Accuracy Related Penalty IRC 6662(a): 5 Tips

5 Tips by Tax Lawyer Philip Falco:

  1. Scan all of your receipts and email the questionable expenses to your CPA for review.
  2. Keep a mileage log and provide the actual log to your CPA.  Telling your CPA what your mileage was is not enough to avoid the IRC 6662(a) accuracy related penalty.
  3. Work with a CPA who has integrity and who will be willing to “fall on the knife” if he gave you incorrect tax advice.  Everyone makes mistakes, not everyone is willing to own up to them.
  4. Categorize your expenses all year long.  If you are not sure if something is a business expense, ask right away and properly categorize it.  It is up to the taxpayer to show the IRS you properly categorized an expense.  This seems simple but is subtly complex.  The IRS will willingly categorize an expense as personal unless taxpayer shows otherwise.
  5. Evidence is the name of the tax game.  In the digital age, there is no excuse for not archiving old receipts.  These documents can be critically important many years down the road.  Keep them, especially those pertaining to rental real estate (purchase, improvements) and business expenses.  Really any real estate evidence should be archived since an owner occupied real estate holding can be converted to a rental.  If so, adjusted basis (ex depreciation) becomes very important.

Accuracy Related Penalty IRC 6662(a)

Section 6662(a) imposes an accuracy-related penalty equal to 20% of the underpayment to which section 6662 applies. Section 6662 applies to the portion of any underpayment which is attributable to, among other things, negligence or disregard of rules or regulations. Sec. 6662(b)(1).  Underpayment of tax is typically attributable to negligence.

IRC Section 6662(c) provides that “[f]or purposes of section 6662, the term ‘negligence’ includes any failure to make a reasonable attempt to comply with the provisions of the Code, and the term ‘disregard’ includes any careless, reckless, or intentional disregard.”

Negligence also includes any failure to exercise ordinary and reasonable care in the preparation of a tax return or any failure to keep adequate books and records and to properly substantiate items. Sec. 1.6662-3(b)(1), Income Tax Regs.

Burden of Proof

Section 7491(c) provides that the Commissioner bears the “burden of production” with regard to penalties and must come forward with sufficient evidence indicating that it is appropriate to impose the penalty. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner meets his “burden of production”, however, the “burden of proof” remains with the taxpayer, including the burden of proving that the penalty is inappropriate because of reasonable cause under section 6664. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.

Exception: Reasonable Cause for Taxpayer’s Position

Section 6664(c)(1) provides that the penalty under section 6662(a) shall not apply to any portion of an underpayment if it is shown that there was reasonable cause for the taxpayer’s position and that the taxpayer acted in good faith with respect to that portion. See Higbee v. Commissioner, 116 T.C. at 448. The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Petitioners have the burden of proving that the penalty is inappropriate because of reasonable cause under section 6664. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.

Reasonable cause can be reliance on a CPA’s tax advice.  However, For reliance to be reasonable, “the taxpayer must prove by a preponderance of the evidence that the taxpayer meets each requirement of the following three prong test: (1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.” Neonatology Assocs., P.A. v. Commissioner, 115 T.C. at 99.

As an example, if a taxpayer tells his CPA about mileage without also giving the CPA a mileage log, this has been held to be not sufficient, and the accuracy related penalty was imposed.

It is up to the taxpayer to show that he provided his CPA with sufficient documentation of a deduction.

Practical Effect: Your CPA will have to write a letter to the IRS, be interviewed by the IRS, or testify in Tax Court (or US District Court) to adequately present this approach.

Meticulous bookkeeping is critical for taxpayers in the 21st Century.  Please feel free to ask us about our bookkeeping, accounting, and tax services.

Denver Head Tax a deduction on Colorado State Income Tax Return

We do a host of tax return amendments for clients either as part of OVDP, or simply corrected errors spotted by clients of other CPA’s, c.f.  IRS Pre-Audit Investigations.

As part of our thorough review we noticed that a different accounting office had added back in full the amount of state and local income tax paid by a taxpayer.  Here’s what we gathered based on the tax law.

Colorado State Income Tax return 104 starts with the federal income tax from form 1040.  Pursuant to CRS §39-22-104, certain items are added; that is, taxpayer will pay Colorado State tax on those items even though taxpayer did not pay federal income tax on those items.

