Religious Obligations and College Expenses Don't Trump Obligation to Pay Delinquent Taxes

When an individual works out an installment plan with the IRS, the two parties must agree on how much to set aside for the individual's living expenses. As one might imagine, there is often disagreement on how much a taxpayer thinks he needs compared to how much the IRS thinks he needs. In Thompson v. Comm'r, 140 T.C. No. 4 (3/4/13), the disagreement centered on whether the taxpayer was required to tithe 10 percent of his income to his church and whether expenses for his children's college were necessary expenses. The Tax Court agreed with the IRS and held that such expenses are conditional expenses rather than necessary expenses. Thus, the taxpayer could not take them into account when calculating how much he could pay the IRS on an installment plan.

Background

George Thompson has been a member of the Church of Jesus Christ of Latter-Day Saints his entire life and has regularly contributed 10 percent of his monthly income to the Church. He holds a position as a shift coordinator in the Church's Manhattan Temple. Additionally, George is a scouting coordinator for the Church and is responsible for overseeing six scout troops in different congregations in New Jersey. He receives no money for these positions. In 2008, the IRS assessed trust fund recovery penalties against George for unpaid employment tax liabilities. The IRS advised George that it intended to levy to collect the unpaid tax penalties and that George could request a hearing with the IRS's Office of Appeals. George submitted Form 12153, Request for a Collection Due Process (CDP) or Equivalent Hearing, in which he did not contest the amount owed. The CDP period tax liabilities totaled approximately $151,000.

Two years earlier, George had entered into a partial payment installment agreement with the IRS for payment of non-CDP period tax liabilities and penalties. Subsequently, the IRS determined that George had defaulted on the partial payment installment agreement and sent him a Notice of Defaulted Installment Agreement under Section 6159(b) - Notice of Intent to Levy Under Section 6331(d). As of August 1, 2008, George owed $731,000 for the non-CDP period tax liabilities and penalties.

George requested a partial payment installment agreement that would encompass all of his tax liabilities and penalties for the CDP and non-CDP periods. George submitted Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals, and reported that he had a monthly income of $27,633 ($331,596 per year) and monthly expenses of $24,416 ($292,992 per year). Included in the total monthly expenses were other expenses of $5,294, which consisted of: (1) church tithing expenses of $2,110; (2) church service expenses of $232; and (3) college expenses of $2,952. George's lawyer requested a partial payment installment agreement whereby George would pay $3,000 a month for his unpaid tax liabilities and penalties for both the CDP and non-CDP periods.

According to the settlement officer, the other expenses of $5,294 did not qualify as necessary expenses under the guidelines of the Internal Revenue Manual. Rather, the IRS categorized them as conditional expenses. As a result, the settlement officer concluded that George was eligible for a partial payment installment agreement if the monthly payment was $8,389. George did not agree, and when the IRS issued a notice that it would proceed to levy on George's assets, George filed a petition in Tax Court.

Taxpayer's Arguments

Before the Tax Court, George argued that the settlement officer abused her discretion by classifying his tithing as a conditional expense in determining the amount he could afford to pay in a partial payment installment agreement. George made three separate arguments. First, he argued that given his positions in the Church, tithing is required by the Internal Revenue Manual to be treated as a necessary expense because it was a condition of his employment with the Church, notwithstanding the fact that he receives no financial remuneration for his Church positions. He introduced a letter from a bishop in the Church that stated that George would have to resign his positions with the Church if he did not tithe.

Second, George argued that classifying his tithing as a conditional expense was a violation of his rights under the Free Exercise Clause of the First Amendment because if he was not able to tithe then his church will require him to resign his ministerial positions. According to George, the settlement officer's classification of George's tithe as a conditional expense was tantamount to the settlement officer deciding who could be a minister in George's church.

Third, George argued that classifying his tithing as a conditional expense was a violation of the Religious Freedom Restoration Act of 1993.

George also contended that it was an abuse of discretion for the settlement officer to not allow his children's college expenses as a necessary expense. According to George, each of his five children had a neurological disability that required them to attend Brigham Young University.

Tax Court's Analysis

The Tax Court disagreed with all of George's arguments and concluded that it was not an abuse of discretion for the IRS to classify George's tithing and his children's college expenses as a conditional expense under the Internal Revenue Manual.

The court noted that, in evaluating a taxpayer's ability to pay an installment amount, the IRS classifies a taxpayer's expenses into two categories: (1) necessary expenses; and (2) conditional expenses. The necessary expense test has two prongs, one of which must be satisfied in order for an expense to be considered a necessary expense. The expense must provide for either (1) the taxpayer's health and welfare or (2) the taxpayer's production of income. If a taxpayer requests a partial payment installment agreement, then the taxpayer is allowed only necessary expenses; conditional expenses are not allowed.

With respect to the tithing requirement, the court noted that because George did not receive compensation for his positions in the church, his tithing payments were not for the production of income. Thus, he failed the second prong on that test. Therefore, to be considered a necessary expense, the tithing payments must satisfy the first prong of the necessary expense test; i.e., provide for George's health and welfare.

The Tax Court stated that the First Amendment to the Constitution provides that Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof and that George was correct that the Free Exercise Clause prevents the government from interfering in a church's selection of its ministers. However, the court observed, the settlement officer did not interfere with the church's decision of whether to keep George as a minister. With respect to the letter from the church bishop stating that if George did not pay his tithe he would be required to resign his positions with the church, the court said that George was overlooking the fact that it was his church who was requiring him to resign his positions if he did not tithe the settlement officer was not requiring George to resign his position, nor was she pressuring the church to do so.

