The last flight of Arthur Joseph Stack is a tragedy at many levels.  People are calling him anything from a terrorist to a hero, depending upon their point of view.  Regardless of how you feel about that, there are a number of more significant aspects of this very sad experience that need to be put in perspective, and I wanted to touch upon those which I think are most important. 

            For starters, it is always distressing when someone feels so overwhelmed with problems that he takes his own life.  We all need a support group, and the picture of Joe is one of a loner.    He had IRS problems, but there in no indication that he engaged a competent professional to help him.  Setting fire to his home did not cancel the mortgage on it.  Killing himself relieved Mr. Stark of having to deal with the IRS and his other problems, but did not terminate any IRS debt he owed, which is now the problem for his family.

            More troubling, however, is what seems to be a growing attitude that if you have problems, or are offended by something or someone, you are entitled to take another person’s life.  If the IRS personnel who died or were injured on February 18^th had been Mr. Stack’s adversaries, that would not have justified his action, but the fact is they were innocent bystanders – in the wrong place at the wrong time – makes his last act seem even more tragic.  He is no more a hero than those responsible for the Oklahoma City bombing in the 1990’s.

            With that said, let’s look at the things that seemed to bother Mr. Stack, as there were two in particular.  Mr. Stack’s beef with the IRS began with the passage of Section 1706 of the Tax Reform Act of 1986, which deprived certain professionals – engineers, draftsman, computer programmers – of what had been their ability to operate their business as an independent contractor.  There are benefits and burdens to being an employee or a contractor, but for people who actually functioned as contractors, it was a serious blow to lose that privilege, and it surely cost them a great deal in taxes and other benefits.  However, it was a privilege, not a right.  But no one has a “vested right” to particular treatment at tax time.  Our Internal Revenue Code is a disaster.  In addition to basic, revenue raising provisions, it contains a potpourri of provisions to encourage behavior, reward highly paid lobbyists’ benefactors, deter some conduct, and outright punish other conduct and people.  Although the Internal Revenue Service was the target of his action, tax laws are not made by the Internal Revenue Service.  They are made by Congress – those wonderful Representatives who we elect or re-elect every two years, and the equally wonderfully Senators who run once every six years.  According to the Congressional history of Section 1706, this change in the law resulted from the efforts of the largest, best funded and most powerful lobby that Congress faces – the U.S. Treasury.  

            We are supposed to be a government of laws, and not of men.  If we don’t like a particular law, we have the right to present our views to Congress.  Apparently, Mr. Stack wrote letters to people in Congress, but from the rest of the picture that emerges, they were probably not the kind that would have gotten positive action if they were read at all.  If no one listened to his written complaints, Mr. Stack could likewise have paid a courteous visit to the office of the Congressman in his District to discuss his complaints, but there is no evidence that he tried.  We all have a right to state our views, but do not have a right to have them acted on.  Fair or not, this provision became the law in 1986. Mr. Stack was not the only person hurt by it, but he should have tried to work within the system rather than striking out at it.

            In another part of Mr. Stack’s odyssey, he was seduced by the siren song of advisors who told him he could become his own church, and thereby obtain the exemptions available to real churches.  It is not the purpose of this article to delve into the wisdom or foolishness of allowing churches to operate in a tax exempt fashion.  Suffice it to say that there are policy as well as First Amendment issues present which drive that treatment.  However, no matter how offended Mr. Stack might have been that those institutions receive special benefits, this is a classic example of a plan which was “too good to be true.” 

            Mr. Stark claimed in his manifesto that he relied on respected professionals – lawyers and accountants – before taking this position.  Your writer has seen similar scams, and wagers that Mr. Stack was told “don’t ask another professional for a second opinion, because this is too specialized for most lawyers and accountants to understand.”  If too good to be true doesn’t scare you away, the second part should.  There was a time when reliance on supposedly respected lawyers and accountants was at least a defense to penalties, but has never been enough to change the tax treatment of a transaction itself. Unfortunately, the tax shelters which have been the subject of criminal and civil litigation during this century can point to the same kind of heritage, and few of the people who invested in them sought a second, objective opinion, and they too faced significant monetary penalties.  This kind of lesson is an expensive one, but crashing into an IRS office could never solve the underlying problem.

