John Trapani, CPA

Putting The Pieces Together For You

(805) 497-4411

2975 E. HILLCREST DRIVE

THOUSAND OAKS, CA 91362

IRS Audit Defense Services

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:

 John Trapani

Certified Public Accountant

2975 E. Hillcrest Drive, #403

Thousand Oaks, CA 91362

(805) 497-4411

John@TrapaniCPA.com

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JOHN TRAPANI assists both taxpayers directly and advises taxpayers’ tax professionals.