The court stated that George was not entitled by the Constitution to be relieved of paying his substantial delinquent tax liabilities and penalties in order to pay his tithe. His position, the court said, would allow religious organizations to control vital government functions, and this was not the intention or purpose of the Free Exercise Clause of the First Amendment. Rather, it prohibits the government from exercising control over religious functions.

With respect to the college expenses, the court noted that Form 433-A states [w]e generally do not allow you to claim tuition for private schools, public or private college * * * [h]owever, we may allow these expenses, if you can prove that they are necessary for the health and welfare of you or your family or for the production of income. First, the court noted that Form 433-A does not have the force of law and confers no rights on taxpayers. Second, the court said that even if George had established the fact that each of his five children had a neurological disability requiring them to go to Brigham Young University, it would not make any difference in its analysis with respect to the allowability of college expenses. Form 433-A clearly states that the expenses may not be allowed, and that discretion to allow the expenses lies with the IRS. Thus, the court held that Form 433-A does not require the IRS to classify a taxpayer's college expenses as a necessary expense.

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Fraudulent Amended Returns Filed by Company's Accountant Tolled Statute

More often than not, the Tax Court rules in favor of the IRS and federal appellate courts do not generally overrule the Tax Court. However, in City Wide Transit, Inc. v. Comm'r, 2013 PTC 27 (2d Cir. 3/1/13), the Second Circuit did just that it reversed the Tax Court, which had ruled against the IRS.

The question before the appellate court was this: Did a CPA impersonator that filed fraudulent tax returns on behalf of a company in order to embezzle money that the company otherwise owed the IRS, intentionally evade that company's taxes within the meaning of Code Sec. 6501(c)(1)? And, if the accountant did commit tax evasion, did he toll the statute of limitations by fraudulently amending tax returns that the company had already filed? In reversing the Tax Court, the Second Circuit concluded that the accountant intentionally evaded the corporation's taxes and thus triggered the statute of limitations tolling provision with respect to the corporation. Accordingly, the IRS could reach back in time and assesses taxes owed by the taxpayer at any time.

Facts

Ms. Ray Fouche owned several bus companies, including City Wide Transit, Inc. (City Wide). City Wide transported handicapped children throughout New York City. By the end of 1998, Fouche's bus companies, including City Wide, collectively accrued about $700,000 in outstanding payroll tax liabilities. To negotiate a reduction of these liabilities, Fouche hired Manzoor Beg, who falsely held himself out as a CPA. Fouche gave Beg a blank power of attorney. On behalf of City Wide, Fouche paid Beg $30,000 in April 1999 and promised him 25 percent of the amount he successfully saved City Wide as result of his negotiations. Fouche also hired a third-party payroll service, Brand's Paycheck, Inc., to prepare Form 941, Employer's Quarterly Federal Tax Return, for June 1997; December 1998; March 31, June 30, and December 31, 1999; and March 31, and June 30, 2000. For each of those last five quarters, Fouche drafted checks payable to the IRS sufficient to cover City Wide's liabilities and gave them, along with the corresponding returns that Brand's prepared, to Beg, who in turn promised to deliver them to the IRS revenue officer with whom he was negotiating.

Instead of filing the correct returns, however, Beg prepared, signed, and filed another set of returns on Forms 941 for those five quarters (i.e., the Beg returns). In those returns, Beg fraudulently added advance earned income credit (EIC) payments that significantly reduced City Wide's tax liabilities. Beg then altered the checks that City Wide drafted by changing the payee from the IRS to an account that he maintained at Habib American Bank in the name of Himalayan Hanoi Craft. He deposited or cashed those checks for his own personal use, and drafted new checks to cover City Wide's now fraudulently reduced tax liabilities.

Beg also prepared, signed, and filed amended Forms 941 for the June 1997 and December 1998 quarters (i.e., the Beg amendments) in order to add fraudulent EIC payments to the returns that City Wide previously filed. Beg did not personally benefit from these amendments but presumably filed them in an effort to conceal the fraudulent EIC payments he included in the returns that he drafted. Through this scheme, Beg embezzled hundreds of thousands of dollars from City Wide, and City Wide received certain tax refunds. The fraudulent EIC reductions totaled $372,000.

Upon discovering Beg's scheme, the government filed charges, and Beg pled guilty to preparing false tax returns for City Wide. A district court began sentencing proceeding, but Beg died during the course of those proceedings and the court, therefore, dismissed the case.

Based on Beg's guilty plea, the IRS began a civil examination of City Wide's returns to recover the taxes that had been underassessed as a result of Beg's fraud. Subsequently, the IRS assessed additional taxes owed by Wide City of $372,000. The IRS did not assess any fraud penalties against Fouche or City Wide.

Statute of Limitations

Under Code Sec. 6501(a), the IRS is required to assess any tax imposed within three years after the return was filed. This provision, however, contains certain exceptions that make the limitations period limitless. Code Sec. 6501(c)(1) provides that, in the case of a false or fraudulent return with the intent to evade tax, the tax may be assessed at any time. Code Sec. 6501(c)(2) provides that in the case of a willful attempt in any manner to defeat or evade tax imposed, the tax may be imposed at any time.

Tax Court Case

City Wide challenged the IRS assessments as time barred because the assessments were outside of the three-year statute of limitations. On December 11, 2008, after various meetings and conversations with City Wide, the IRS issued a Notice of Determination that upheld the tax assessments. City Wide filed a petition with the Tax Court.

Before the Tax Court, City Wide argued that the three-year statute of limitations barred the IRS from the relevant assessments and that the Internal Revenue Code's tolling provisions were inapplicable. The Tax Court noted that the IRS could trigger the tolling provisions under Code Sec. 6501(c)(1), (2), or both by showing with clear and convincing evidence that Beg had the specific intent to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes. The Tax Court concluded, however, that the IRS did not meet that standard.