            Mr. Stack had a lot of problems with the IRS, including a criminal conviction for which he went to jail.  If he failed to file an income tax return or to report income, he was only making things worse.  Being upset with the system cannot confer different benefits on him than those for similarly situated taxpayers if we are in fact a nation of laws and not men.  This incident is simply the latest example of someone taking out his anger against the Government, most of whose employees are simply trying to do their job to the best of their ability and, in the case of the IRS, administer a tax code in which the word “logic” never appears.  If there are scoundrels in this scenario, they are not among anyone Mr. Stack tried to harm, but in any event the rest of us taxpayers will now get to pay for his damages to the IRS’ building.

            It is news to no one that the United States’ economy has been in rough shape for at least the past year and a half.  A lot of people are having trouble making ends meet, and in some situations this means that they are getting behind in their taxes.  As a practitioner, I am often asked by my clients “is the IRS going any easier on people who get behind as a result of the economic slowdown?”  On an individual level, this is a difficult question to answer, except to say that each case is different and the IRS looks at the facts of each case.  At a macro level, the IRS’s own statistics suggest it is taking a hard line. 

            The IRS recently published “Fiscal Year Enforcement Results” for fiscal year 2009, which ended September 31, 2009.  In this fiscal year, the number of IRS collection officers fell from 5,492 to 5,451, less than 1%.  However, IRS collections dropped from $31,100,000,000 in fiscal year 2008 to $26,900,000,000 in fiscal year 2009.  Meanwhile, the IRS filed considerably more Notices of Federal Tax Lien, perfecting its interest against other creditors:  for fiscal year 2008, 768,168 were filed; in fiscal year 2009, the number of tax liens filed jumped to 965,618.  As any taxpayer who has faced a Notice of Federal Tax Lien knows, this filing becomes a matter of public record, and the effect on one’s credit history and ability to borrow is considerable.  But as harsh as the filing of a Notice of Federal Tax Lien can be, the effect may be less than the impact of an IRS levy, which could be on a bank or investment account, or on an employer to garnish wages.  The IRS issued 2,631,038 levies in fiscal year 2008, but the number exploded up to 3,478,181 in fiscal year 2009.

            It doesn’t take a mathematician to see that this increased activity–the kind of things that hurt taxpayers most–did not increase the total IRS collections during this period.  Indeed, the IRS Taxpayer Advocate, in her 2009 Annual Report to Congress, noted that there was no obvious causal relationship between the number of lien notices filed and the amount of overall revenue collected.  But there is more!  

            In August 2009, while this was going on, the Treasury Inspector General for Tax Administration issued a report finding that the IRS continues to improperly freeze refunds in taxpayer accounts, and as a result people are waiting for their refunds longer, while the IRS is ultimately going to pay substantial interest on those accounts.  The Inspector General noticed that the IRS’ inability to promptly resolve some accounts can adversely affect taxpayers who may need the refunds to help meet their financial obligations.  The Inspector previously observed the same problems in the September 1999 and March 2002 reports, and noted here that the IRS had not yet implemented its recommendations from the prior reviews. 

            So what does this mean to the average person who owes something to the IRS?  Every case is different, but one can expect a more affirmative IRS collection policy at this time in spite of the state of the economy.  People should maintain a level of estimated tax payments and deposits so that when their personal or business tax returns are filed, there is no tax underpayment.  And if they owe taxes and need to secure a collection alternative from the Internal Revenue Service–such as an installment agreement or an offer in compromise–it’s essential that they be “in compliance” – timely filing returns, making sufficient current tax deposits, etc., so that the liability does not “pyramid.”  This makes it all the more important that people owing taxes take the opportunity to consult with a knowledgeable professional to find out what their rights and obligations are, as well as to understand the process they are confronting. 

            Unfortunately, Congress has yet to create a deduction or tax credit for depression or stress, although many taxpayers would like to see it happen as part of Obamacare.  Right now, people who itemize deductions may be able to claim medical expenses for treatment of stress or depression, but the actual deduction is often disappointing because only the amount which exceeds 7% of your adjusted gross income can actually be used to reduce the taxable income. But what if you receive damages for stress or depression? A pair of recent cases decided by the United States Tax Court involving taxpayers with damages for problems in their work environment provides some insight into when and how these elements affect the taxability of the damages received.