One such item is State Income Tax.  State and local income tax is deductible pursuant to IRC §164(a)(3) on a 1040.  It makes sense for Colorado to essentially disallow a deduction for the tax the income of which it is taxing.

Enter local tax, such as the Denver Head Tax. I have good news for you: the Denver Head Tax is deductible on the 1040 and Colorado 104.  It is not added in pursuant to CRS §39-22-104.  The add-in applies only to state income taxes, not local taxes.



Innocent Spouse Relief Even for the Wealthy

If a taxpayer prevails under the provisions of Innocent Spouse Relief, the taxpayer will be freed of that tax-liability shackle. Philip Falco, CPA, Juris Doctor provides you with Tax Tips based on the Ehrmann case and based on his insight and then discusses the requirements for Innocent Spouse Relief.  He discusses a recent tax case drafted by the United States Tax Court, Kathryn D. Ehrmann v. Commissioner of Internal Revenue, T.C. Summary Opinion 2014-96.  This is a very recent case, which is dated September 23, 2013.  This case may not be relied upon as precedent, but it is still telling of the Court’s view on Innocent Spouse Relief cases.

Tax Tips for those entering or exiting marriage (Divorce) as to Innocent Spouse Relief:

  • Consider not paying the tax in dispute,
  • Hire competent tax counsel to draft tax language in divorce decree, stipulation, or settlement agreement,
  • Consider filing your tax return using a different filing status such as separately or head of household (if qualified).
  • Before getting married, hire us to do a tax compliance checkup on your fiancé.  If you are getting married a bit older in life, this actually makes sense since you really would not know a person’s tax history.  Concealment of prior tax history is a common reason for petitions under Innocent Spouse Relief.

Innocent Spouse Relief, Equitable Relief: the catch-all

Generally, married taxpayers who file a joint Federal income tax return are jointly and severally liable for the tax reported or reportable on the return. Sec. 6013(d)(3); Butler v. Commissioner, 114 T.C. 276, 282 (2000). Section 6015, however, allows a spouse to obtain relief from joint and several liability in certain circumstances.

Section 6015(a)(1) provides that a spouse who has made a joint return may elect to seek relief from joint and several liability under subsection (b) (dealing with relief from liability for an understatement of tax with respect to a joint return). Section 6015(a)(2) provides that an eligible spouse may elect to limit that spouse’s liability for any deficiency with respect to a joint return under subsection (c) (dealing with relief from joint and several liability for taxpayers who are no longer married or who are legally separated or no longer living together). If a taxpayer does not qualify for relief under either subsection (b) or (c), the taxpayer may seek equitable relief under subsection (f).

Equitable Innocent Spouse Relief: Requirements

There are seven threshold conditions that a requesting spouse must satisfy to be eligible for relief under section 6015(f):

  1. the requesting spouse filed a joint Federal income tax return for the tax year or years for which relief is sought;
  2. the requesting spouse does not qualify for relief under section 6015(b) or (c);
  3. the claim for relief is timely filed;
  4. no assets were transferred between the spouses as part of a fraudulent scheme;
  5. the nonrequesting spouse did not transfer disqualified assets to the requesting spouse;
  6. the requesting spouse did not knowingly participate in the filing of a fraudulent joint return; and
  7. the liability from which relief is sought is attributable to an item of the nonrequesting spouse.

If a requesting spouse satisfies the threshold conditions of Rev. Proc. 2013-34, sec. 4.01, the Commissioner considers whether the requesting spouse is entitled to a streamlined determination of equitable relief under section 6015(f).  If a requesting spouse is not entitled to a streamlined determination because the requesting spouse does not satisfy all the elements in Rev. Proc. 2013-34, sec. 4.02, the requesting spouse’s request for relief may be considered using the equitable relief factors in Rev. Proc. 2013-34, sec. 4.03.

