consequently, careful analysis is required.

Late this afternoon, President Obama signed into law the tax extenders legislation referenced in my blog earlier today.  Hopefully, we can now complete our client year-end tax planning.

The Protecting Americans from Tax Hikes Act of 2015 Passes Both the U.S. House of Representatives and the U.S. Senate

iStock_000015972731_MediumLate in the day on December 15, 2015, the U.S. House of Representatives passed the Protecting Americans from Tax Hikes Act of 2015 (the “Act”). The Act, which represents a $622 billion tax package, revives many taxpayer-friendly provisions of the Code that expired a year ago.

The Act passed the House with a vote of 318 to 109. Voting in favor of the Act were 77 Democrats and 241 Republicans.

The Act moved to the U.S. Senate, where it was presented along with a comprehensive spending bill. As expected, the Senate voted in favor of the legislation today by a vote of 65 to 33. Consequently, the Act moves from Congress to the desk of President Obama. Most commentators expect that he will promptly sign the Act into law, as his administration has shown strong support.

In anticipation of President Obama signing the Act into law, the following is a brief overview of some of the most important provisions:

Business Provisions of the Act

The Act includes several business taxpayer provisions, including:

  1. Built-In Gains Tax Recognition Period Reduced. The Act retroactively and permanently sets the recognition period under Code Section 1374(d)(7) at five years.
  2. S-Corporation Charitable Contributions. The Act retroactively and permanently extends Code Section 1367(a)(2) that had expired on December 31, 2014. Consequently, if an S-Corporation contributes money or property to a charity, each shareholder may take into account his or her pro-rata share of the fair market value of the contributed property in determining his or her income tax liability. In other words, the contribution flows through to the shareholders. Likewise, the shareholder gets to reduce the basis in his or her stock by his or her pro-rata share of the corporation’s adjusted basis in the contributed property (rather than by the amount of the charitable deduction that flowed through to him or her). This provision should be a benefit to charities.
  3. Research Credit. The research credit allowed under Code Section 41(h) was retroactively and permanently extended. It had already expired as of December 31, 2014.
  4. RIC Interest and Related Dividends and Short-Term Capital Gain Dividends. The Act retroactively and permanently extends the rules contained in Code Section 871(k), exempting from gross income and the withholding tax the interest-related dividends and short-term capital gain dividends received from a regulated investment company. These provisions had expired as of December 31, 2014.
  5. Small Business Stock. Under Code Section 1202(a)(4), assuming certain requirements were met, a taxpayer prior to this year was allowed to exclude all gain from the disposition of qualified small business stock acquired after September 27, 2010, but before January 1, 2015. The exclusion applied for both regular income tax and alternative minimum tax purposes. The Act permanently and retroactively extended this provision for stock acquired after December 31, 2014.
  6. New Markets Tax Credit. The Act retroactively extends the new markets tax credit under Code Section 45D(f) through the end of 2019. Unless extended or made permanent, it will expire on December 31, 2019.
  7. 15-Year Straight-Line Cost Recovery for Qualified Leasehold Improvements. The Act permanently extends the 15-year recovery period for qualified leasehold improvements, qualified restaurant property and qualified retail improvement property.
  8. Section 179 Expensing. The Act permanently and retroactively extends the small business expensing limitation and phase-out amounts that were in effect from 2010 to 2014. Consequently, for 2015 forward, the Code Section 179 deduction limit is $500,000. Likewise, the deduction phase-out commences at $2 million. Both the limitation and the phase-out threshold will be indexed for inflation beginning next year. This provision of the Act also extends 50% bonus depreciation through the end of 2019.