            Julie Domeny, whose case is reported at T.C. Memo 2010-9, suffered from multiple sclerosis (MS) before she took a position with the Pacific Autism Center for Education, where her duties included community development, fund raising and writing grants.  After a change in supervisors, problems in the workplace caused her MS symptoms to flare up.  They worsened when she found that her supervisor was embezzling funds, and although she notified management of this unlawful work environment, no action was taken.  Ultimately, purportedly because of absence from work, she was notified that she was terminated, and her MS symptoms “spiked.”

            Ms. Domeny engaged a lawyer and without filing a lawsuit, they negotiated a very generally worded settlement agreement which failed to specify the exact reason for which she was receiving a settlement.  Part of it was paid to her as compensation, and she reported that on her tax return, but she also received a Form 1099 for a separate part of the award as “nonemployee compensation,” which she did not pay tax on.

            I.R.C. § 104(a)(2) provides an exclusion from gross income for the amount of any damages – other than punitive damages – received on account of personal physical injuries or physical sickness.  The statute covers damages whether or not there is a lawsuit or formal agreement.  However, the Section further provides that “emotional distress” shall not be treated as a “physical injury or physical sickness,” to the extent the amounts received exceed the amount paid for medical care attributable to emotional distress.  The issue facing the Tax Court was whether there was a “direct cause or link” between the damages and the personal injuries sustained.  Although the agreement lacked express language specifying the purpose of the compensation, the Court accepted Ms. Domeny’s testimony regarding exposure to a hostile and stressful work environment, and how it worsened her MS symptoms to a point that she was unable to work.  The Court inferred from the manner in which the settlement payment was split that the employer was aware that at least part of her recovery might not have been taxable.  The Court concluded that the payment was to compensate her for the physical injuries resulting from her stress, and excludable.

            The Tax Court reached a different result in the case of Marion Wells, who sought to exclude the settlement she received for depression (beyond the amount paid for medical care to treat emotional distress).  The same operative sections of the Internal Revenue Code were at play, but the condition arose from alleged gender discrimination and retaliation.  Ms. Wells’ alleged stress was due to altercations with her supervisor and inaction by her employer about seeking therapy, taking leave and eventually being terminated.  The settlement agreement stated that the amount she received was “as damages for her emotional distress due to depression and other claims, not as wages or back pay.”  She treated the settlement as excludable, but the IRS concluded that it was includable. 

            The Tax Court agreed with the IRS that the settlement payment was made for emotional distress and that, as a matter of law, it is not excludable from her gross income.  The Court stressed that the settlement was not attributable to physical injury or sickness, but to a nonphysical injury – gender based discrimination and unlawful retaliation. 

            What do these cases mean for people who are stressed or depressed?  If you have expenses for medical treatment of your condition, be sure to present and discuss them with your return preparer before just deducting them.  If you make a claim for damages, there is a line of demarcation to be wary of:  if you can point to an actual physical sickness as the reason for the damages, you have satisfied an important condition for excluding the recovery from income under I.R.C. § 104.  If not, you will in all likelihood not qualify. In either event, anyone faced with a serious problem should contact their personal tax advisor about the proper treatment of any damages, and encourage the legal representative handling the claim to contact that tax advisor to see if specific language ought to be included in the agreement.  Ms. Domeny won her case without such language, but having a specific identification of the reason for the payment will make it more likely that the amount properly excludable is in fact excluded at tax time.

            Let’s face it: employees are wonderful.  We couldn’t do without them.  However, they can be expensive.  Beyond their base compensation, employers must pay federal taxes – in addition to withholding the employee’s share of income tax, FICA and Medicare, there is an employer’s share of Medicare and FICA that must deposited regularly.  There’s also annual FUTA tax, as well as quarterly state unemployment tax.  And there are benefits, ranging from medical coverage, to vacations, to sick leave, to name just three, that employers must pay.