Under Rev. Proc. 2013-34, sec. 4.03, equitable relief under section 6015(f) may be granted if, taking into account all the facts and circumstances, it would be inequitable to hold the requesting spouse responsible for all or part of the liability. In making the decision, the Commissioner weighs a number of factors, including, but not limited to:

  • Marital status. Whether the requesting spouse is no longer married to the nonrequesting spouse as of the date the Service makes its determination.
  • Economic hardship. Whether the requesting spouse will suffer economic hardship if relief is not granted.
  • Knowledge or reason to know. In the case of an income tax liability that was properly reported but not paid, whether, as of the date the return was filed or the date the requesting spouse reasonably believed the return was filed, the requesting spouse knew or had reason to know that the nonrequesting spouse would not or could not pay the tax liability at that time or within a reasonable
    period of time after the filing of the return.
  • Legal obligation. Whether the requesting spouse or the nonrequesting spouse has a legal obligation to pay the outstanding Federal income tax liability.
  • Significant benefit. Whether the requesting spouse significantly benefitted from the unpaid income tax liability or understatement.
  • Compliance with income tax laws. Whether the requesting
    spouse has made a good faith effort to comply with the income tax
    laws in the taxable years following the taxable year or years to which
    the request for relief relates.
  • Mental or physical health. Whether the requesting spouse was in poor physical or mental health.

“Weighs” is highlighted because not ALL of the factors need be present, which is especially true in the Ehrmann case, as discussed below.

Economic Hardship

Kathryn D. Ehrmann v. Commissioner of Internal Revenue, T.C. Summary Opinion 2014-96, September 23, 2014, sheds light on “economic hardship”.

For purposes of this factor, an economic hardship exists if satisfaction of the tax liability, in whole or in part, will cause the requesting spouse to be unable to pay reasonable basic living expenses. Id. sec. 4.03(2)(b), 2013-43 I.R.B. at 401. The facts and circumstances considered in determining whether the requesting spouse will suffer economic hardship include:

  1. the requesting spouse’s age, employment status and history, ability to earn, and number of dependents;
  2. the amount reasonably necessary for food, clothing, housing, medical expenses, transportation, and current tax payments; and
  3. any extraordinary circumstances such as special education expenses, a medical catastrophe, or a natural disaster.
  4. In addition, consideration is given to the requesting spouse’s current income and expenses and the requesting spouse’s assets.

Ms. Ehrmann, the court found, would not suffer economic hardship if relief were denied based on the following facts:

  1. Ms. Ehrmann sought a refund of money that had already been paid. Thus, her current financial circumstances will not be adversely affected if relief is denied.  TAX TIP: Consider not paying the disputed tax.
  2. Ms. Ehrmann earned significant income from her position as a senior managing director at CB Richard Ellis. On her Form 8857 petitioner estimated that her 2011 salary and bonus would total over $300,000. In her affidavit filed with the Hennepin County District Court, petitioner disclosed that she earned nearly $340,000 in salary and bonuses for 2011. Moreover, nothing in the record suggests that Ms. Ehrmann’s earning potential has declined since then.
  3. Ms. Ehrmann  owned substantial assets, including the Wayzata and Hilton Head residences and a number of luxury vehicles.
  4. Although petitioner had no dependents, her expenses include expenses paid to support her adult children.

In the end, the Court found this factor neutral.  It is pointed out and highlighted that the tax court did not find this factor as weighing against Ms. Ehrmann.

The tax court stated, citing Rev. Proc. 2013-34, sec. 4.03(2)(b), “[t]his factor weighs in favor of relief where the requesting spouse would suffer economic hardship if relief is denied and is neutral where the requesting spouse would not suffer economic hardship if relief is denied.”

Implied by the Rev. Proc. and the tax court is that economic hardship either works in favor of the petitioning taxpayer or is a neutral factor, but NOT a factor weighing against Innocent Spouse Relief.

As such, wealth of the taxpayer seeking Innocent Spouse Relief is NOT weighed against the taxpayer.

Innocent Spouse Relief is available to the rich, which is counter intuitive in my view.

Legal Obligation

For purposes of this factor, a legal obligation is an obligation arising from a divorce decree or other legally binding agreement. Rev. Proc. 2013-34, sec. 4.03(2)(d), 2013-43 I.R.B. at 402. This factor weighs in favor of relief if the nonrequesting spouse has the sole legal obligation to pay the outstanding income tax liability pursuant to a divorce decree or agreement and weighs against relief if the requesting spouse has the sole legal obligation. Id. This factor is neutral if both spouses have a legal obligation to pay pursuant to a divorce decree or agreement or if the divorce decree or agreement is silent as to any obligation to pay the outstanding income tax liability.