Individual Provisions of the Act

The Act includes several individual taxpayer provisions, including:

  1. Enhanced child tax credit. The Act makes the child tax credit, with a $3,000 un-indexed threshold, permanent. The threshold was scheduled to rise to $10,000 and be indexed for inflation. The Act eliminates the threshold increase and the index for inflation.
  2. American Opportunity Tax Credit. The Act makes the American Opportunity Tax Credit permanent.
  3. Mass Transit. The Act permanently extends the employee exclusion for employer-provided mass transit. Now, the exclusion ceiling is equivalent to the employer-provided parking exclusion (i.e., $250 per month).
  4. State and Local Sales Tax Deduction. The Act permanently extends the life of Code Section 164(b)(5) so that a taxpayer who itemizes his or her deductions may elect to deduct state and local general sales and use taxes in lieu of state and local income taxes. Under Code Section 164(b)(5)(I), this provision, absent the Act, expired on December 31, 2014.
  5. Nontaxable IRA Transfers to Eligible Charities. The Act makes Code Section 408(d)(8)(F) permanent. Consequently, individuals who are at least 70½ years of age may exclude from gross income qualified charitable distributions from IRA’s, subject to an annual cap of $100,000.
  6. Home Mortgage Debt Discharge Exclusion. Under Code Section 108(a)(1)(E), prior to this year, an individual taxpayer could exclude from gross income the discharge of indebtedness from a qualified personal residence, up to $2 million for married taxpayers filing jointly, and $1 million for single taxpayers or married taxpayers filing separately. This provision of the Code expired on December 31, 2014. The Act, however, gives it new life, albeit for a brief period of time. The provision will now expire on December 31, 2016, unless extended or made permanent.

Many taxpayers and tax advisors feared that no extenders act would not be passed by the end of 2015. Fortunately, lawmakers were able to reach a compromise. We expect President Obama will sign the Act into law well before the end of the year. Stay tuned!

The Chief Financial Officer’s Act of 1990 (“1990 Act”) was signed into law by President George H.W. Bush on November 15, 1990.  One of the major goals of the 1990 Act was to improve the financial management and to gain better control over the financial aspects of government operations.  One provision of the 1990 Act in this regard established a requirement that the government’s financial statements be audited.  Interestingly, we had not seen comprehensive legislation with this focus since the Budget and Accounting Procedures Act of 1950 was enacted by lawmakers.

As a result of the 1990 Act, the Government Accountability Office (“GAO”) annually audits the financial statements of the Internal Revenue Service (“IRS”).  The general objectives of the audit are two-fold:  (i) to determine whether the IRS’s financial statements are fairly presented; and (ii) to determine whether the IRS is maintaining effective internal controls over financial reporting.

As you may suspect, the success of the tax collection efforts of the IRS directly impacts federal receipts.  Accordingly, the effectiveness of the financial management of its operations is critically important to both lawmakers and taxpayers.

On November 12, 2015, the GAO issued its audit report for fiscal years 2014 and 2015.  The report spans, with attachments, over 150 pages, and contains some interesting information.  Some may characterize the information as downright scary!


The GAO concludes that the Service’s financial statements are “fairly presented in all material respects.” That is the good news. With good news, however, there is sometimes bad news. This happens to be one of those cases.

The bad news is that the “IRS did not maintain effective internal control over financial reporting as of September 30, 2015, because of a continuing material weakness in internal controls over unpaid tax assessments.” Weaknesses in the IRS systems and errors in taxpayer accounts apparently rendered its systems incapable of readily distinguishing between taxes receivable, compliance assessments, and tax write-offs. Consequently, the IRS, in its financial reporting, had to make over $9 billion in adjustments to the numbers computed by its financial systems. One has to assume this work was both laborious and costly. YIKES!

If that is not bad enough, the GAO noted some continuing and some new deficiencies in the IRS’s financial reporting systems, including:

  • Missing security updates;
  • Insufficient audit trails;
  • Insufficient monitoring of key systems; and
  • Use of weak passwords

Together, these problems, according to the GAO, constitute a significant deficiency in the Service’s internal controls over its financial reporting systems. Unless these matters are fully addressed, the GAO concludes that the IRS’s financial data and taxpayer data will be at “increased risk of inappropriate and undetected use, modification, or disclosure.”