            When business is down, it is natural to try to find ways to cut operating expenses.  Hopefully, you will not be misled by the siren song of those who have an instant solution: “converting” your employees to independent contractors.  The pitch sounds great.  You issue each person a check every month, without having to worry about withholding, the employer’s share of the FICA and Medicare taxes, FUTA, Texas Workforce Commission taxes, etc.  Moreover, you don’t have to make contributions to any benefit plans, guarantee vacations, etc.  Why didn’t you think of this sooner?

            The answer is simply that it’s good that you didn’t, and it will be dangerous if you try it.  The circumstances governing the status of a worker as an employee versus an independent contractor are beyond the scope of this article, but basically depend on factors involving the extent of behavioral and financial control exerted over the worker.  If the people in question are “employees” now, just changing their titles to “contractor” is not going to work a conversion.  If they continue to perform the same work on roughly the same terms that have been observed, the IRS and state authorities are not going to accept the hocus pocus of a change of title.  What is the downside if you try this and are “caught”?

            Well, besides the expense of an audit, the outcome will not be pretty.  Under I.R.C. §§ 3101, 3111 and 3402, the IRS is authorized to assess against the employer twenty-five percent (25%) of the compensation paid as income tax withholding, as well as the employee’s share of FICA and Medicare taxes, and the employer’s share of FICA and Medicare taxes, plus the FUTA tax that would be owed.  Penalties and interest will also be assessed against those amounts.  Since the amount owed for FUTA depends upon the amount paid to the state employment fund, the effect of playing this game for both state and federal purposes could be extremely expensive, as one would also face a make-up payment to the state.  Delinquent Forms W-2 and corrected Forms W-3 may have to be prepared and filed with the Social Security Administration.

            To give you examples of the downside of misclassification, last summer the United States District Court for the Southern District of Iowa held that Raymond Porter and his company, Porter Livestock Products, were liable for the foregoing federal employment and unemployment taxes for employees he improperly attempted to classify as independent contractors.  More recently, Mr. and Mrs. David Martin were told by the United States Tax Court that he, the individual who incorporated his own real estate business, was an “employee” of the corporation, it was responsible for these taxes, and was not eligible to deduct the employment taxes that were in dispute.  The potential exposure is considerable. 

            In addition, in particularly flagrant situations, there are two other possible consequences.  First, from a purely civil point of view, if the IRS concludes that the business owner should have known that the employees were improperly treated, the owner faces the possibility of the § 6672 trust fund recovery penalty being assessed against him personally if his business can’t pay the taxes immediately.  Second, in the most flagrant situations, the IRS could take the position that the misclassification is a criminal matter, and a willful failure to pay taxes (a misdemeanor) or an attempt to evade payment of taxes (a felony). 

            If you are approached by someone with a plan like this, I strongly suggest that you run in the other direction.  If you are at all attracted to it, be sure to review every detail of it with your current tax advisor.  Don’t make a move in this direction without doing so!

            People are always generous at this time of the year, and it’s a great time to remember folks who have helped your business in one fashion or another.  Business gifts can be deductible for income tax purposes, but there are some rules you need to be thinking about. 

            Assuming that what you are giving someone is truly a “gift,” and not some form of disguised compensation, the general rule under the Internal Revenue Code has forever included an annual limitation on deductions to the extent of $25 for each recipient.  It doesn’t matter how many gifts you gave, or how much each of them was worth—the total deductible amount per recipient is $25.  In this regard, the cost of the item to the gift-giver, not its value to the recipient, is what is considered.  If you incur additional costs such as engraving of jewelry, packaging, insurance, mailing or other delivery, those costs are not subject to the $25 limitation.  

            The deductible amount is not the only thing to think about.  As you make a list of who’s been naughty and who’s been nice, the gift must really be to someone you have a “business” relationship with—someone who has been helpful to your business.  This can include customers, business associates, clients, referral sources, and professional advisors.  The guy who parks your car in the garage next to your office probably doesn’t qualify, even though he’s pulled your bacon out of the fire several times by retrieving it quickly.  Moreover, the connection must be present when the gift is given—if challenged, you’ll have to demonstrate that the generosity was appropriate, customary and helpful, and closely related to your business. 

