IRS AUDIT ISSUES
The dollar amounts involved
in disasters are usually very large, especially compared to other amounts on
the return of the taxpayer who experiences the event. The disaster casualty
loss tax return is more of a “target” for examination than the normal return by
both federal (IRS) and the local state tax authorities. For this reason the
best defense is to have a well documented analysis to support the tax position
being taken on a disaster year / disaster recovery year tax return.
The firm of JOHN TRAPANI
C.P.A., is dedicated to
providing information to taxpayers and tax professionals dealing with the
complexities of resolving the income tax consequences of a catastrophic event.
These situations are always stressful for the taxpayer. At these times,
taxpayers are in psychological shock and that makes it even more difficult to
deal with the tax reporting responsibilities. Complying with the reporting
requirements of the Internal Revenue Code adds to the stress. Taxpayers don’t
read the Code and are suspicious of the positions presented in instructions in
IRS publications and forms. Most tax professionals don’t deal with more than
three or four disaster events in their whole carrier.
Our clients bring us
many interesting disaster reporting / recovery situations. We have also had the
opportunity to assist taxpayers who have already filed tax returns that need to
be adjusted / corrected or the ongoing process of reporting has become more
than their original tax professional can deal with. But still, there are always
situations that we have not seen or even imagined. Over a period of more than
twenty years, we have not seen two disaster situations that are even close to
being similar.
CATASTROPHIC
EVENTS ARE NOT TRIVIAL
Sometimes the IRS
does make mistakes in applying the rules and taxpayers win in court. In one
situation, the IRS had an incorrect position that stood for over 25 years
before a taxpayer successfully challenged it successfully; that was back in
1956. In 2012 the IRS also lost a case in a Supreme Court case. But these are
rare situations.
There are thousands
of audits that never get a public airing in court – overall, that is probably
good. But are taxpayers getting a fair deal? Not all audits need to be
addressed in court or in a Revenue Ruling or even a IRS Private Letter Ruling.
Either the taxpayer succeeds in the audit without litigation or the taxpayer
concludes that further prosecution of their position is going to be too costly.
The additional stress of fighting the IRS is more than can be absorbed by a
family after dealing with the rest of the trauma that the catastrophic event
created for them. It is also possible that the taxpayer simply does not have
enough information to make a good decision. Sometimes the taxpayer is correct and
the IRS defeats them because the taxpayer does not have the correct strategy or
information regarding comparable cases where the taxpayer succeeded. This
situation is a travesty for the taxpayer.
WHAT
IS YOUR SITUATION?
The IRS and taxpayers
do not always agree on the proper approach to report a catastrophic loss event.
The large number of tax cases that go to court and rulings published by the IRS
since the inception of the Internal Revenue Code are evidence that this is a
complex area. Many tax cases seem to involve issues where the taxpayer has no
chance of being successful. The massive amount of official information (court
cases and ruling) is often difficult to sift through. Many tax professionals
have only one client every five or ten years who has experienced a catastrophic
event. The profession does not provide significant professional education to
train professionals. When professional education is offered few professionals
attend. At the same time taxpayers are forced to make major financial decisions
in a short period of time about assets in which their emotional investment may
be greater than their financial investment. The “deck” is stacked against the
taxpayer; many professionals are simply not prepared to help. If the poorly
prepared return is audited, the tax preparer does not know where to start.
The firm of JOHN TRAPANI
C.P.A., is available to
assist before the first tax return is due, during the recovery process and once
the return is called for audit. We are also available to assist in the
evaluation of a tax position that has been reported on a tax return.
Below are five topics
that cover issues that arise in many audits. These topics address issues that can
trigger an audit, or potentially create huge reporting and tax liability problems.
You have many
problems to deal with in the recovery process. From the outset, potential problems
can be created inadvertently that will have a direct effect on your disaster recovery.
Preparing for audit issues and preparing all the necessary documentation to
report your disaster year / disaster recovery years tax returns is of prime
importance.