The Service already faces enormous challenges relating to safeguarding taxpayer information, warding off invalid tax refund claims arising out of cases of identity theft, and implementing the tax provisions of the Patient Protection & Affordable Care Act. Unfortunately, these are not the only challenges confronting the IRS. As reported in previous blog posts (see "Strong Commentary from Washington Regarding IRS Budget Cuts" and "The IRS Continues to Face Severe Budget Cuts—What Does this Mean to Tax Advisors and Their Clients?"), the IRS continues to face significant budget cuts. Together, these challenges appear to be a recipe for disaster. The GAO report issued on November 12, 2015 supports this scary conclusion. As taxpayers and tax practitioners, we should be concerned about all of these matters.

As a general rule, in accordance with IRC § 162(a), taxpayers are allowed to deduct, for federal income tax purposes, all of the ordinary and necessary expenses they paid or incurred during the taxable year in carrying on a trade or business.  There are, however, numerous exceptions to this general rule.  One exception is found in IRC § 280E.  It provides:

“No deduction or credit shall be allowed for any payment paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any state in which such trade or business is conducted.”

Marijuana-plant-300x200Congress enacted IRC § 280E as part of the Tax Equity and Fiscal Responsibility Act of 1982, in part, to support the government’s campaign to curb illegal drug trafficking.  Even though several states have now legalized medical and/or recreational marijuana, IRC § 280E may come into play.  The sale or distribution of marijuana is still a crime under federal law.  The impact of IRC § 280E is to limit the taxpayer’s business deductions to the cost of goods sold.

On October 22, 2015, the U.S. Tax Court issued its opinion in Canna Care, Inc. v. Commissioner, T.C. Memo 2015-206.  In that case, Judge Haines was presented with a California taxpayer that is in the business of selling medical marijuana, an activity that is legal under California law.

The facts of this case are interesting.  Bryan and Lanette Davies, facing significant financial setbacks and hefty educational costs for their six (6) children, turned to faith for a solution.  After “much prayer,” Mr. Davies concluded that God wanted him to start a medical marijuana business.  Unfortunately, it does not appear that he consulted with God or a qualified tax advisor about the tax implications of this new business before he and his wife embarked upon the activity.

The good news for the Davies is that their business blossomed.  In fact, they employ ten (10) people in the business and have enjoyed financial success.  They timely filed state and federal income tax returns, reported income and paid, what they believed, was the proper amount of taxes.  The bad news for the Davies is the fact that the IRS did not agree with their computation of the tax liability.

The IRS issued a notice of deficiency.  Not able to resolve the matter at IRS appeals, the Davies found themselves in the U.S. Tax Court.  The sole issue in the case was whether the taxpayers’ business deductions were properly disallowed by the Service under IRC § 280E.

To no avail, the Davies presented numerous arguments as to why marijuana should no longer be a controlled schedule I substance.  They also asserted that their new business created employment opportunities for others, cured their family’s financial woes, and allowed them to participate in civic and charitable activities.

Judge Haines quickly dismissed the Davies’ arguments, concluding the sale of marijuana is prohibited under federal law—marijuana is a schedule I controlled substance.  Accordingly, IRC § 280E prevents taxpayers from deducting the expenses incurred in connection with such activity (other than the cost of goods sold).

Faced with a tax assessment exceeding $800,000, the Davies argued that their business does more than sell marijuana.  In fact, it sells books, shirts and other items related to medical marijuana.  Citing other cases, they argued that their expenses should be apportioned among the various activities (i.e., the sale of medical marijuana and the sale of other items), and that they should be able to deduct the expenses related to the sale of the non-marijuana items.

The court explained that, where a taxpayer is involved in more than one distinct trade or business, it may be able to apportion its ordinary, necessary and reasonable expenses among the different trades or businesses.  Unfortunately for the Davies, they could not show that they operated two (2) or more trades or businesses.  In this case, the facts indicated that the sale of shirts, books and other items was merely incidental to the sale of medical marijuana.  There was not more than one (1) trade or business.