            From time to time, you’ll make a “gift” of entertainment, and those can be an exception to the limitation.  If you take someone to dinner, to a sporting event or a show, you start with 100% of the amount paid, and the gift is not subject to the $25 limitation, but rather takes a 50% haircut like all other meals and entertainment.  If you give another person tickets to a sporting or cultural event, but do not attend with them, you have an option:  you can deduct up to $25 per gift (subject to the maximum limitation per recipient), or the cost of the tickets can be treated as in “entertainment expense” if they are given in connection with a business discussion, in which case they are treated as an entertainment expense and subject to the aforementioned 50% “haircut.” 

            We’re talking here about business gifts, and not charitable contributions.  Charitable deductions are subject to a different set of rules and thus not subject to these limitations.  As always, when in doubt, I recommend you consult your professional tax advisor before thinking about the tax benefits you’ll get from making gifts.

            The Internal Revenue Code provides a basic exclusion from income taxation of the proceeds of a life insurance policy.  However, what happens if a taxpayer surrenders the life insurance policy with loans against the cash value?  The formal rule is that amounts received upon the surrender of a life insurance contract which are not received as an annuity are specifically included in gross income to the extent that they, when added to amounts previously received under the contract and excluded from gross income, exceed the investment in the contract.  How this works was illustrated in the sad news which the United States Tax Court delivered to Mr. and Mrs. Harvey Barr earlier this year. 

            Mr. Barr’s mother purchased a life insurance policy in anticipation of helping her children pay the estate tax liability when she passed away.  She bought a whole life policy in the face amount of $200,000, which was not an annuity.  However, Mr. Barr and his sister were the co-owners and the beneficiaries.  The senior Mrs. Barr paid the premiums each year for the first eight or nine year, and then no premiums were paid, but the policy instead borrowed against its cash value to pay the annual premium.  In other words, premiums were automatically paid from dividend accumulations and the cash value of the policy.  Once Mr. Barr and his mother decided that the policies were no longer necessary, they allowed the policy to terminate, surrendering it in December 2005, and received a check from the insurer of $11,648.33, as well as a $304.20 dividend.  The Form 1099-R, Distributions from Pensions, Annuities, Retirement of Profit Sharing Plans, etc., from the insurance company showed a gross distribution and taxable amount of $135,963.44.  However, the Barrs did not include that latter amount on their income tax return.

            The IRS determined that this entire amount was taxable to them, and the Tax Court agreed.  Mr. Barr’s net distribution of $11,648.33 represented the total cash value, plus a terminal dividend, less the amounts withheld to pay the outstanding policy loan balances.  The satisfaction of the loans, according to the Tax Court “had the effect of a pro tanto payment of the policy proceeds” to Mr. Barr and constituted income to him.  To make matters “worse,” the Court held that this was ordinary income to the Barrs, rather than a capital gain, because there was no “sale or exchange” of a capital asset.  The surrender of an insurance policy was held not to be a capital asset in cases going back to 1936.

            The two morals of the story are these.  When one receives a Form 1099-R that reflects a result different than what was expected, the sooner one gets to a tax advisor the better.  A secondary lesson is that like many other situations, one should visit with a tax advisor before proceeding with any financial transaction of this sort.

            One of the nice things about helping a good cause, one eligible for charitable contributions, is that you are actually doing both good for the beneficiaries of the charity and, if you dot your “I’s” and cross your “T’s,” benefitting yourself.  That is, if you do it right, you get a tax deduction for your contribution.  However, particularly as we get close to the end of the year and folks begin thinking of making gifts they haven’t made earlier, there are a number of rules you have to follow.

            First and foremost, make sure you keep records to substantiate the contribution if the IRS ever shows up and wants you to prove what you paid.  This makes it important to minimize your cash contributions, or at least to keep some sort of contemporaneous record of what you give and to whom you give it.  Frankly, I recommend making your gifts by check or, if possible, credit card, and to get a receipt when you can.

            If you are in a position to be really generous, and to make a gift of $250 or more, there is an absolutely draconian provision of the Internal Revenue Code that you need to be aware of, at least if you want a tax deduction.  Internal Revenue Code § 170 is the provision that allows a deduction for charitable contributions, but it provides in §(a)(8) that for any contribution of $250 or more, the taxpayer has to substantiate the contribution by a contemporaneous written acknowledgement of the contribution from the recipient organization.  The statute further provides that the acknowledgement must identify the amount of cash and a description of any non-cash property contributed, whether the organization provided any goods or services in considerations for that property, and in the latter situation, a description of and good faith estimate of the value of such goods and services.  The statute further requires this to be a contemporaneous acknowledgement, in that it must be obtained on or before the date on which the taxpayer files the tax return containing the charitable deduction (or the deadline date for filing that return). 