Although the IRS pointed to a number of egregious acts Beg performed that caused the IRS to fail to collect the full amount of City Wide's taxes, the Tax Court held that those actions did not prove that Beg filed fraudulent returns intending to defeat or evade City Wide's taxes. According to the Tax Court, that tax evasion was only the incidental consequence or secondary effect of Beg's embezzlement scheme. The court found persuasive City Wide's argument that Beg intended only to cover up his embezzlement scheme and not defeat or evade City Wide's taxes. The IRS could not point to anything in the record, the Tax Court noted, that would cause the court to believe that City Wide's argument was meritless. Accordingly, the Tax Court concluded that the IRS was time barred from assessing the additional taxes. The IRS appealed.

Second Circuit's Decision

The Second Circuit began its analysis by noting that the burden of proving that a false or fraudulent return was filed with intent to evade tax is on the IRS and such proof must be made by clear and convincing evidence. However, the court stated, because tax evaders do not reveal their fraudulent evasion, the IRS may establish fraud through circumstantial evidence. To prove intentional evasion of tax, the IRS must establish that (1) an underpayment exists; and (2) some portion of the underpayment was due to fraud.

The court cited the Supreme Court decision in Bufferd v. Comm'r, 506 U.S. 523 (1993), in noting that limitations statutes barring the collection of taxes otherwise due and unpaid are strictly construed in favor of the IRS. The limitations period for assessing taxes, the court said, is extended if the taxes were understated due to fraud of the preparer.

The Second Circuit had before it a very narrow question: whether, considering all the evidence, the Tax Court made a mistake by concluding that the IRS failed to establish by clear and convincing evidence that Beg intended to evade City Wide's taxes through his embezzlement scheme. The court concluded that Beg's scheme clearly did, and the Tax Court made a mistake.

The Second Circuit said that, by concluding that the IRS failed to prove that Beg intended to evade City Wide's taxes and that, at best, tax evasion was but an incidental, secondary effect to Beg's embezzlement scheme, the Tax Court inappropriately substituted motive for intent.

The Second Circuit stated that Beg's motivation for fraudulently amending the June 1997 and December 1998 returns that City Wide had previously filed was unclear. He presumably did so, the court said, in order to cover up the false EICs he included on the five returns that he drafted and filed in the first instance. But, the court stated, Beg's motivations were inconsequential, and it was clear that he filed the two amended returns intending to evade tax for the foregoing reasons. The court concluded that the IRS presented clear and convincing evidence that Beg intended to evade City Wide's taxes for the seven taxable quarters in question, thereby triggering the tolling provision under Code Sec. 6501(c)(1).

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Step-by-Step Guide to Preparing a Return for a Disabled Veteran

By Kathryn M. Morgan, EA

There are several different types of disability compensation for retired military members. Unlike regular military retirement compensation, disability compensation is nontaxable. The tax treatment of disability compensation depends on when the disability was awarded, who awarded it, and the type of award. For a list of the types of disability compensation for which veterans are eligible, see www.dfas.mil/retiredmilitary/disability/disability.html.

OBSERVATION: The Defense Finance and Accounting Service (DFAS) is responsible for withholding and reporting taxes for any taxable retirement payments on IRS Form 1099R. DFAS is a division of the Defense Department.

Common Types of Disability Claims

While there are many different types of disability claims for which compensation is available, the following three are the most common:

(1) Veterans Administration (VA) Disability Award (Code Sec. 104(a)(4); Rev. Rul. 78-161; 38 U.S.C. Section 3010(a))

(2) Concurrent Retirement and Disability Payments (CRDP) (IRM Section 21.6.6.3.20)

(3) Combat Related Special Compensation (CRSC) (IRM Section 21.6.6.3.30)

Internal Revenue Manual (IRM) Section 21.6.6.3.20 (10/1/12), discusses the tax treatment of these types of disability payments. Often, disability awards are backdated; thus, amended returns are required to obtain tax refunds for amounts originally reported as taxable income but subsequently recharacterized as nontaxable income. The following discussion details the treatment of amended returns for backdated awards, as well as the tax treatment of a current year award.

By far the most common disability compensation award is a VA disability award, where the individual receives a disability percentage rating from the VA. These awards can take years to be approved and are often backdated with the veteran getting a large lump sum payment when the award is finalized. If the veteran appeals a compensation award, and is subsequently awarded a higher percentage, that award may also be back dated and affect a prior tax year.

VA disability compensation is nontaxable to the veteran or survivor and is not reported on any tax forms. The veteran will receive a report showing any adjustments due to cost-of-living adjustments (COLA) or other changes affecting the monthly benefit during the year.

While the disability compensation is not reported on the veteran's tax return, practitioners must know the amount because it will affect the general sales tax option on the veteran's Schedule A. The amount of nontaxable VA benefits must be added to total income when calculating the sales tax using the optional sales tax tables.

OBSERVATION: The general sales tax deduction is frequently up for review with other sunset tax breaks and could be phased out at any time. It was recently extended to years beginning before 2014 by the American Taxpayer Relief Act of 2012.

CRDP is a program that started phasing in during 2004 over a 10 year period for veterans with a disability percentage of over 50 percent. This program allows them to receive their military retirement and their disability compensation without one offsetting the other. Each year from 2004 2014, the offset from the retired pay by the VA goes down until it is completely phased out after 2014. When a veteran is granted a VA disability percentage during the year and it is backdated into previous tax years, specific information is necessary to prepare the return and any amended returns correctly.

Preparing a Return for the Year of a Disability Award

When a veteran is awarded VA disability compensation that increases amounts he or she is already receiving, the veteran will receive a letter with columns listing:

(1) Rate Entitled - This is the total rate of VA disability compensation that the veteran is entitled to based on the new/updated award.