PRACTICE ALERT:  Whether more than one (1) trade or business exists is a question of facts and circumstances.  Under CHAMP v. Commissioner, 128 T.C. 182 (2007), if a taxpayer operates more than one (1) distinct trade or business, it may be allowed to apportion its expenses among the trades or businesses.  If only one (1) of the businesses is impacted by IRC § 280E, only the expenses relating thereto should be denied.  The key is establishing that more than one (1) trade or business exists, and reasonably be able to apportion the expenses among those trades or businesses.  Keeping separate books and records, and accounting for business expenses in a separate manner, is likely the best approach.  The more separation and distinction among the businesses the better the chances of showing more than one (1) trade or business exists.  Maintaining separate entities or business names for each activity may be warranted.

The Davies lost the case and are now faced with a hefty tax bill.  Unless IRC § 280E is amended, taxpayers involved in the sale of medical and/or recreational marijuana, despite state legalization, will be presented with the same dilemma faced by the Davies in Canna Care, Inc. v. Commissioner.

As reported in previous blog posts (January 17, 2014, January 21, 2014, and January 20, 2015), federal budget setbacks continue to severely impact the Internal Revenue Service (“IRS”) and its ability to carry out its lofty mission:

I-Stock Boxing Gloves

 “[T]o provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all.”

Senator Ron Wyden (D-OR), Ranking Member of the United States Senate Committee on Finance, understands the critical role the IRS plays in maintaining our tax system.  In a letter to IRS Commissioner John Koskinen, dated September 2, 2015, Senator Wyden professionally, but directly, questions the agency’s reallocation of IRS limited resources away from information technology (“IT”), enforcement and collection.

As reported in my January 20, 2015 blog post, IRS Commissioner Koskinen pronounced that, as a result of the budget cuts facing the IRS, in addition to several other expense cutting measures, (i) the IRS would not update and/or replace IT systems as previously scheduled; and (ii) the IRS would implement staff reductions and furloughs, resulting in 280,000 fewer collection matters being pursued and 46,000 fewer audits being conducted this fiscal year.

In his letter, Senator Wyden points out some interesting facts that call into question Commissioner Koskinen’s expense cutting decisions.  Foremost, Senator Wyden raises the fact that about $5.10 of taxes owed are collected for every dollar spent on enforcement efforts.  Consequently, it is troubling that the Service is curtailing collection efforts, the very function that creates revenue.  Isn’t there a better place to reduce expenses within the agency?

Senator Wyden predicts that as a result of Commissioner Koskinen’s expense cuts, in addition to reduced tax collections, the number of tax cheats will rise.  This is especially true if the IRS does not use its available resources to improve IT systems.

It is difficult to disagree with Senator Wyden’s predictions or his criticism of the cost cutting measures being implemented within the IRS.  In fact, Senator Wyden concludes the combination of reduced enforcement activity and funding cuts for IT systems is a “dangerous cycle” that will likely lead to increased tax fraud in this country.  He states:

Shouldn’t the American public view diminished enforcement and reduced IT spending for what they really are:  tax cuts for tax cheats and kickbacks to crime syndicates?

The facts are the facts.  The budget cuts facing the IRS are significant.  Commissioner Koskinen is presented with a very difficult dilemma.  One thing is clear – cutting the funding for collection, enforcement, and IT systems will not serve our tax system well.  That said, where should the cuts be made?

Budget cuts that negatively impact taxpayer service will also likely result in a reduction in tax collections.  With the Code as complex as it is, taxpayer service is paramount to maintaining tax revenues.  The Service plays an important role in providing guidance to taxpayers about their tax obligations.  Numerous empirical studies reveal good taxpayer service improves taxpayer voluntary compliance, leading to increased collections.  Consequently, there may be no good place for Commissioner Koskinen to cut the agency’s expenses going forward without negatively impacting collections and compliance.

Maybe the best answer for our country is to have lawmakers rethink which government agencies should take the brunt of expense reductions.  Logic would tell us that the IRS, the very agency that collects revenues, should probably be last on the list.

Senator Wyden asked Commissioner Koskinen to respond to his letter by October 2, 2015.  I suspect the response will be an interesting read.  Stay tuned!

