Appealing An I.R.C. § 280E IRS Tax Audit

While the sale of cannabis is legal in California as well as in a growing number of states, cannabis remains a Schedule 1 narcotic under Federal law, the Controlled Substances Act. As such businesses in the cannabis industry are not treated like ordinary businesses. Despite state laws allowing cannabis, it remains illegal on a federal level but cannabis businesses are obligated to pay federal income tax on income because I.R.C. §61(a) does not differentiate between income derived from legal sources and income derived from illegal sources.

Taxation Of Cannabis Businesses

The Sixteenth Amendment of the U.S. Constitution prohibits the Federal government from taxing “gross receipts”. In Edmondson vs. Commissioner, 42 T.C.M. (CCH) 1533 (T.C. 1981), the Tax Court decided that Jeffrey Edmonson, self-employed in the trade or business of selling amphetamines, cocaine, and cannabis, was permitted to deduct his business expenses resulting from his trade. Discomforted by this outcome, the following year Congress enacted I.R.C. §280E, disallowing all deductions and credits for amounts paid or incurred in the illegal trafficking in drugs listed in the Controlled Substances Act.

Under I.R.C. §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law. Cannabis, including medical cannabis, is a controlled substance. While I.R.C. §280E disallows cannabis-related businesses to deduct “ordinary and necessary” business expenses, it would be unconstitutional for the IRS to disallow businesses to deduct Cost Of Goods Sold when calculating gross income. This concept was first applied in the Tax Court case of Olive vs. Commissioner Of Internal Revenue, 139 T.C. 19 (2012).

I.R.C. Section 280E IRS Tax Audits

It is no surprise that cannabis businesses are proliferating as more States legalize cannabis and make available licenses to grow, manufacture, distribute and sell cannabis. The IRS recognizes this and it is making these cannabis businesses face Federal income tax audits. IRC §280E is at the forefront of all IRS cannabis tax audits and enforcement of §280E could result in unbearable tax liabilities.

Proving deductions to the IRS is a two-step process:


• First, you must substantiate that you actually paid the expense you are claiming.

Second, you must prove that an expense is actually tax deductible.

Step One: Incurred And Paid The Expense.

For example, if you claim a $5,000 purchase expense from a cannabis distributor, offering a copy of a bill or an invoice from the distributor (if one is even provided) is not enough. It only proves that you owe the money, not that you actually made good on paying the bill. The IRS accepts canceled checks, bank statements and credit card statements as proof of payment. But when such bills are paid in cash as it typical in a cannabis business, you would not have any of these supporting documents but the IRS may accept the equivalent in electronic form.

Step Two: Deductibility Of The Expense.

Next you must prove that an expense is actually tax deductible. For a cannabis businesses this is challenging because of the I.R.C. §280E limitation; however a cannabis business can still deduct its Cost Of Goods Sold (“COGS”). Cost of goods sold are the direct costs attributable to the production of goods. For a cannabis reseller this includes the cost of cannabis itself and transportation used in acquiring cannabis. To the extent greater costs of doing business can be legitimately included in COGS that will that result in lower taxable income. You can be sure the IRS agents in audits will be looking closely at what is included in COGS.

Appealing An I.R.C. Section 280E IRS Tax Audit

Now if your cannabis IRS tax audit is not resolved, the results may be challenged. After the Revenue Agent has concluded the tax examination, the agent will issue a copy of the examination report explaining the agent’s proposed changes along with notice of your appeals rights. Pay attention to the type of letter that is included as it will dictate the appeals process available to you.

The “30-day letter”

The “30-day letter” gives you the right to challenge the proposed adjustment in the IRS Office Of Appeals. To do this, you need to file a Tax Protest within 30 days of the date of the notice. The Appeals Office is the only level of appeal within the IRS and is separate from and independent of the IRS office taking the action you disagree with. Conferences with Appeals Office personnel are held in an informal manner by correspondence, by telephone, or at a personal conference.