(2) Rate Paid - This is the amount of VA nontaxable income the veteran was receiving.

(3) Amount Withheld - This is the amount of the VA income that the veteran did not receive because it was offset by the taxable military retired pay.

(4) Effective Date - This is the effective date of the new/updated compensation payments.

COMPLIANCE TIP: Important items to note for the filing of the tax return are the date of the award, the file number, the monetary calculations, and the signature page. Copies of all of these are necessary and should be attached to the return. As a result, the return will have to be mailed to the IRS due to the attachments.

OBSERVATION: It is important to remember that when dealing with the VA, dates on the letters are misleading. Payments begin the first day of the month after the veteran becomes entitled to the new/updated compensation payment. Thus, a new compensation amount with an effective date of December 1 is not actually paid to the veteran until January 1 of the following year, so always keep that in mind when adding the amounts for adjustments. (38 U.S.C. Section 5111)

It is important to note that, until the VA award has been processed, the military retirement form (DFAS) 1099R will reflect the full amount of pension the taxpayer received for the year. DFAS will not go back and correct or back out the amount of the pension that should have been nontaxable from the first of the year until the award date. Thus, the tax preparer must make the appropriate adjustments on the veteran's return.

In the year of the original award or updated award, the original Form 1040 should be completed as follows:

(1) All tax information reported to the taxpayer is entered on the appropriate lines (e.g., enter the amount reported on the Form 1099-R sent by DFAS on the pension income line on Form 1040).

(2) An adjustment is necessary to the amount reported on Form 1099-R (and, thus, the pension income line of Form 1040) and is calculated by using the following formula:

Amount withheld x Number of months in the year that particular amount was withheld

EXAMPLE: Assume a veteran receives a VA award letter, dated February 2013, with an award backdated to July 1, 2012. The letter shows that for tax year 2012, the taxpayer had $538 withheld from July 1 thru October 1, 2012, and had $340 withheld from October 1 thru December 1, 2012. Because payments begin a month after the date of the award, the July 1 payment was actually received in August and so on. Thus, for the 2012 tax year, the adjustment is $2,294 ($1,614 ($538 3) + $680 ($340 2)).

(3) The adjustment is reported on the Other income line of Form 1040 as a negative number with the notation VA Disability Adjustment See Attachments included on the dotted line.

(4) The return is completed as normal and prepared for mailing.

(5) A copy of the Form 1099-R from DFAS and all other reporting documents that are normally required are attached to the return.

(6) A copy of the first page, all pages with monetary computations, and the signature page of the VA award letter are attached to the return.

(7) At the top of the Form 1040 and the top of the VA award letter, a notation should be added that says VA Disability Award.

(8) The veteran's social security number should be included on all pages of the return and all attachments.

COMPLIANCE TIP: An adjustment may be necessary on the veteran's state return. For example, in Louisiana, an adjustment is required on LA 540, Schedule E. The starting point for the Louisiana return is the federal adjusted gross income (AGI) amount, and military retirement is deducted on Schedule E. Normally, the taxpayer reports any retirement amount from Form 1099-R on the Schedule E; however, where there was VA disability adjustment, for instance, the starting point already has the negative adjustment for the VA award in it, so the practitioner must add that back into income on the state return or the taxpayer would have a double deduction. Additionally, if the taxpayer is over 65, special state subtractions may come into play for pension amounts reported on the federal return. If the reported amounts of pension income are backed out somewhere else on the federal return (e.g., as a negative adjustment on the Other income line), practitioners must be careful that the special state subtraction is reversed.

Amending Prior Year Returns Affected by Backdated Disability Awards

When an award is backdated into a prior tax year, an amended return must be filed for a tax refund. Special limitations periods apply to backdated VA disability awards. In such cases, the normal three-year statute of limitations for filing a refund claim is extended, for purposes of permitting a credit or refund based on the amount of the award, until the end of the one-year period beginning on the date of such determination. Thus, if a veteran received an award on a letter dated June 2012 and the award was backdated to February 2005, the veteran can amend tax returns from 2008 to 2012 (i.e., June 2012 is extended to June 2013, and the five prior-year returns as of that date would be returns for 2012, 2011, 2010, 2009, and 2008). However, in no case does the statute extend to any tax year that began more than five years before the date of such determination.

OBSERVATION: The five-year limitation period can be detrimental in situations where a veteran has had to litigate over a long period of time to get a disability award. In Haas v. U.S., 2012 PTC 261 (Fed. Cl. 2012), a veteran began pursuing disability compensation in 2001 as a result of his military service, and was finally awarded a 100 percent disability rating. Ultimately, he was successful in establishing that he had been exposed to Agent Orange. The ruling granting the award occurred eight years after the veteran's initial claim was filed and over five years after the Board of Veterans Appeals's original denial of his claim. The VA issued its rating decision on December 1, 2009, in which it found the veteran was 100 percent disabled from July 30, 2001, onward. The veteran applied for a refund for years 2001-2009, based on the fact that the military pay on which he paid taxes was nontaxable. While the court was sympathetic, the veteran was barred from seeking refunds for years 2001-2004.

COMPLIANCE TIP: It's important to double check state law to see if the state follows federal law as far as limiting the time for which a refund claim can be made for disability awards.

The process for amending a prior year return for a backdated award is basically the same as preparing a return for a current year award, including double checking whether any change in AGI affects other parts of the return (i.e. itemized deductions, credits, etc).