TOPICS
RESTRICTIONS
ON IRS ABILTY TO USE 20/20 HINDSIGHT AGAINST TAXPAYERS IN AUDITS OF DISASTER
RETURNS - CHIEF COUNSEL ADVICE (CCA) 200750016
IRS
REVENUE PROCEDURE 2007-56 - COMPLIANCE DEFERRALS
ESTIMATED
TAXES AFTER THE DISASTER
UNDERPAYMENT & LATE PAYMENT PENALTIES & INTEREST
WHAT...?
YOU DID NOT REPORT INSURANCE PROCEEDS ON YOUR TAX RETURN!
RESTRICTIONS ON IRS ABILTY TO USE 20/20
HINDSIGHT AGAINST TAXPAYERS IN AUDITS OF DISASTER RETURNS - CHIEF COUNSEL
ADVICE (CCA) 200750016
Near the end of 2007,
the IRS issued CCA 200750016,
(November 08, 2007). A CCA is an advice memo issued by the legal side of the
IRS, The Office of Chief Counsel. It deals with the issue of examining taxpayers
casualty losses. The IRS states that the rules that apply to taxpayers do not
apply to the IRS. (That statement might suggest that your worst fears are going
to be confirmed. Not true this time.) The rules that the IRS must comply with
are more restrictive than what is expected of taxpayers. The question arises
because of year-ends and time-lines. The taxpayer files a return for 2012 in
2013; but the IRS does not call until 2015. A lot of transactions have occurred since the return
was filed, what can the IRS auditor use, how much 20/20 vision can they apply. The
CCA states the issue and its conclusion as follows:
ISSUE:
Treatment of Gulf Hurricane casualty loss claims involving reimbursement, or a
reasonable expectation of reimbursement, for the loss from federal or State
grants.
CONCLUSION:
The same rule does not apply under the I.R.C. §165 regulations to taxpayers claiming a casualty loss and to the
IRS when it examines a claimed loss.
Taxpayers must reduce
their casualty loss deduction by the amount of any reimbursements received from
insurance and other sources and by the amount of reimbursements they reasonably
expect in the future as determined at the end of the taxable year of the casualty.
Taxpayers should also reduce their casualty loss deduction by the amount of any
expected reimbursements determined as of the time of the filing of the tax
return claiming the loss
Examiners use the
same criteria as the taxpayer, but must base their determination of
the facts and circumstances known as of the end of the tax year for which the
casualty loss is claimed. The IRS may not reduce casualty losses claimed on the
return being examined to reflect receipt of reimbursement received after the
end of the tax year being audited, or to reflect an expectation of
reimbursement from grants or other sources arising after the taxable year end
and by the time the return was filed or of the examination.
This CCA indicates two important issues:
One,
the CCA was issued specifically relating to the 2005 Katrina Disaster. We see
from this CCA that the IRS is auditing losses, even in one of
the most economically depressed disaster areas.
Two,
the IRS cannot use 20/20 hindsight two years later after a good faith return
has been filed. This is consistent with the theory that each tax year stands on
its own merits based on the facts and circumstances that exist at the time.
This is a two edged
sword, in this case the CCA may assist the taxpayer in avoiding penalties and
interest costs that might arise in an examination of their tax return filed in
connection with a disaster loss, but it reminds us of the taxpayers’
responsibility to be diligent in reporting the facts of the disaster that are
available at the time the return is prepared.
(CCAs are generally restricted to a
single taxpayer or event, as in this case, Hurricane Katrina. The general
application is worth mentioning to an agent, if your audit is going bad due to
an examiner’s use of information that was not available to you at the time you
prepared the tax return.)
IRS REVENUE PROCEDURE 2007-56
COMPLIANCE DEFERRALS (Code
Section 7508A)
: When a disaster
occurs, the IRS will impose IRC Section 7508A to provide relief from many
filing deadlines. The section also creates suspensions of other tax deadlines
and due dates, including many limitations on audit statute of limitation time
constraints. Regulations issued during 2007 provide detail explanations of how
the section would be applied in a disaster. The regulations (§301.7509A-1)
include 8 examples that are very detail. The professional should match-up the
regulations with the taxpayers’ situation at the time of the disaster to
determine extensions that may apply. The current delineation of all
postponements are contained in Rev. Proc. 2007-56.