In a carefully drafted divorce decree, stipulation, or settlement, an ‘Innocent Spouse’ may successfully plead this factor.  We provide tax counsel to spouses during the process of divorce. In Ehrmann, the decree was drafted in a way that could have been improved.  I won’t shed more light on this issue at this time, but feel free to contact me.  As such, the tax court found this factor neutral.

Tax Form 8857: Innocent Spouse Relief

Blank Receipt – No Tax Deduction for Charitable Contributions

The U.S. Tax Court issued a decision concerning tax deductions of charitable contributions in Thad Deshawn Smith v. Commissioner of the Internal Revenue, October 2, 2014.  The case is a great way to discuss what the IRS and Tax Court require as far as documentation.

Mr. Deshawn attempted to deduct a whopping $27,277 in noncash charitable contributions in 2009.  He donated clothes, electronics, etc to AMVETS.  AMVETS wrote Mr. Deshawn blank “tax receipts”.  Have you ever noticed this practice when donating to Goodwill?  Goodwill just hands you a blank receipt.  Well that practice does not cut it.

The critical failure was that the receipts did not specify the items donated.  Mr. Deshawn made a valiant effort to document the donation by creating spreadsheets.  However, because there was no evidence that the spreadsheets were submitted (hint – signed) by AMVETS, no deduction was allowed.

Here is some technical background.

Contributions of $250 or More:

Section 170(f)(8)(A) provides that an individual may deduct a gift of $250 or more only if he substantiates the deduction with a contemporaneous written acknowledgment of the contribution by the donee organization. This acknowledgment must:

  1. include “a description (but not value) of any property other than cash contributed”;
  2. state whether the donee provided
    any goods or services in exchange for the gift; and
  3. if the donee did provide goods or services, include a description and good-faith estimate of their value. Sec. 170(f)(8)(B); sec. 1.170A-13(f)(2), Income Tax Regs.

The acknowledgment is “contemporaneous” if the taxpayer obtains it from the donee on or before the earlier of:

  1. the date the taxpayer files a return for the year of contribution; or
  2. the due date, including extensions, for filing that return. Sec. 170(f)(8)(C).

Contributions exceeding $500

For noncash contributions in excess of $500, taxpayers are required to maintain reliable written records with respect to each item of donated property. Sec. 1.170A-13(b)(2) and (3), Income Tax Regs.

These records must include, among other things:

  1. the approximate date the property was acquired and the manner of its acquisition;
  2. a description of the property in detail reasonable under the circumstances;
  3. the cost or other basis of the property;
  4. the fair market value of the property at the time it was contributed; and
  5. the method used in determining its fair market value. Sec. 1.170A-13(b)(2)(ii)(C) and (D), (3)(i)(A) and (B), Income Tax Regs. The taxpayer must include with his return “a description of such property and such other information as the Secretary may require.” Sec. 170(f)(11)(B).

Contributions Exceeding $5,000

For contributions of property (other than publicly traded securities) or similar items of property valued in excess of $5,000, the taxpayer must generally satisfy the substantiation requirements discussed previously and must also:

  1. obtain a “qualified appraisal” of the items; and
  2. attach to his tax return a fully completed appraisal summary. Sec. 170(f)(11)(C); sec. 1.170A-13(c)(2), Income Tax Regs.;

Interest Deductible Even On Non-Taxpayer’s Mortgage

I came across this today in passing while working on a tax case.

Most homeowners deduct home mortgage interest on Schedule A of their 1040.  Actually, this is usually a taxpayer’s largest deduction.  Well, what if the taxpayer is not liable for the mortgage can taxpayer still take the deduction?

For example, taxpayer’s parents transferred title of a home to taxpayer.   The mortgage remained the obligation of parents.  Taxpayer does not refinance.  Taxpayer pays mortgage.  May taxpayer deduct the interest paid on schedule A?  I have to admit that the IRS is pretty generous on this one.  The IRS permits taxpayer to take the deduction on schedule A.  Thank you IRS!

What follows is the background and legal support.

1.163-1(b), Income Tax Regs., provides: “Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness.”

However, “title” to the real estate is required.  Real estate title can include legal, equitable, and beneficial title. Hynes v. Commissioner, 74 T.C. 1266, 1288 (1980); Song v. Commissioner, T.C. Memo. 1995-446; Bonkowski v. Commissioner, T.C. Memo. 1970-340, affd. 458 F.2d 709 (7th Cir. 1972). This is where it can get complicated and you would need to seek a tax pro, such as myself, on this point.