COMPLIANCE TIP: For the explanation on the Form 1040X, a statement similar to the following may be added: Taxpayer received a backdated VA Disability Award on [insert date]. The award letter is attached. Calculations for the adjustment are as follows: [insert calculation]. All changes to the return flow from the adjustment to AGI based on this calculation. Practitioners should include the primary social security number and the notation Retroactive VA Disability Award on the top of the Form 1040X, all tax return pages, and all attachments. If the adjustment has affected other things, like additional schedules and worksheets, these should be attached, even if it is a worksheet normally not sent with an original return.

Combat Related Special Compensation (CRSC)

The Combat Related Special Compensation (CRSC) program is a program managed by the Army, Navy, Air Force, or Marines, and not the VA, for retired veterans. Thus, payments are made by DFAS. Unlike CRDP payments, CRSC payments are nontaxable. Thus, it's important that the veteran knows if he or she is receiving CRDP or CRSC payments. Once DFAS determines that a veteran is eligible for both CRDP and CRSC payments, the veteran is offered a choice of which one to pick and is able to change that choice once a year. This is all done at DFAS and will affect the veteran's DFAS 1099-R.

Other than the original award notification from DFAS, which is usually a postcard with no monetary information on it, a veteran receives an award letter showing his percentage of CRSC award and the effective date. The same rules apply with respect to a DFAS Form 1099R as apply for a VA award DFAS will not adjust the Form 1099R to remove the backdated award amount.

To compute the adjustment for the year of the award, the practitioner must obtain the percentage award and the award date from the CRSC award letter to the veteran. Once that information is obtained, the practitioner calculates the necessary adjustment for the individual tax years as follows: Total monthly pension (if the veteran has received the pension for the whole tax year simply divide the the Form 1099R, Box 1, amount by 12) CRSC percentage award the number of months the award was received.

The original or amended tax returns are then prepared as discussed above, except that, instead of writing VA Disability Award at the top of the return pages and attachments, CRSC Award should be written on the top of those pages.

About the Author

Kathryn M. Morgan is an Enrolled Agent with 20 years experience. She is a retired member of the U.S. Air Force and specializes in military and veterans tax affairs. Ms. Morgan is a Master Tax Advisor with H&R Block in Bossier City, Louisiana.

Circular 230 Disclaimer

Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of (i) avoiding penalties the IRS and others may impose on the taxpayer or (ii) promoting, marketing, or recommending to another party any tax related matters.

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The IRS Is Now Accepting All 2012 Returns

The IRS has reprogrammed all returns and is now accepting all 2012 returns and schedules. IR-2013-25 (3/4/13).

Last week, the IRS announced that it has finished updating its tax-processing systems, allowing all remaining individual and business taxpayers to file their 2012 federal income tax returns. According to the IRS, it completed reprogramming and testing of its systems for tax-year 2012 including all remaining updates required by the American Taxpayer Relief Act (ATRA) of 2012, enacted by Congress in January.

This final step clears the way for those claiming residential energy credits on Form 5695, Residential Energy Credits, and various business tax credits and deductions to file their returns.

The IRS began accepting 2012 returns in phases as it worked quickly to update various forms and instructions and made critical adjustments to its processing systems to reflect the current law. As a result, the agency began accepting most returns filed by individual taxpayers on January 30. Additional returns could be accepted in February. All remaining returns, affecting in relative terms the smallest group of taxpayers, can now be filed.

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Pastor Hit with Negligence Penalty for Unsubstantiated Deductions; Home Office Deduction Allowed

A pastor could not deduct travel, meals and entertainment, or parking expenses because, while the court had no doubt they were incurred in connection with his profession, the expenses were not sufficiently substantiated; thus, negligence penalties also applied. Bernstine v. Comm'r, T.C. Summary 2013-19 (2/25/13).

Alvin Berstine has served as a pastor for more than 35 years. In 2008, he moved from New York to the San Francisco Bay area to serve as the pastor of Bethlehem Missionary Baptist Church in Richmond, California. The church provided Alvin with an office on the church campus but not living space. However, it did provide him with a $12,000-a-year home allowance. Alvin rented a 1,200-square-foot house in which he dedicated one room, approximately one-third of the house, for use as an additional pastor's office. Alvin purchased supplies, including computer software, computer accessories, books, pens, pencils, paper, and printer cartridges, for use in his home office. The church did not reimburse Alvin for these supplies. Alvin spent most of his professional time in his home office; he met with parishioners only at the office the church provided. Additionally, Alvin used his car to make hospital and sick visits and to organize community events in and around Richmond. Alvin also traveled throughout California in connection with his position as vice president of the State Church Convention. Alvin was considered an independent contractor, and the church issued him a Form 1099-MISC, Miscellaneous Income, for 2008. On the basis of the independent nature of his relationship with the church, he reported his income and expenses on a Schedule C. He took a home office deduction of approximately $9,000 and deducted approximately $44,000 of other expenses, which included bank charges, cell phone service charges, membership dues in clergy organizations, and costs for continuing education, parking, tolls, postage, clergy garments, and dry cleaning.

The IRS issued a notice of deficiency that was based on Alvin's 2008 income tax return and disallowed all the other expenses and business-use-of-home expenses. The IRS determined an income tax deficiency of $18,700. In addition, with respect to the items in dispute, the IRS determined that Alvin failed to substantiate or to show the business purpose of certain reported expenditures and assessed a $3,700 accuracy-related penalty.

The issues before the Tax Court were: (1) whether Alvin was entitled to certain deductions claimed on his Schedule C, including the home office expense; (2) whether Alvin was entitled to deduct charitable contributions reported on his Schedule A; and (3) whether Alvin was liable for the Code Sec. 6662(a) accuracy-related penalty.

