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Courts Play Host To Another Cast Of Unusual Characters

(RIVERWOODS, ILL., January 29, 2002) – Although tax law is not regarded as exciting by most, every so often the creative interpretation of the rules by taxpayers can make even a mundane tax case most interesting, if not downright entertaining, according to CCH INCORPORATED (CCH), a leading provider of tax law information. And 2001 was no exception, as taxpayers who were called to court tried to justify how they creatively applied the complex rules of federal tax law.

"In some proceedings, you have to wonder exactly what the taxpayer – or quite often, the tax evader – was thinking when they took the steps that landed them in court. While in other cases, you can see how things just start to spiral out of control," said Kay Harris, a CCH tax law editor.

While the courts didn’t hesitate to throw the book at those who wantonly disregarded the rules, they did show patience for those who just found themselves in too deep.

Here’s a look at some of the more interesting tax issues that played out in the nation’s courts during 2001.

So bizarre were the circumstances that landed a Fargo, N.D. liquor store owner in court that, well, you could make a movie out of it. But, the Tax Court was so taken with our leading character – who impressed them as a "sincere, although mistaken, individual" – that this tale has a relatively happy ending. While the taxpayer was hit with some heavy tax deficiencies and penalties, the Court did not find that he intended to commit fraud.

At the center of our story is a liquor store owner, his store and the issues of underpayment of taxes and disallowed expenses, which for the most part were related to the taxpayer’s failure to maintain any meaningful distinction between his personal income and expenses and those of his business.

Prior to the years in question, his wife had done his bookkeeping. But when she died tragically in an auto accident, the taxpayer muddled through on his own, without professional tax help or the necessary bookkeeping skills or knowledge.

That’s when the trouble started. And while the IRS went after both the taxpayer and his business for fraud, the Tax Court was surprisingly more lenient.

While the taxpayer drew money freely from his business for everything from a $10,000 diamond ring to his wife’s funeral expenses, he reported no income for the years in question and did not file an income tax return for two of those years.

His business made cash "loans" totaling nearly $100,000 to the taxpayer and his family – although no loan documents existed and there was no evidence that there was any intent to repay the corporation. The corporation held title to the $60,000 condominium in which the taxpayer and his wife lived, as well as the cars that he and his children drove.

The family’s summer vacations were mischaracterized as annual stockholders’ meetings for the corporation. The business, of course, paid the expenses the family incurred during their meetings by the lake.

He also allowed the store’s till to be used regularly to cash employee paychecks and cover expenses, without reporting the money taken from the till as income.

And then, there were the gambling trips to Vegas – all for the good of the business, of course.

To the taxpayer, it made perfect sense to take a couple of trips each year to Las Vegas to exchange Canadian currency from his business and deduct the trips as a business expense. After all, the casinos provided a better exchange rate than he could get in Fargo. And once there, a little gambling with the company’s money also seemed in order.

Between 1991 and 1993, he won more than $21,000 gambling, but did not report any gambling winnings for those years. After coming to the conclusion that since he gambled with the company’s Canadian currency the winnings were taxable to the business, he did, however attempt to correct the previous omissions and reported $20,000 of gambling winnings on the corporation’s 1994 return.

He may have continued along this route undetected except for a routine review the IRS conducted of records of businesses in the Fargo area to make sure that businesses had properly reported cash transactions. During the review, the IRS came across records from a car dealership that revealed the liquor store had purchased a car for about $9,000 in cash.

On the basis of that, the IRS started an investigation of the liquor store and its owner and discovered the questionable deductions and unreported income. The IRS charged the liquor store and the owner with fraud.

The Tax Court agreed with the IRS that additional taxes were owed. However, the Court did not agree that tax evasion and fraud had occurred. Rather, the kindly Court found that what was proved was a negligent or, at most, willful disregard of rules and regulations.

Imagine hearing from your CPA that you could exclude from gross income Social Security taxes withheld from your wages or that you are guaranteed a tax refund. Sound too good to be true? Well, of course, it is.

But that didn’t stop this tax preparer, or his tax planning firm, from making such claims. Of course, he wasn’t a CPA either; he just represented himself as one.

The IRS got wind of his tax advice and tried to get the "CPA" to stop and to cooperate – without much luck: He continued plying his not-so-ethical trade and wouldn’t even produce a list of his clients for the IRS. He also threatened to sue clients for breach of contract if they cooperated with the IRS by withdrawing their amended returns, or if they admitted liability and paid any assessed penalties.

The IRS sought a preliminary injunction against him and his firm to stop him from preparing false returns, making false claims and threatening clients and to require him to cooperate with the IRS investigation. A federal district court in North Carolina agreed with the IRS to issue the injunction, finding that the tax preparer’s efforts to influence or intimidate his clients would irreparably harm the tax system and the public if he were not stopped.

"It’s just a lot of paperwork," said an exasperated entrepreneur who reported income and expenses for her businesses with little documentation to back her claims. The IRS was less than pleased – especially since one of her businesses was an accounting, bookkeeping and income tax service.

The taxpayer ran a business services company, as well as a wedding minister service. She also provided notary public services. And although she made part of her living helping others keep good books and records, she didn’t take a liking to detailed bookkeeping for her own businesses.

In an audit of her 1996 return, the IRS found deductions had been overstated by nearly $40,000. On the Schedule C for her business services company, she had deducted $59,323. When pressed for substantiation for the expenses, the taxpayer was unable to come up with documentation for most of the expenses, including all of her reported bad debt, travel, meal and car expenses and depreciation. As a result, the Tax Court cut the allowable expenses and unsubstantiated deductions.

As for her notary public business, the taxpayer reported $9,240 in income. Under the tax code, income from services as a notary public is not subject to self-employment tax. However, she had no records for the business, and when asked about such records responded: "It’s just a lot of paperwork. I didn’t bring the details."

Too bad, then, the Court said, ordering she pay the self-employment tax on $9,140. Since she did have a notary seal, however, the Court generously allowed her to exclude $100 from self-employment income.

For a Texas dentist, his job may have been his life’s work, but the Tax Court found that he took the maxim far beyond what the tax law allows. In a review of the dentist’s 1996 federal return, the IRS found many expenses mischaracterized.

For example, grocery expenses were claimed as dental practice postage expenses; payments made to his children at the rate of his child support obligation were deducted as "contract services"; and all expenses related to his residence were deducted as dental lab expenses.

He also deducted all amounts paid on his credit card, including those for clothing, bedding and cosmetics and tickets to entertainment events, claiming that they were gifts to unidentified staff members. Payments for laundry, sunglasses, a bicycle, erotic tapes, children's videos and tax protest materials also were deducted as business expenses.

According to the dentist, every single payment that he made during the year was business-related. Justifying his deductions, he testified: "…it's very difficult for me to distinguish between a personal expense and business expense when it comes to a credit card. I charge most of my business expenses up on a credit card, and I deduct whatever I have paid for that year, I deduct that."

Explaining his deduction of items based on checks payable to cash, he testified: "…personal and business to me are one and the same. It's no use to pay expenses and maintain two bank accounts."

In the absence of credible proof that these items truly were business related, the Court sided with the IRS, finding a deficiency of approximately $40,000 in the dentist’s federal income tax for 1996 and assessing an additional penalty of about $8,000.

Michael A. McCann v. Commissioner of Internal Revenue

About CCH INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served over four generations of tax and business professionals and their clients. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH web site can be accessed at cch.com. The tax and accounting destination site can be accessed at tax.cchgroup.com.

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