Rev.
Proc. 2007-56 includes a complete list of tax
related deadlines that may be deferred by the IRS when a disaster strikes.
Section .05 of the Procedure lists the types of deferrals that are included in
the list.
.05 Significant Changes.
When a Presidentially declared disaster occurs, the IRS guidance usually
postpones the time to perform the acts in section
301.7508A-1(c)(1) as well as this revenue procedure.
Certain
acts, such as filing Tax Court petitions in innocent spouse and other
nondeficiency cases, and making certain distributions from, contributions to,
recharacterizations of, and certain transactions involving qualified retirement
plans (as defined in section 4974(c)),
have been added to this revenue procedure even though they are also listed as
acts postponed under section
301.7508A-1(c)(1).
The list
is extensive and is updated periodically. If the IRS announces the imposition
of the relief provisions related to an area that affects taxpayers, tax
professionals are advised to consult the IRS regarding the release covering the
disaster of and also Rev.
Proc. 2007-56.
ESTIMATED TAXES AFTER THE DISASTER
While the due date
for making an estimated tax payment may be affected by Rev. Proc. 2007-56, the
actual payment will still be due. People who experience a disaster loss may
decide to stop paying estimated taxes. They believe that the casualty loss will
eliminate all their tax liability. This is often a mistake, especially for
self-employed people. While a casualty loss deduction
will reduce the income tax liability,
it does not reduce self-employment tax, business property losses are
reported on Form 4684 (page 2) and carried forward to Form 4797. Thus they do
not affect the calculation of self-employment taxes.
Additionally,
taxpayers often believe the loss is valued at the replacement cost of their lost
items or the appraised loss amount. Losses are usually much smaller than
expected. The insurance proceeds will reduce or eliminate much of the
deduction. Generally people who are uninsured don’t get as much tax benefit
from the deduction as they expect. Their economic loss far outweighs their tax
benefit. The personal loss deduction will be reduced by $100 and 10% of their Adjusted
Gross Income as reported at the bottom of page one of Form 1040.
UNDERPAYMENT & LATE
PAYMENT PENALTIES & INTEREST
The
provisions of the Internal Revenue Code that covers the late payment and
underpayment of taxes, including interest and penalties for negligence and
fraud are within the IRS’s tool box including casualty and involuntary
conversion events.
However,
if a taxpayer elects to defer a gain from an involuntary conversion and within
the time limit provided completes the replacement but falls short of
reinvesting all the proceeds in qualified replacement property, an amended
return for the year(s) the gain(s) were realized must be filed. In these cases,
the taxpayer is billed for interest only, no penalties apply. Where the gain is
realized over multiple years, the reporting of recognized gains should be on a
last received, first reported basis. In other words, if proceeds of $200,000
are received, half in year one and half in year two, and a realized gain after
offseting the cost basis of $120,000 is 80,000, requires the taxpayer to
reinvest $200,000 to defer the whole of the $80,000 gain. If only $110,000 is
reinvested, it would require the year two proceeds of $80,000, that would
become taxable. The remaining proceeds from year two of $20,000 would not be
recognized as gain in year two since it is less than the total gain.
Alternatively,
if the taxpayer estimates that less than all of the proceeds will be reinvested
and reports the income on that basis and pays the tax, no interest would be due
to the taxpayer on that portion of the funds that are reinvested in excess of
what was originally planned. If later, within the replacement period, the
taxpayer actually invests the proceeds previously reported, an amended return
may be filed to reduce the prior income reported and claim a refund. The IRS is
not required to pay interest on such refunds. This is not a change in the
election, simply a change in the amount.
WHAT...? YOU DID NOT REPORT INSURANCE
PROCEEDS ON YOUR TAX RETURN!