The Tax Court held that Alvin was entitled to the home office deduction but denied many of the other deductions. The court noted that, as a general rule, if there is sufficient evidence that the taxpayer has incurred a deductible expense, but the taxpayer is unable to fully substantiate the precise amount of the deduction, the court may estimate the amount of the deductible expense and allow a deduction to that extent. For the court to estimate the amount of an expense, there must be some basis upon which an estimate may be made.

However, under Code Sec. 274(d), the court observed, a taxpayer must satisfy strict substantiation requirements for certain kinds of expenses, such as those for travel, meals and entertainment, and listed property as defined in Code Sec. 280F(d)(4). To deduct these expenses, the taxpayer must maintain adequate records and documentary evidence to prove the amounts, times, places, and purposes of the expenses.

With respect to Alvin's deduction for educational expenses and books, the court concluded that one-third of the supplies were for business and the remaining two-thirds were personal. The court noted that, in reaching this conclusion, its estimate weighed heavily against Alvin because of the quality of his records.

With respect to Alvin's uniform and dry cleaning expenses, the court said Alvin did not show that the clothing was required and that it was not suitable for general personal use and there was no way for the court to decide from the record whether the clothing purchased or dry cleaned was for specialized clergy uniforms. Thus, the court denied these deductions.

The court also denied Alvin's deduction of over $2,000 for cell phone use as, for the year at issue (2008), cell phones were listed property and the only evidence in support of Alvin's cell phone use was the payment of the cell phone bills.

OBSERVATION: For tax years ending after December 31, 2009, cell phones are not listed property and thus the strict substantiation rules do not apply.

As for Alvin's deductions for travel and meals and entertainment, the court noted that such expenses are subject to a more rigorous standard of proof and must be corroborated by adequate records with specific information, including the amounts, times, places, and purposes of the business travel. Alvin's records reflected the amounts expended for travel, meals and entertainment, and parking, but not the time, place, and business purpose of each expenditure. Although he testified generally that these expenses were incurred in connection with his profession, the court found insufficient information to meet the requirements of Code Sec. 274(d). The court stated that it had no doubt that Alvin incurred travel and related expenses in connection with his profession; however, it was constrained to find in his favor without more specific information. Accordingly, Alvin was not entitled to deduct the travel, meals and entertainment, or parking expenses.

With respect to the home office deduction, the Tax Court noted that, although Alvin met with members of his congregation at the office the church provided, his home office was the focal point of his activity involving all other individuals with whom he was involved with in his trade or business. Because Alvin's trade or business was not limited to serving the church and because most of his business activity was conducted at his home office, the court concluded that he qualified for the home office deduction.

For a discussion of the home office deduction, see Parker Tax ¶85,500. For a discussion of the listed-property substantiation rules, see Parker Tax ¶94,950.

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Sequestration Reduces Whistleblower Awards, IRS Says

As a result of the automatic reductions taking place as a result of sequestration, whistleblower awards will be reduced March 1, 2013, through September 30, 2013. IRS website (3/4/13).

When information that has been provided to the IRS results in the detection of underpayments of tax or the detection and bringing to trial and punishment persons guilty of violating the tax laws or scheming to do so, the IRS may approve a reward in a suitable amount from the proceeds of amounts collected in cases when rewards are not otherwise provided by law. This is referred to as a "whistleblower" award.

In a notice posted on its website, the IRS stated that, pursuant to the requirements of the Balanced Budget and Emergency Deficit Control Act of 1985, as amended, certain automatic reductions will take place as of March 1, 2013. These required reductions include a reduction in whistleblower awards. As a result, the sequestration reduction is applied to award payments to whistleblowers issued pursuant to Code Sec. 7623 on or after March 1, 2013. The sequestration reduction rate will be applied until the end of the fiscal year (September 30, 2013) or intervening Congressional action, at which time the sequestration rate is subject to change. As determined by the Treasury Department in conjunction with the Office of Management and Budget, whistleblower payments subject to the reduction will be reduced by 8.7 percent.

The reduction required by the Balanced Budget and Emergency Deficit Control Act of 1985, as amended, will be applied after the Whistleblower Office determines the amount of collected proceeds and the applicable award percentage under Code Sec. 7623. The Whistleblower Office will then compute the award that would have been paid, and then apply the reduction. Whistleblowers will be advised of the reduction in correspondence from the Whistleblower Office concerning a proposed award amount and an award determination.

For a discussion of the rules relating to whistleblower awards, see Parker Tax ¶262,300.

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Physical Presence in U.S. Didn't Preclude Taxpayer from Being Eligible for the 150-Day Rule for Filing a Tax Court Petition

Although a taxpayer who moved to Canada still came back to the United States on occasion, an IRS notice mailed to the taxpayer was considered addressed to a person outside the United States and the 150-day rule applied for filing a Tax Court petition. Smith v. Comm'r, 140 T.C. No. 3 (2/28/13).

In 2007, Deborah Smith and her daughters moved from San Francisco to Canada and became permanent residents of Canada. Deborah continued to own a home and maintain a post office box in San Francisco. In December 2007, Deborah returned to San Francisco to move her remaining furniture to Canada.

On December 27, 2007, while Deborah was in San Francisco, the IRS mailed a deficiency notice to Deborah's San Francisco post office box. She did not pick up the notice and on January 8, 2008, returned to Canada. On May 2, 2008, Deborah received a copy of the notice, and on May 23, 2008, she filed a petition with the Tax Court. The IRS filed a motion to dismiss for lack of jurisdiction and argued that Deborah's petition was not timely filed. Deborah objected, contending that, under Code Sec. 6213(a), she was entitled to 150, rather than 90, days to file a petition with the Tax Court.