Weight ScalesOn May 11, 2015, after serving as Director of the Office of Professional Responsibility (“OPR”) for approximately six (6) years, Ms. Karen Hawkins announced her intention to step-down and retire, effective July 11, 2015.

The OPR is responsible for interpreting and applying the Treasury Regulations governing practice before the Internal Revenue Service (commonly known as “Circular 230”).  It has exclusive responsibility for overseeing practitioner conduct and implementing discipline.  For this purpose, practitioners include attorneys, certified public accountants, enrolled agents, enrolled actuaries, appraisers, and all other persons representing taxpayers before the Internal Revenue Service.

The vision of the OPR is “to be the standard-bearer for integrity in tax service.”  As stated on OPR’s website, its “vision, mission, strategic goals and objectives support effective tax administration by ensuring all tax practitioners, tax preparers, and other third parties in the tax system adhere to professional standards and follow the law.”  Its specific goals include:  increasing tax advisor awareness and understanding of Circular 230; applying the principals of due process in all investigations and proceedings; and building, training and motivating its administrative team.

Ms. Hawkins will undoubtedly be missed by her work government colleagues.  She will also be missed by the tax community.  During her tenure at the OPR, she not only cleared the decks of a large backlog of pending disciplinary cases, she increased tax practitioner awareness and understanding of Circular 230.  Ms. Hawkins consistently made herself available to the tax community, speaking at numerous tax institutes and forums (including the Oregon Tax Institute).  In a direct, clear and concise manner, she reminded practitioners of their obligations under Circular 230.  Ms. Hawkins did not shy away from tough questions raised by tax practitioner audiences.  Instead, she hit the questions head on and provided complete and earnest answers.  Ms. Hawkins was likely responsible, in whole or in part, for the amendments to Circular 230 that alleviated the need for tax advisors to insert the silly disclaimers on all written communications that may contain federal tax advice.

While I have to assume Ms. Hawkins was a tough adversary in any disciplinary proceeding, especially given her no-nonsense approach to matters, she gave good and well-needed guidance to the tax community following amendments to Circular 230.  The tax community should be thankful for all of Ms. Hawkins’ hard work and her strong dedication to the tax profession.  She will be greatly missed.

As of the writing of this blog post, the Commissioner of the Internal Revenue Service had not named a successor Director.  I assume that Lee Martin, the Deputy Director, will serve as acting Director until a successor is named.

As reported in my January 21, 2014 blog post, federal budget cuts continue to hit the IRS hard.  In the Consolidated Appropriations Act of 2014, our lawmakers cut the Service’s budget by more than $500 million.  The Continuing Appropriations Resolution, 2015, signed by President Obama on September 19, 2014, gave the Service about a $350 million budget setback.

While it is hard to debate the need for government budget cuts these days, deciding where to make the cuts is surely a difficult endeavor.  Nevertheless, perplexing as it may be, lawmakers find it necessary and appropriate to cut the funding of the IRS, a division of our government that collects revenue.  Making these budget decisions even more baffling, we currently have an annual tax gap in this country of over $450 billion.  Adequately funding the IRS so that it can enforce our tax laws, thereby reducing the annual tax gap, should be a given.  Apparently, it is not a given to our lawmakers.

Of interesting note, the annual tax gap has increased by approximately $150 billion since 2001.  Yet, the IRS has had its budget slashed by over $1 billion in the last five (5) years.

According to IRS Commissioner John Koskinen, the funding of the IRS this fiscal year ending September 30 is back to the 2008 funding level.  He suggests the results will be felt by taxpayers and tax advisors, including:

  • At least 46,000 fewer business and individual audits will conclude this fiscal year;
  • Taxpayers will encounter about a thirty (30) minute wait when calling a service center to reach an IRS representative;
  • 3,000 to 4,000 IRS employees will lose their jobs and there is the possibility that employee furlough days will be implemented this fiscal year, reducing the ability of the IRS to provide taxpayer service;
  • Approximately 280,000 or more fewer collections will be made this fiscal year;
  • IT systems will not be replaced or updated this fiscal year as scheduled; and
  • Implementation of taxpayer identification theft protections will have to be delayed until a future fiscal year.