You received
significant insurance proceeds from your claim for reimbursement for a loss of
property and you failed to report the receipt in the required manner on your
income tax return for the year of receipt.
What are the
implications of your failure?
There is some good
news, but a lot of potentially bad news.
Over the years we
have talked to several people who assert:
“The insurance company does not issue a
Form 1099 reporting to the IRS. The IRS does not ‘know’ I have received any
insurance reimbursements. I am not telling the tax collector I received this
money.”
BIG MISTAKE!!!
Generally, most
people would assume two possible choices; report receipt of the insurance
proceeds and follow all the IRS reporting rules, or fail to report and live in
a state of anxiety fear that the IRS will audit their finances and find the
hundreds of thousands of dollars that was deposited into a bank accounts. (For
IRS examiners, such a discovery of a large, unusual deposit that has not been
reported is like finding a real diamond at the bottom of the Cracker Jacks
box.)
It is interesting to
find out that the tax code includes a provision for such taxpayer attitudes.
Additionally, proper reporting might not involve any tax liability and would
relieve ongoing anxiety about the IRS finding out the proceeds were not
reported.
It turns out that
there is a third possibility. That possibility holds out some chance for
redemption, but is not a complete “get out of jail free card.” The significant
relevant part of the Internal Revenue Code was enacted into law in 1954. The
IRS issued corresponding regulations in 1957. The rules have been around for a
long time. Those 1957 regulations includes the following sentence:
“A
failure to so include such gain in gross income in the regular manner shall
be deemed to be an election by
the taxpayer to have such gain recognized only to the extent provided in
subparagraph (1) of this paragraph even though the
details in connection with the conversion are not reported in such return.”
Emphasis
added, Regulation 1.1033(a)-2(c)(2), sentence #4)
This sentence is
generally referred to as the “deemed election.”
The significant
portion of paragraph (1), referred to in the above excerpt, states:
“Gain,
if any, shall be recognized, at the
election of the taxpayer, only to the
extent that the amount realized upon such conversion [receipt of insurance
proceeds for lost property] exceeds the
cost of other property purchased by the taxpayer which is similar or related in
service or use to the property so converted.” (From
Regulation 1.1033(a)-2(c)(2), sentence #4)
In other words, if
the taxpayer does not report the receipt of the insurance proceeds, the IRS
(through its regulations) assumes that the taxpayer has made an implicit
election to reinvest the proceeds in qualified replacement property. For a
taxpayer that does not reinvest the proceeds and the total proceeds received
exceed the cost basis of the lost property, this IRS position does not provide
any relief of anxiety. Nor does it relieve the taxpayer of any potential tax
liability.
It appears that the
taxpayer who realized proceeds in excess of the cost basis of the asset lost
has received a “gift” from the IRS as a result of the “deemed election.”
But there is still a
problem?
The “deemed
elections” is a two edged sword. There are two parts to the reporting process.
The first part is the initial reporting of the insurance proceeds, the IRS has
provided relief here with the “deemed election” if the taxpayer makes no report
of the proceeds. But the second is where the taxpayer gets into trouble. The taxpayer
must still report the actual reinvestment of the insurance proceeds. The IRS
does not provide relief for this part. In 2001 the IRS issued an interpretation
of the regulation. In that interpretation, the IRS burst a bubble that many
professionals lived in. Up to that time many accountants who read the “deemed
election” sentence quoted above, assumed that it covered both the election to
replace and the actual reinvestment of
the proceeds. The 2001 IRS interpretation said NO to the second part.