            Recently, the Courts told two taxpayers that this provision was mandatory, and disallowed their deductions for failure to observe it.  In Bruzewicz v. United States, the United States District Court for the Northern District of Illinois disallowed a deduction for a donation of a charitable easement of real property for failure to meet this acknowledgement obligation, where the taxpayers did not have a statement from the charity which acknowledged the gift beyond a reference to “an easement.”  The Court denied the contention that this was “substantial compliance” even before it reached the question of the valuation of the easement. 

            In Addis v. Commissioner, the United States Tax Court reached a similar result involving a contribution of the premiums to pay life insurance, where the contributor was to receive part of the ultimate death benefit, but the charity failed to identify that as a “benefit” that the taxpayer would receive for making the contribution. 

            The Internal Revenue Code contains other limitations on charitable deductions that relate to the kind of property donated, as well as limitations that kick in for contributions at larger levels, such as $500 and $5,000, where qualified appraisals may be required.  The best advice to any reader is to keep records, and if you are generous at the $250 level or above, contact your personal tax advisor to make sure that you get exactly what you need from the charitable organization so that this does not become a situation where you are unable to “give to Caesar that which is Caesar’s.”

Since the passage of the first Internal Revenue Code, it has seemed as if the lion’s share of personal income taxes have been paid by higher income taxpayers.  If high tax rates were not enough, Congress came up with a series of things to add to the burden. In recent times, it enacted the dreaded alternative minimum tax.  Then George H. W. Bush broke his “read my lips” promise, and signed legislation that phased out itemized deductions and deductions for exemptions as income levels rise.  Now, as the George W. Bush tax cuts are scheduled to expire after 2010, and the Obama administration and its Democratic Congress is talking about raising the rates on ordinary income, dividends and capital gains to their old levels or above, we also have the specter of a surtax on income over $1 million for married couples, and $500,000 for individuals, to help pay for the health care plan.  Can matters get worse?  Well, if you read the newspapers lately, it sure sounds like it:  the IRS has recently announced that it is about to create an enforcement “unit” which targets “the very wealthy.”  What’s a successful taxpayer to do when faced with all of this? 

            There is no need for “wealthy taxpayers” to fear that unmarked cars carrying Agents from the new “Global High Wealth Industry Group” are suddenly going to be parking in their neighborhood and spying on them.  The IRS reorganizes its resources periodically, and this is the first time it has begun to view “wealthy people” as if they were worthy of special consideration.  Once this group gets its sea legs, one should realize that it is probably not going to affect very many people, even if one satisfies the as yet undefined standard of “wealthy.” In this regard, every taxpayer at this level should consider whether she is in a group that has been targeted for special attention.

            The IRS announcements indicate that there are a number of places where they believe there is significant non-compliance.  The first involves international transactions, and particularly taxpayers who hold money in bank accounts or other investments outside the United States.  There is nothing illegal about doing that.  If a taxpayer can demonstrate that whatever money went overseas has been taxed in the United States, or that those accounts are properly being reported on the required forms, and that all income is being recognized on U.S. tax returns, any audit should be short and more inconvenient than threatening. 

            The next group that needs to be concerned includes anyone who has invested in what is known as a “listed transaction” or a “transaction of interest.”  Most of these are tax shelters.  During the 1970’s and early 1980’s, some were sold to the higher end of what were middle class people, but since the late 1990’s they seem to have been marketed to high income individuals who can benefit most from them.  The IRS has been increasingly focused on such transactions, and the scrutiny is likely to continue.

            A third group involves taxpayers who have transactions with the entities they own.  At first blush, this sounds as if the IRS always looked at one to the exclusion of the other, but that is a false impression.  In this writer’s experience representing taxpayers over many years, an audit of an individual always included at least a survey of the returns of any closely held entities she owned, and a survey of an entity like a corporation or partnership invariably included a survey of the returns of the major officers and owners.  Transactions between people and their entities always received scrutiny in these audits, but perhaps the IRS is simply going to look at them more closely.