I will point out that the 1098 will not be in your name but the IRS has spoken: deduct, deduct, deduct!

Taxation of Artists: Business or Hobby Losses – Tax Tips

Artists typically have financial challenges while they build a market for their artwork.  During the many years of likely tax losses, the IRS might re-characterize losses as nondeductible hobby losses.  So if an artist is an employee while also building a business as an artist, the IRS might disallow the losses to be deducted against employment income.  This can be very unfair since the artist could be in genuine pursuit of a business.

Tax Background: Business

Section 162(a) allows as a deduction “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” To be entitled to deductions under this section, the taxpayer must show that she engaged in the activity with an actual and honest objective of making a profit. Hulter v. Commissioner, 91 T.C. 371, 392 (1988).

However, “a reasonable expectation of profit is not required.” Sec. 1.183-2(a), Income Tax Regs. The Tax Coiurt determines whether the taxpayer has the requisite intent to earn a profit on the basis of all surrounding facts and circumstances. Golanty v. Commissioner, 72 T.C. 411, 426 (1979), aff’d without published opinion, 647 F.2d 170 (9th Cir. [*24] 1981); sec. 1.183-2(b), Income Tax Regs. In making this determination, greater weight is accorded to objective facts than to the taxpayer’s subjective statement of intent. Keanini v. Commissioner, 94 T.C. 41, 46 (1990); sec. 1.183-2(a), Income Tax Regs.;

Tax Background: Hobby

If an activity is not engaged in for profit, no deduction attributable to it is allowed except to the extent of gross income derived therefrom (reduced by deductions allowable without regard to whether the activity was engaged in for profit). Sec. 183(b). Thus, losses are not allowable for an activity that a taxpayer carries on primarily for sport, as a hobby, or for recreation. Sec. 1.183-2(a), Income Tax Regs.

Intent to Earn a Profit

The regulations set forth a nonexclusive list of nine factors relevant in ascertaining whether the taxpayer conducted an activity with the intent to earn a profit. They are:

  1. the manner in which the taxpayer conducts the activity;
  2. the expertise of the taxpayer or her advisers;
  3. the time and effort spent by the taxpayer
    in carrying on the activity;
  4. the expectation that assets used in the activity may appreciate in value;
  5. the success of the taxpayer in carrying on other similar or dissimilar activities;
  6. the taxpayer’s history of income or losses with respect to the activity;
  7. the amount of occasional profits, if any;
  8. the financial status of the taxpayer; and
  9. elements of personal pleasure or recreation. Sec. 1.183-2(b), Income Tax Regs.

No factor or group of factors is controlling, nor is it necessary that a majority of factors point to one outcome. See Keating v. Commissioner, 544 F.3d 900, 904 (8th Cir. 2008), aff’g T.C. Memo. 2007-309; Engdahl v. Commissioner, 72 T.C. 659, 666 (1979) (taxpayer’s profit motive must be ascertained “not on the basis of any one factor but on the basis of all the facts and circumstances”); sec. 1.183-2(b), Income Tax Regs. Certain factors may be accorded more weight in a particular case because they have greater salience or persuasive value as applied to its facts. See Vitale v. Commissioner, T.C. Memo. 1999-131, 77 T.C.M. (CCH) 1869, 1874, aff’d without published opinion, 217 F.3d 843 (4th Cir. 2000); Green v. Commissioner, T.C. Memo. 1989-436, 57 T.C.M. (CCH) 1333, 1343 (noting that all nine factors do not necessarily apply in every case).

1. Manner in Which Activity is Conducted

Conducting an activity in a businesslike manner may show that the taxpayer intends to earn a profit from it. Sec. 1.183-2(b)(1), Income Tax Regs. Facts evidencing a businesslike manner include (among other things) the taxpayer’s maintenance of complete and accurate books and records; the taxpayer’s conduct of the activity in a manner resembling that in which successful practitioners conduct similar business activities; and the taxpayer’s change of operating procedures, adoption of new techniques, or abandonment of unprofitable activities in a manner consistent with a desire to improve profitability. Giles v. Commissioner, T.C. Memo. 2006-15; sec. 1.183-2(b)(1), Income Tax Regs.