Under Code Sec. 6213(a), a Tax Court petition for redetermination of a deficiency is timely if it is filed within 90 days (i.e., the 90-day rule) or, if the notice is addressed to a person outside the United States, 150 days (i.e., the 150-day rule) after the notice's mailing date. Deborah filed her petition 148 days after the notice's mailing date. The IRS said the 90-day rule applied because Deborah was in the United States when the notice was mailed and delivered. Deborah contended that the notice was addressed to a person outside the United States and the 150-day rule applied because she was a resident of Canada (i.e., when the notice was mailed and delivered), received the notice in Canada, and experienced delay in receiving the notice.

The Tax Court agreed with Deborah and held that she was entitled to the 150-day period. The court stated that its position with respect to determining whether a taxpayer is a person outside the United States (and thus entitled to 150 days to file a petition) was distilled in the following language from Looper v. Comm'r, 73 T.C. 690 (1980): "the 150-day rule applies either when the taxpayer is out of the country or when the address on the notice is a foreign address. Citing Degill Corp. v. Comm'r, 62 T.C. 292 (1974), the Tax Court said that prior Tax Court caselaw showed that being out of the country means physically located outside the United States. The court rejected as unduly restrictive a reading of the statute that the 150-day rule applies only in cases where the taxpayer is out of the United States and not in cases where the address is a foreign address.

OBSERVATION: Two Tax Court judges dissented, saying that the meaning of the expression "a person outside the United States" has during the last 60 years taken on a fixed meaning, dependent on the taxpayer's physical location and, thus, the 90-day rule applied. Another judge dissented, saying that the Tax Court lacked jurisdiction unless the notice is addressed to a person outside the United States and the notice in this case was not so addressed. Rather, the notice was addressed to Deborah's post office box address in San Francisco, California (i.e., an address inside the United States).

For a discussion of the rules relating to the filing of a petition with the Tax Court, see Parker Tax ¶263,510.

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IRS Postpones Election Deadline to Deduct Hurricane Sandy-Related Losses in Prior Year

The IRS has postponed until October 15, 2013, the deadline to make an election under Code Sec. 165(i) to deduct in the preceding tax year losses attributable to Hurricane Sandy sustained in a federally declared disaster area. Notice 2013-21.

In late October 2012, Hurricane Sandy struck the east coast causing severe damage in a number of states. The President issued major disaster and emergency declarations under the authority of the Robert T. Stafford Disaster Relief and Emergency Assistance Act for certain areas in Connecticut, Delaware, District of Columbia, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Virginia, and West Virginia. The Federal Emergency Management Agency (FEMA) determined certain areas within those states and the District of Columbia to be eligible for Public Assistance or Public Assistance and Individual Assistance under the Stafford Act.

Under Code Sec. 165(i), if a taxpayer sustains a loss attributable to a federally declared disaster occurring in a disaster area, the taxpayer may elect to deduct that loss for the tax year immediately preceding the tax year in which the disaster occurred. For this purpose, a federally declared disaster is a disaster determined by the President to warrant assistance by the federal government under the Stafford Act (including a disaster for which the President issues a major disaster declaration or an emergency declaration), and a disaster area is the area so determined to be eligible for such assistance.

The Code Sec. 165(i) election is made by filing a return, an amended return, or a refund claim on or before the later of: (1) the due date of the taxpayer's income tax return (determined without regard to any extension of time for filing the return) for the tax year in which the disaster actually occurred; or (2) the due date of the taxpayer's income tax return (determined with regard to any extension of time for filing the return) for the immediately preceding tax year. The election is irrevocable 90 days after the taxpayer makes the election. Under Code Sec. 7508A, the IRS may postpone the deadline for making the election.

Under its authority in Code Sec. 7508A, the IRS has issued Notice 2013-21, in which it postpones until October 15, 2013, the deadline to make an election under Code Sec. 165(i) to deduct in the preceding tax year losses attributable to Hurricane Sandy sustained in a federally declared disaster area in Connecticut, Delaware, District of Columbia, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Virginia, or West Virginia resulting from Hurricane Sandy.

For a discussion of other Hurricane Sandy tax relief, see Parker Tax ¶79,320.

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Interest Rates on Overpayments and Underpayments of Tax Remain the Same for 2d Quarter

The IRS announced that interest rates will remain the same for the calendar quarter beginning April 1, 2013. Rev. Rul. 2013-6.

Under Code Sec. 6621, the rate of interest is determined on a quarterly basis. For taxpayers other than corporations, the overpayment and underpayment rate is the federal short-term rate plus 3 percentage points.

Generally, in the case of a corporation, the underpayment rate is the federal short-term rate plus 3 percentage points, and the overpayment rate is the federal short-term rate plus 2 percentage points. The rate for large corporate underpayments is the federal short-term rate plus 5 percentage points. The rate on the portion of a corporate overpayment of tax exceeding $10,000 for a taxable period is the federal short-term rate plus one-half (0.5) of a percentage point.

The IRS has announced that the interest rates will remain the same for the calendar quarter beginning April 1, 2013, as they were for the first quarter of 2013. Thus, the rates for the second quarter of 2013 are:

(1) 3 percent for overpayments (2 percent in the case of a corporation);

(2) 3 percent for underpayments;

(3) 5 percent for large corporate underpayments; and

(4) 0.5 percent for the portion of a corporate overpayment exceeding $10,000.

The interest rates announced today are computed from the federal short-term rate determined during January 2013 to take effect February 1, 2013, based on daily compounding.

For a discussion of the rules relating to interest on underpayments and overpayments of tax, see Parker Tax ¶261,500.

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Transition Relief Available for Employers Claiming the Work Opportunity Credit

Because the work opportunity tax credit was extended in 2013 retroactively for 2012 and employers need additional time to comply with certain requirements, the IRS is providing transitional relief through April 29, 2013. Notice 2013-14.