Commissioner Koskinen predicts these most recent IRS budget cuts will ultimately result in a loss of $2 billion or more in tax revenue that would have otherwise been collected this fiscal year.  WOW!

These budget cuts remind me of a story I heard about a top salesperson who worked for a successful manufacturer and was consistently responsible for the vast majority of the company’s sales.  He was paid solely on a commission basis that was industry standard.  One day, a new CEO was hired.  Shortly thereafter, the CEO called the salesperson into his office and advised him that he was cutting his commission by 30% because the salesperson was making too much money.  In fact, the salesperson was making more than the new CEO.  What followed?  The salesperson terminated his employment with the company and went to work for a competitor.  Sales plummeted!  Like cutting a successful salesperson’s commission, it defies logic to cut the budget of a revenue-generating branch of the government.  Time will tell if Commissioner Koskinen’s predictions will become a reality.  It seems certain the budget cuts will result in:

  • Lower tax collections; thereby negatively impacting any chances of reducing the tax gap;
  • Less taxpayer service; and
  • Prolonged examination and appeal processes due to IRS staffing challenges.

Taxpayers and tax advisors will need to be patient in their encounters with the IRS.  The Service’s ability to carry out its mission—to provide “taxpayers top quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all” has been significantly hindered by the budget cuts.

Thomas v. Commissioner, TC Memo 2013-60 (February 26, 2013)

The saga of Michael and Julie Thomas started in the early part of this decade.  Michael was the head of real estate acquisition for DBSI in Idaho.  There, he met fellow DBSI employee Don Steeves, who was a CPA with seven (7) years of experience, primarily working in the real estate investment industry.  When Michael started two real estate businesses, TIC Capital ("TIC") and TICC Property Management ("TICC"), he hired Steeves as an independent contractor to serve as CFO of TIC and as the managing partner of TICC.  His compensation was incentive based—he received compensation which was based on the financial success of the two businesses.  In good years, Steeves’ compensation was off the charts.  In addition to acting as CFO for the two businesses, Steeves prepared Michael’s and Julie’s income tax returns.  They relied upon him to oversee all aspects of accounting and tax compliance for both of the businesses and their personal affairs.  They let him take total control of these functions.

TIC acquired real estate and then broke it into tenancy-in-common interests, and sold the interests to passive investors who were generally acquiring property through Section 1031 exchanges.  In most cases, the acquisition and resale of the tenancy-in-common interests occurred simultaneously.  After the properties were sold, TICC would manage the properties for the tenancy-in-common owners for a fee.

While the economy and the real estate markets were hot, both of the companies made significant profits.  As we all know, the booming economy and real estate markets did not last forever.

In September 2007, Steeves resigned from the two businesses, but continued to perform bookkeeping work for both of the businesses, as well as for Michael and Julie, until about March 2008.  He continued to prepare the Thomas’s tax returns until about 2009.

In late 2008, the IRS entered the picture.  It audited the Thomas’s 2006 and 2007 income tax returns.  Guess who appeared on IRS Form 2848 (Power of Attorney and Declaration of Representative) for the Thomas’s?  You guessed correctly – CPA Don Steeves!

The IRS quickly learned the tax returns did not comport to the Thomas’s business records.  Upon learning this, Mr. Thomas demanded CPA Steeves produce accounting records to support the entries he placed on their tax returns.  Apparently, CPA Steeves did not comply with the Service’s request.

Mr. Thomas hired a CPA named Dave Stewart to take over the audit.  Mr. Stewart, who had thirty-four (34) years of experience, quickly learned that CPA Steeves did a very poor job of maintaining the accounting records for Michael and Julie and likely misappropriated funds.  He worked with the auditor and they ultimately agreed to a tax deficiency for both years under review.

Michael and Julie eventually turned the matter over to the Boise Police Department; they alleged CPA Steeves had committed theft, fraud, and misappropriation of their funds.  Also, they sued Don Steeves in a civil suit for more than $1.2 million.

This case focused on the applicability of the Code Section 6662 accuracy-related penalty.