According to the IRS,
the sentence only covers the election to replace. The taxpayer still has the
responsibility to report the reinvestment. Further, if a tax return is filed
for a year in which proceeds are reinvested but the reinvestment is not
reported as replacement, the IRS assumes that the taxpayer has decided that the
acquisitions not reported are excluded from being part of a qualified
reinvestment, forever. The IRS takes the position that only those reported
acquisitions (replacements) are the ones that the taxpayer wants to include as
reinvestments. This would seem to be a rational conclusion for taxpayers who
report the receipt of the proceeds. But, if you are relying on the “deemed
election” should you be allowed to make a “deemed replace?” The IRS does not
agree with that position. It is interesting that the IRS took nearly fifty
years to take a position on the situation. Some tax cases touch on the
situation, but do not actually address the possibility of a “deemed
replacement.” It is interesting that the IRS took that position in a Field
Service Advice (FSA) instead of a change to the actual regulation or issuing a
Revenue Ruling both having a higher level of authority than a FSA.
In any case, if no
reinvestment takes place, the gain is taxable.
Therefore, the
“deemed election” is of minor value. It is essentially useless in the event
where a taxpayer reinvests the proceeds in the same year as the proceeds are
received but makes no reporting of the receipt or the reinvestment.
If the proceeds are
reinvested in a subsequent year and the reinvestment is properly reported, the
taxpayer must also amend the tax return for the year that the proceeds
were received to make a definitive election to reinvest the proceeds. This
takes care of an innocent oversight on the return for the year of proceeds were
received.
However, the IRS does
not permit an amended return to “correct” the oversight of reporting a
qualified reinvestment / replacement.
If you need to
discuss your situation with your tax adviser, you can tell them to check out
IRS Field
Service Advice (FSA) 200747053. The IRS was so sure of their
conclusions that they actually issued the FSA twice.
The rules are
generally structured to be “taxpayer friendly.” Failing to follow the rules can
create a lot of trouble for taxpayers who are otherwise dealing with enough
stress in their process of recovering from a catastrophic event. Income taxes
are one area that can be handled reasonably easy if the assistance of a
knowledgeable professional is sought.
There is one possible
consolation if the situation describes is your situation. If the gain does not
exceed $500,000, the taxpayer and spouse may be eligible to use the provision
of the tax code that applies to the exclusion of gain, up to $250,000 ($500,000
for a married couple), on the disposition of a primary personal residence. There are limitations on the ability to use
this exclusion in a disaster.
PROFESSIONALS AND TAXPAYERS
·
Are you dealing with the IRS on an
audit of a casualty, disaster loss with or without a recovery that “triggers”
consideration of the involuntary conversion deferral benefits?
·
Has the IRS disqualified your
designation of replacement property?
·
Is the IRS questioning your loss
computation?
·
Is the IRS questioning your proof or an
“intention to replace property” involuntary converted?
·
Does the IRS question your support for
the cost basis of the assets that were damaged or destroyed in the catastrophic
event?
·
Has the IRS said that you used the
“cost of repairs” method incorrectly?
·
Is there a dispute concerning the
statute of limitations?
There are so many
ways that the IRS can challenge a taxpayer in a disaster recovery tax return.
Send an email to us at
“John@TrapaniCPA.com” or write me a letter describing your issues. We may
contact you if need additional information. Your question will be answered t
the extent that it can be in a brief reply, or we will suggest steps that you
can take.
Taxpayers make simple
mistakes that result in significant cost that could have been avoided.
Dealing with an audit
of a catastrophic loss will likely involve a dollar amount that is the largest
amount to appear on your tax return. It is worth paying proper attention to the
situation.
If you are at the
beginning of resolving a casualty loss reporting, thinking about how to report
it on a tax return, you need strategic or simple tactical information to
consider as you progress in your recovery process, We may be of assistance.
Each of your decisions will affect your financial results. Don’t take a chance
compounding mistakes.
The information in
this material is provided to assist those who wish to minimize their exposure
to tax reporting examinations and to assist those who are in the process of a
disaster tax examination with information that may limit exposure to
adjustments. In the event that you need additional assistance contact us via
email, US Postal Service or call us at:
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JOHN TRAPANI
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Certified Public Accountant
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2975 E. Hillcrest Drive, #403
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Thousand Oaks, CA 91362
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(805) 497-4411
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John@TrapaniCPA.com
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JOHN TRAPANI assists both
taxpayers directly and advises taxpayers’ tax professionals.