In order to demonstrate a profit motive, a taxpayer need not keep records of the sort maintained by a Fortune 500 company. In many situations, informal recordkeeping is sufficient. See, e.g., Burrus v. Commissioner, T.C. Memo. 2003-285, 86 T.C.M. (CCH) 429, 435-437 (cattle activity); Fields v. Commissioner, T.C. Memo. 1981-550, 42 T.C.M. (CCH) 1220, 1225 (same); Edge v. Commissioner, T.C. Memo. 1973-274, 32 T.C.M. (CCH) 1291, 1298 (farming); [*30] Farrell v. Commissioner, T.C. Memo. 1983-542, 46 T.C.M. (CCH) 1290, 1295 (same); Harrison v. Commissioner, T .C. Memo. 1996-509, 72 T.C.M. (CCH) 1258, 1262 (gold mining and treasure salvaging activity). For creative artists in particular, our precedents indicate that the recordkeeping required to evidence a profit motive is not rigorous.

In Churchman v. Commissioner, 68 T.C. 696 (1977), the Tax Court held that a taxpayer who had been involved in art activities for 20 years had a profit motive. The taxpayer kept all receipts of her art-related expenses and kept a journal recording what works she had sold and to whom. The Court found that her record keeping was sufficient to show that she conducted her art activity in a businesslike manner even though she “did not keep a complete set of books pertaining to her artistic activities.” Id. at 702.4.

2. Expertise of the Taxpayer and Her Advisors

A taxpayer’s expertise, research, and study of the accepted practices in an industry, as well as her consultation with experts, may indicate a profit motive. Sec. 1.183-2(b)(2), Income Tax Regs. In cases involving artists, the Tax court has considered (among other things) the taxpayer’s education, teaching activities, public recognition, and skills.

In Churchman, 68 T.C. at 702, the Tax Court found that the taxpayer had the requisite expertise as an artist where she studied art for 2½ years, taught art at the college level, had her works shown in commercial galleries at least once a year, and was the subject of articles and critical reviews in newspapers and magazines. In Waitzkin, 63 T.C.M. (CCH) at 2745, the Tax Court found that the taxpayer had the requisite expertise as an artist where she devoted most of her time to producing artwork, promoted her art to collectors and museums, and sold art for many years through galleries and otherwise.

The term “advisors” means advisors relevant to the field of art, such as galleries not necessarily financial advisors..

3. Taxpayer’s Time and Effort

The fact that a taxpayer devotes considerable time and effort to an activity may indicate a profit objective. Giles v. Commissioner, T.C. Memo. 2006-15. Having another job does not necessarily detract from this conclusion–in section 183 cases, this is likely the rule rather than the exception–because a taxpayer may engage in more than one trade or business simultaneously. See Gestrich v.Commissioner, 74 T.C. 525, 529 (1980), aff’d without published opinion, 681 F.2d 805 (3d Cir. 1982); Sherman v. Commissioner, 16 T.C. 332, 337 (1951). In Churchman, 68 T.C. at 697, we noted that the taxpayer taught art classes at two [*37] colleges and had “given numerous workshops independently of any institution.” The Tax Court regarded this as a positive factor in concluding that she was engaged in the trade or business of art. Id. at 702.

4. Expectation of Appreciation in Value

An expectation that assets used in the activity will appreciate in value may indicate a profit motive. Sec. 1.183-2(b)(4), Income Tax Regs. Even if the taxpayer derives no profit from current operations, she may reasonably entertain an expectation of overall profit when asset appreciation is factored in. Ibid. The expectation of appreciation becomes less speculative when a taxpayer shows actual success in an endeavor that could plausibly lead to appreciation. Cf. Tinnell v. Commissioner, T.C. Memo. 2001-106; Hoyle v. Commissioner, T.C. Memo. 1994-592.

In Waitzkin, 63 T.C.M. (CCH) at 2745, where the artist likewise had a large inventory, the Tax Court found that she had the potential to “enjoy greater financial benefits from her work” as it gained recognition and that “at any moment, [she] might become even more commercially successful.” Cf. Allen v. Commissioner, 72 T.C. 28, 36 (1979) (finding ski lodge to be a trade or business where lodge had appreciated in value and taxpayers reasonably expected the value of their assets to continue increasing).