Under Code Section 6662(a), a taxpayer is liable for a 20% penalty on any under-payment of tax attributable to:

  1. negligence; or
  2. disregard of rules or regulations; or
  3. a substantial underpayment of a tax.  For this purpose, a substantial underpayment of tax is an underpayment which is more than the greater of:  10% of the tax required to be shown; or $5,000.

There is a major exception to the application of this penalty.  The penalty does not apply to any portion of an underpayment of tax if it is shown the underpayment was due to reasonable cause and the taxpayer acted in good faith.

In this case, Michael and Julie Thomas alleged they relied upon Don Steeves, an experienced tax advisor.  They turned all accounting and tax matters over to him.  Accordingly, they argued that they acted with reasonable cause and in good faith.  They had no reason to believe that Mr. Steeves was other than competent and honest.

Reliance on the advice of a tax professional may establish reasonable cause and good faith. In accordance with Treasury Regulation Section 1.6664-4(b)(1), if a taxpayer relies upon the professional judgment of a competent tax advisor who has been provided all of the necessary and relevant information, the taxpayer will generally be cleared of an accuracy-related penalty.

To prove “reasonable reliance,” the taxpayer must jump over three hurdles:

Hurdle #1:  The tax advisor must have sufficient experience or expertise to justify reliance;

Hurdle #2:  The taxpayer must have provided the advisor with the necessary and accurate information; and

Hurdle #3:  The taxpayer must have relied in good faith on the tax advisor’s guidance.

Here, Don Steeves was a CPA; he had 7 years of experience in the real estate industry.  Mr. Thomas knew CPA Steeves from his work with DBSI.  According to testimony at trial, Mr. Thomas provided Mr. Steeves with all documents and information he requested, including mortgage and interest records.

So, the court concluded Hurdle #1 and Hurdle #2 were met.  Steeves had sufficient experience and expertise.  Also, the taxpayers provided him with all of the information required to accurately prepare the tax returns.  The ultimate question came down to whether the Thomas’s reliance upon CPA Steeves was in good faith.

In this case, Michael and Julie Thomas gave CPA Steeves their power of attorney at the outset of the audit.  It was not until the IRS uncovered the numerous return problems that Mr. Thomas terminated Mr. Steeves, instituted a civil lawsuit against him, and went to the police so criminal action could be pursued.  Before that, Michael and Julie believed in Don Steeves and they relied upon him.

Judge Gerber of the US Tax Court concluded that Michael and Julie Thomas met their burden and showed they had acted in good faith and with reasonable reliance on the advice of a professional tax advisor.  Consequently, the Code Section 6662 penalty was tossed out.

This is a textbook case for applying the reasonable reliance defense to a Code Section 6662 penalty.  The Tax Court clearly and thoughtfully reviewed the elements of the reliance defense.  So, this decision should serve as a good textbook reference if you come across a case where the defense may be viable.  The take-away is simple:  The accuracy-related penalty does not apply to any portion of an underpayment of tax where the taxpayer acted with reasonable cause and in good faith.   A reasonable cause determination takes into account all of the relevant facts and circumstances.   The taxpayer claiming reliance on a tax professional must prove that:

  1. The tax adviser was a competent professional who had sufficient expertise to justify reliance;
  2. The taxpayer provided necessary and accurate information to the tax adviser; and
  3. The taxpayer actually relied in good faith on the tax adviser’s judgment.

Treasury issues long-awaited amendments to Circular 230.  On June 9, 2014, Treasury published amendments to Circular 230 that we have been anticipating for the past several months.  It looks like the crazy email disclaimers, just like leisure suits, will be a thing of the past.  Among many changes to Circular 230, the final regulations eliminate or clarify the complex rules for written advice.  Based upon my first read of the regulations, it certainly appears Treasury has been listening to tax practitioners.

Stay tuned, I will be posting a summary of the amended regulations soon.

Search This Blog



Larry Brant

Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.

Recent Posts


Select Category:


Select Month:

Upcoming Speaking Engagements


Back to Page