The American Taxpayer Relief Act of 2012 (the Act) amended Code Sec. 51 to extend the work opportunity tax credit (WOTC) through December 31, 2013, for taxable employers and for qualified tax-exempt organizations. The credit was extended for taxable employers hiring individuals in targeted groups as defined in Code Sec. 51(d)(1) through (d)(10), and for qualified tax-exempt organizations hiring qualified veterans as defined in Code Sec. 51(d)(3). The extension does not apply to the unemployed veterans or disconnected youth targeted group categories, which had expired as of January 1, 2011. Thus, during 2012, the WOTC was available for employers hiring qualified veterans, and not for hiring members of other targeted groups. The Act, which was signed into law on January 3, 2013, retroactively extended the availability of the WOTC for taxable employers who hired individuals from those other targeted groups in 2012. Because the Act did not amend Code Sec. 52 or Code Sec. 3111(e), qualified tax-exempt organizations may continue to claim the WOTC under Code Sec. 3111(e) only for hiring qualified veterans, and not for hiring any other targeted group members.

Under Code Sec. 51(d)(13)(A), an individual is not treated as a member of a targeted group unless (1) on or before the day the individual begins work, the employer obtains certification from the designated local agency (DLA) that the individual is a member of a targeted group; or (2) the employer completes a pre-screening notice (Form 8850) on or before the day the individual is offered employment and submits the notice to the DLA to request certification not later than 28 days after the individual begins work.

Because the WOTC was extended retroactively for 2012 for members of targeted groups (other than qualified veterans), employers need additional time to comply with the requirements of Code Sec. 51(d)(13)(A) for those targeted groups. Similarly, because the WOTC for qualified veterans was set to expire for qualified veterans hired after December 31, 2012, employers that hire qualified veterans after December 31, 2012, may also need additional time to comply with the requirements of Code Sec. 51(d)(13)(A). As a result, the IRS issued Notice 2013-14, which provides employers with additional time to file Form 8850 with a DLA. Notice 2013-14 provides the following transitional relief:

(1) Transition relief for taxable employers that hire members of targeted groups (other than qualified veterans). A taxable employer that hires a member of a targeted group (as defined in Code Sec. 51(d)(2) through (10), other than a qualified veteran described in Code Sec. 51(d)(3)) on or after January 1, 2012, and on or before March 31, 2013, will be considered to have satisfied the requirements of Code Sec. 51(d)(13)(A)(ii) if it submits the completed Form 8850 to the DLA to request certification not later than April 29, 2013.

(2) Transition relief for all employers that hire qualified veterans. An employer that hires any qualified veteran described in Code Sec. 51(d)(3) on or after January 1, 2013, and on or before March 31, 2013, will be considered to have satisfied the requirements of Code Sec. 51(d)(13)(A)(ii) if it submits the completed Form 8850 to the DLA to request certification not later than April 29, 2013.

For a discussion of the work opportunity credit, see Parker Tax ¶104,500.

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IRS Finalizes Reg on Underpayment of Estimated Tax Penalty for 2009

The IRS finalized a regulation relating to reduced estimated income tax payments for qualified individuals with small business income for any tax year that began in 2009. T.D. 9613 (2/27/13).

Under Code Sec. 6654, a penalty is imposed in the case of an individual taxpayer's underpayment of estimated tax. Estimated tax is payable in four installments throughout the tax year, and the amount of each required installment is generally 25 percent of the required annual payment of estimated tax. Under Code Sec. 6654(d)(1)(B), the required annual payment is the lesser of (1) 90 percent of the tax shown on the income tax return for the tax year (or, if no return is filed, 90 percent of the tax for the year), or (2) 100 percent of the tax shown on the taxpayer's return for the preceding tax year (or 110 percent if the taxpayer's adjusted gross income for the preceding tax year exceeded $150,000). The provision allowing for the payment of 100 (or 110) percent of the tax shown on the taxpayer's return for the preceding tax year does not apply if the preceding tax year was less than 12 months or if the taxpayer did not file a return for that year.

In 2009, Code Sec. 6654(d)(1)(D) provided a special rule under which the applicable percentage of tax shown on the return for the preceding tax year (either 100 or 110 percent) was reduced to 90 percent for qualified individuals for tax years that began in 2009. In other words, for tax years that began in 2009, a qualified individual's annual required payment of estimated tax was the lesser of (1) 90 percent of the tax shown on the return for the 2009 tax year (or, if no return is filed, 90 percent of the tax for the year), or (2) 90 percent of the tax shown on the individual's return for tax year 2008. To implement this special rule, the IRS issued Prop. Reg. Sec. 1.6654-2, which provided exceptions to the penalty for an individual's failure to pay estimated income tax.

The IRS has now finalized the proposed regulation without change. The final regulation explains who is a qualified individual under Code Sec. 6654(d)(1)(D) and how a taxpayer establishes that the taxpayer is a qualified individual. Under the final regulation, a qualified individual is any individual (1) whose adjusted gross income shown on the individual's return for the preceding tax year (before the tax year that begins in 2009) is less than $500,000, and (2) who certifies that more than 50 percent of the gross income shown on that return was income from a small business. If an individual was married and filed a separate return for a tax year that began in 2009, then to qualify, the individual's adjusted gross income shown on the preceding year's return must have been less than $250,000, rather than $500,000.

Income from a small business is defined in general terms as income from a trade or business, the average number of employees of which was less than 500 for calendar year 2008. The final regulations specify that the trade or business must have been a bona fide trade or business of which the individual was an owner.

The final regulations apply only to tax years that began in 2009.

For a discussion of the penalty that applies for underpayments of estimated tax, see ¶251,105.