5. Taxpayer’s Success in Other Activities

A track record of success in other business ventures may indicate that the taxpayer has the entrepreneurial skills and determination to succeed in subsequent endeavors. This in turn may imply that the taxpayer, when embarking on these endeavors, does so with the expectation of making a profit. Sec. 1.183-2(b)(5), Income Tax Regs. On the other hand, the absence of prior business experience creates no inference that the taxpayer lacks a profit motive when undertaking a new venture. See Arwood v. Commissioner, T.C. Memo. 1993-352.

In a typical section 183 case, the taxpayer achieves considerable success in a business activity and later embarks on a new activity that the IRS regards as a hobby or sport.

6. History of Income or Losses

The fact that a taxpayer incurs a series of losses beyond an activity’s startup years may imply the absence of a profit objective. Sec. 1.183-2(b)(6), Income Tax Regs. This inference may not arise where losses are due to “customary business risks or reverses” or to “unforeseen or fortuitous circumstances which are beyond the control of the taxpayer.” Ibid. This inference may also be weaker in some fields of activity than in others. As we early recognized: “If losses, or even repeated losses, were the only criterion by which farming is to be judged a business, then a large proportion of the farmers of the country would be outside the pale. It is the expectation of gain, and not gain itself which is one of the factors which enter into the determination of the question.” Riker v. Commissioner, 6 B.T.A. 890, 893 (1927).

Because it often takes many years to achieve economic success in the creative arts, we have found that “a history of losses is less persuasive in the art field than it might be in other fields.” Churchman, 68 T.C. at 701-702. In Waitzkin, 63 T.C.M. (CCH) at 2745, the taxpayer was a “nationally recognized artist whose work ha[d] been shown and exhibited in many well-known galleries and famous museums.” We held that she was engaged in the trade or business of art even though she had never made a profit.

7. Amount of Occasional Profits

The fact that a taxpayer derives some profits from an otherwise money-losing venture may support the existence of a profit motive. See sec. 1.183-2(b)(7), Income Tax Regs. Moreover, “an opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are actually generated.” Ibid. The regulations cite a wildcat oil drilling venture as an example of an activity in which an honest profit motive may be founded on “a small chance that * * * [the taxpayer] will make a large profit.” Sec. 1.183-2(c), Example (5), Income Tax Regs.

8. Taxpayer’s Financial Status

The fact that a taxpayer lacks substantial income or capital from sources other than the activity may indicate that she engages in the activity for profit. Sec. 1.183-2(b)(8), Income Tax Regs. An activity that produces losses, if recognized as a trade or business, will normally generate tax benefits for a taxpayer with other income. The receipt of such tax benefits, standing alone, does not establish that the taxpayer lacks a profit motive for the activity. See Engdahl, 72 T.C. at 670; McKeever v. Commissioner, T.C. Memo. 2000-288.

9. Elements of Personal Pleasure

The fact that a taxpayer derives personal pleasure from an activity, or finds it recreational, may suggest that she engages in it for reasons other than making a profit. Sec. 1.183-2(b)(9), Income Tax Regs. The derivation of personal pleasure, however, “is not sufficient to cause the activity to be classified as not engaged in for profit if the activity is in fact engaged in for profit as evidenced by other factors.” Ibid. “Success in business is largely obtained by pleasurable interest therein.” Wilson v. Eisner, 282 F. 38, 42 (2d Cir.1922). Thus, “a business will not be turned into a hobby merely because the owner finds it pleasurable; suffering has never been made a prerequisite to deductibility.” Jackson v. Commissioner, 59 T.C. 312, 317 (1972); Giles v. Commissioner, T.C. Memo. 2006-15.

In Churchman, 68 T.C. at 702, the Court acknowledged that the taxpayer’s art activities “involved recreational and personal elements.” We nevertheless concluded that she conducted this activity with the intent to make a profit, noting that “her work did not stop at the creative stage but went into the marketing phase of the art business where the recreational element is minimal.” Ibid. These less pleasurable activities included maintaining a mailing list, sending out announcements, seeking representation from galleries, keeping receipts of business expenses, and maintaining records of sales and customers. Ibid.

Tax Tips

  1. Pursue your talent, first and foremost, while also running it as a business.
  2. Keep adequate tax records such as receipts from the purchase of materials and receipts from the sale of your artwork.
  3. Document relationships with galleries by archiving emails and contracts.
  4. Try to record the amount of time devoted to your art business: the more time the better for tax deductibility.