            A final group of situations which the IRS has mentioned as candidates for examination includes individuals who receive gifts or property from estates.  This is a change to be concerned about, because the IRS has generally conducted separate examinations of income tax returns on the one hand, and gift and estate tax returns on the other.  The IRS claims it is now going to “coordinate” those examinations.  Whether the agency’s culture will allow this to take place smoothly remains to be seen.

            So what should a taxpayer do if she fears that she will be in the roundup of “usual suspects”?  The first move is to sit down as soon as possible to review her personal or business affairs with her tax advisor.  With the October 15th filing deadline now passed, this is a perfect time to talk to a tax preparer or a tax lawyer and review exactly what her situation is, not only for the sake of 2009, but planning forward for 2010, and to address all the draconian measures that may be appearing in the Internal Revenue Code anyway.  That person should also be able to tell her whether she has the kind of circumstances that are identified above as being on the IRS Radar Screen.  Be sure to cover all aspects of planning, including estate and gift planning and employee benefits, as part of this process.  The other action to be taken is to make sure all transactions are as well documented as they can be.  For instance, if she received a gift from Aunt Bernadette this year, make sure that there are documents to show that it was in fact a gift.  If there is a loan between a shareholder and a corporation, or a business pays travel and entertainment expenses for an owner, those are almost guaranteed audit items.  Likewise, all documents reflecting foreign transactions should be preserved.  And, as always, if approached by someone offering a transaction with tax benefits that seem “too good to be true,” make sure it is reviewed by a truly independent and knowledgeable tax professional before taking the plunge.  That person’s charges will be “cheap at twice the price” if the advice keeps her out of a bad situation.

            It remains to be seen exactly how much upheaval will result from this new “Global High Wealth Industry Group.”  Surely every wealthy individual is the potential subject of an examination, and should begin a review of her situation right now rather than wait until someone mysteriously appears at her door or sends a letter announcing that an audit has begun. 

The United States Tax Court has very recently issued opinions for two couples that highlight the problems that may arise from a tax point of view when someone settles a credit card debt. 

            As long as there have been credit cards, there have been situations where the cardholder has for one reason or another not paid the full amount billed, and has had to “settle” a debt with the credit card company.  It is probable that most people don’t think about this as an income producing event, but Internal Revenue Code Sections 61(a)(12) and 108 provide that any cancellation or forgiveness of debt can give rise to income (unless the person is insolvent before and after the transaction).  Very recently, Mr. and Mrs. Robert Melvin asked the United States Tax Court to decide whether they realized discharge of indebtedness income after settling a credit card debt.  The outcome was disappointing to them, and a lesson for all of us.

            In that case, the Melvins settled a balance due to Chase Manhattan Bank, and the Bank issued a Form 1099-C reflecting the difference between the original debt and the amount they agreed to pay.  Initially, the Melvins asserted that there were disputed charges involved, but they were unable to prove this at trial, and the Tax Court held that the amount of debt for which they were relieved constituted income they were required to report.

            To add insult to injury, the Melvins paid a third party a fee of 25% of the savings, and attempted to deduct that on their tax return.  Although Internal Revenue Code Section 212 allows a deduction for the expenses incurred for the production of income, the Tax Court–for lack of a better term–added insult to injury and denied them a deduction for that amount, so that their income was increased by the entire amount of the canceled debt, and not the net amount from which they benefitted. 

            Mr. and Mrs. William McCormick also took a case involving settlement of their debts to the Tax Court, and had a much better outcome.  The McCormicks maintained a loan account with CitiFinancial Services, and obtained a payoff amount for their account.  They challenged a part of the figure they received, and the manager offered to settle the dispute for a lump sum payment, which they accepted and paid.  CitiFinancial sent a Form 1099-C to the Internal Revenue Service with respect to the difference between the original debt and the amount paid.  In addition, the McCormacks had a credit card with Chase, and when their account was placed with a collection agency, they disputed the balance in the account and ultimately reached a settlement with the credit card issuer.  Chase mailed a Form 1099-C to the McCormacks reflecting the difference. 