Partnership Basis in Contributed Promissory Notes and Guarantees: Tax Tips

Your partnership must file a Beneficial Ownership Information Report with FinCEN.  We file those reports for $349.  Here is our page on that report.

Philip Falco, Attorney, CPA tracks inside and outside partnership basis, prepares 1065 Tax Returns and K1’s (303) 626-7000

Partners of a partnership sometimes contribute promissory notes to the partnership.  As an example, a partner drafts a note payable to the partnership promising to pay the partnership a sum of money.  The question then becomes whether the partner has an increase in partner basis for this.  The other question is what is the partnership’s basis in the promissory note.

Another related scenario is where a partner guarantees a partnership debt owed to a third party.  The question is whether this guarantee increases the basis of the partner in the partnership.

Partnerships don’t pay income tax, but they do file  information returns, and partners are supposed to use the numbers from those returns on their own individual returns. See IRC secs. 701, 6031, 6222(a).  Partnership basis is important because it determines where a distribution such as cash is taxed or not.  It also determines the amount of taxable gain or loss upon sale. An increase in a partner’s basis is desirable.  We provide legal and tax services to partnerships.

The value of what a partner contributes to his partnership can be tricky when he contributes something other than cash–like promissory notes or guarantees. a partnership’s basis in property contributed by a partner is the adjusted basis of that property in the hands of the contributing partner at the time of the contribution. IRC sec. 723.

The Tax Court has held that the contribution of a partner’s own note to his partnership isn’t the equivalent of a contribution of cash, and without more, it will not increase his basis in his partnership interest. See Dakotah Hills Offices Ltd. P’ship v. Commissioner, T.C. Memo. 1998-134, 75 T.C.M. (CCH) 2122.

As such, the partner’s basis does not increase and the partnership’s basis in the notes is zero.

However, a guarantee of a partnership debt to a third party does increase a partner’s basis.

For example, in Gefen v. Commissioner, 87 T.C. 1471 (1986) a partner executed a limited guaranty as a condition of her acquisition of an interest in a limited partnership. Under its terms, she assumed personal liability to the partnership’s existing creditor for her pro rata share of the partnership’s recourse indebtedness to that creditor. She also agreed that the partnership could
call on her to contribute to the partnership an amount equal to the partnership’s outstanding debt.  The Tax Court upheld the partner’s increase in basis for her limited guarantee.

This can be a tricky area.  However, here are tax tips:

  1. Consider guaranteeing a preexisting third party debt rather than contributing a promissory note to the partnership.
  2. Document that the partner is providing personal credit to partnership vendors.
  3. The partner should be obliged to make additional contributions under the guarantee.
  4. The guarantee must create a liability to a third party, not the partnership.

Nonresidents of Colorado Taxed on Colorado Real Estate

It is a little known fact that if a nonresident of Colorado owns real estate in Colorado, such as a ski condo, the nonresident must file a DR 104 and complete the 104PN Part-Year/Nonresident Computation Form upon sale or receipt of rent.

For example, a taxpayer who lives in California and owns a vacation ski condo in Aspen must file a Colorado State Income Tax Return DR 104 upon the sale of the condo or if taxpayer has rental income with respect to the ski condo.  As such, taxpayer would likely file two State tax returns: a California return and a Colorado return.

In addition to Colorado real estate, the following income sources are taxed:

  1. The ownership of any interest in real or tangible personal property in Colorado
  2. A business, trade, profession, or occupation carried on in Colorado
  3. The distributive share of partnership or limited liability company income, gain, loss, and deduction determined under CRS section 39-22-203
  4. The share of estate or trust income, gain, loss, and deduction determined under CRS section 39-22-404
  5. Income from intangible personal property, including annuities, dividends, interest, and gains from the disposition of intangible personal property to the extent that such income is from property employed in a business, trade, profession, or occupation carried on in Colorado. A nonresident, other than a dealer holding property primarily for sale to customers in the ordinary course of his trade or business, shall not be deemed to carry on a business, trade, profession, or occupation in Colorado solely by reason of the purchase and sale of property for his own account.
  6. His share of subchapter S corporation income, gain, loss, credit, and deduction allocable or apportionable to Colorado.