            The Tax Court held that in the case of disputes like this, the IRS may not rely on the contents of a Form 1009-C as evidence of the amount of debt forgiven because the McCormacks asserted a reasonable dispute with respect to the amounts reported, and the Government could not produce “reasonable and probative information” to corroborate the contents of the Forms 1099.  Ultimately the Tax Court held that all but $49.66 of the disputed amounts was not cancellation of debt income. 

            There a number of morals to the story.  The first is that a taxpayer who has a bona fide dispute must document it thoroughly, or will be at risk of having to pay income tax on income to the extent of the settlement of the debt.  Remember that the IRS is going to receive a Form 1099-C from the credit card company, and expect the amount reflected there to be reported on a tax return.  Second, if a person believes that the Form 1099 is in error, it is incumbent upon the person to first contact the issuer of that Form 1099 and try to have a corrected one issued.  This may be accomplished by a phone call, but a letter sent certified mail with return receipt requested is always better proof.  Finally, anyone who faces this situation should bring it to the attention of her personal tax advisor, and make sure that it is properly accounted for during the preparation of her tax return.

            Anyone paying attention to the media for the last month or so must be aware of the battle the IRS has waged with UBS in order to obtain information about owners of heretofore “secret” accounts in Switzerland.  This is part of an IRS effort to track down tax delinquents who are using overseas accounts to hide their income and assets.  A settlement was recently announced whereby the Swiss agreed to reveal a relatively small (in the grand scheme of things) number of the accounts—4,450 versus the 52,000 that the IRS originally alleged—in order to resolve the dispute.  At this point, the IRS has its eyes on other foreign institutions and one can be sure that this is not going to be the end of the IRS’ efforts. 

            So what does all this mean?  The first thing to understand is that there is absolutely nothing illegal or morally improper about having a foreign bank or financial account.  People have such accounts for many reasons.  Some have business connections or spend a great deal of time overseas, and having an account in their host country is natural.  Others, out of fear that the U.S. banking system is going to collapse, have put money in places where they believe it is “safe,” although this writer frankly wonders how long banking systems outside the United States would survive if the U.S. system collapsed as completely as they seem to fear.  Other people have migrated to this country, but had signature authority over accounts in their country of origin which they failed to close, although they now have very little contact with those accounts. 

            From the IRS point of view, there are three problems.  First, U.S. taxpayers are subject to “worldwide” taxation of their income.  Some people use foreign bank accounts to stash income they are supposed to report to the Government, and other simply fail to report income such as interest from the accounts they have overseas.  In doing so, they are filing false income tax returns to the extent that income is not reported.  Second, there is a harmless looking “check the box” entry on Schedule B of every Form 1040, asking whether one has an financial interest or signature authority over one or more accounts outside the United States.  It is likely that most people file their tax returns without paying any attention to this, but if someone either owning an account overseas or having authority marks it “no,” that return is false.  The third and perhaps least known problem is that for those who do have such access to foreign accounts holding more than $10,000 in the aggregate, the law requires the annual filing of a Form TDF-90-22.1, known to tax practitioners as an “F BAR.”  This form is required to be filed by June 30th of the following year, reflecting all foreign accounts and the balances in them.  It is not filed with the income tax return, but rather is filed with an IRS Service Center in Michigan.  There are serious civil and criminal penalties that can be imposed on anyone who files a false income tax return or who fails to file a timely and accurate F BAR. 

            Fortunately for those who took advantage of if, the Internal Revenue Service announced a “voluntary disclosure” program earlier this year, under which eligible individuals could come forward, file six years of amended returns, pay the additional income tax and interest, pay a negligence penalty on the income tax deficiency, file the delinquent FBARs, and pay a penalty based on a percentage of the highest balance in the account. Unfortunately, that program “expired” on October 15, 2009. 

            If you are a person having an interest in or authority over a foreign account, and did not attempt to participate in this program, do not wait another minute to contact a knowledgeable tax lawyer to determine what to do.  The stakes are great, and while the IRS is going to be preoccupied with the persons who participated in the program, it has names of many other account holders, and the worst thing to do would be to just sit back and hope the IRS won’t come calling.