The “Notice Of Deficiency”

If the IRS does not adopt your position, it will send a notice proposing a tax adjustment (known as a statutory notice of deficiency). The statutory notice of deficiency gives you the right to challenge the proposed adjustment in the United States Tax Court before paying it. To do this, you need to file a petition within 90 days of the date of the notice (150 days if the notice is addressed to you outside the United States). If you filed your petition on time, the court will eventually schedule your case for trial at the designation place of trial you set forth in your petition. Prior to trial you should have the opportunity to seek a settlement with IRS Area Counsel and in certain cases, such settlement negotiations could be delegated to the IRS Office Of Appeals. If there is still disagreement and the case does go to trial, you will have the opportunity to present your case before a Tax Court judge. The judge after hearing your case and reviewing the record and any post-trial briefs will render a decision in the form of an Opinion. It could take as much as two years after trial before an Opinion issued. If the Opinion is not appealed to a Circuit Court Of Appeals, then the proposed deficiency under the Opinion is final and your account will be sent to IRS Collections.

IRS Area Counsel are experienced trial attorneys working for the IRS whose job is to litigate cases in the U.S. Tax Court and look out for the best interests of the Federal government. So to level the playing field, it would be prudent for a taxpayer to hire qualified tax counsel as soon as possible to seek a mutually acceptable resolution without the need for trial, and if that does not happen, to already have the legal expertise in place to vigorously defend you at trial.

What Should You Do?

While more States are legalizing cannabis, risks to the cannabis industry still exist. Considering the risks of cannabis you need to protect yourself and your investment. Level the playing field and gain the upper hand by engaging the cannabis tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), the Inland Empire (including Ontario and Palm Springs) and other California locations. We can come up with solutions and strategies to these risks and protect you and your business to maximize your net profits. And if you are involved in crypto currency, check out what a bitcoin tax attorney can do for you.

IRS Targeting Cannabis Businesses With “280E Audits”

We previously reported in our blog that the Trump Administration organized a committee of federal agencies from across the government to combat public support for marijuana and cast state legalization measures in a negative light while attempting to portray the drug as a national threat.

The IRS appears to be following the agenda of the Trump Administration when it comes to Cannabis and has formed special audit groups that are tasked with conducting cannabis tax audits on medical and recreational cannabis businesses. Our office is currently representing cannabis businesses under audit and in U.S. Tax Court and we have learned from IRS agents that they have been given a mandate to audit just about every licensed cannabis operator in their districts.

The IRS recognizes that cannabis businesses deal in cash which makes it harder to substantiate deductions and that the Internal Revenue Code prohibits cannabis businesses from deducting operating expenses. These two factors could lead to an avalanche of audits that could cost cannabis businesses millions in unpaid taxes and penalties.

I.R.C. §280E

The Federal Controlled Substances Act (“CSA”) 21 U.S.C. § 812 classifies marijuana as a Schedule 1 substance with a high potential for abuse, no currently accepted medical use in treatment, and lack of accepted safety for use under medical supervision.

Generally, businesses can deduct ordinary and necessary business expenses under I.R.C. §162. This includes wages, rent, supplies, etc. However, in 1982 Congress added I.R.C. §280E. Under I.R.C. §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law. Cannabis, including medical marijuana, is a controlled substance. What this means is that dispensaries and other businesses trafficking in cannabis have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses.

IRS Guidance On Cannabis.

The IRS issued a memo to provide guidance to its agents on conducting audits of cannabis businesses addressing whether an IRS agent can require a taxpayer trafficking in a Schedule 1 controlled substance to change its tax accounting to conform to I.R.C. §280E.

Not surprisingly that the IRS ruled that IRS agents have the authority to change a cannabis business’ method of accounting so that pursuant to I.R.C. §280E costs which should not be included in inventory are not included in Costs Of Goods Sold (“COGS”) and remain non-deductible for income tax purposes.

Cannabis Tax Audits & Litigation.

It is no surprise that cannabis businesses are proliferating as more States legalize cannabis and make available licenses to grow, manufacture, distribute and sell cannabis. The IRS recognizes this and it is making these cannabis businesses face Federal income tax audits under an “audit technique guide” that has been developed by IRS officials using information from Colorado’s seed-to-sale tracking system. This guide is now being used nationwide with IRC §280E being at the forefront of all IRS cannabis tax audits.

Proving deductions to the IRS is a two-step process:
• First, you must substantiate that you actually paid the expense you are claiming.
• Second, you must prove that an expense is actually tax deductible.

Step One: Incurred And Paid The Expense.

For example, if you claim a $5,000 purchase expense from a cannabis distributor, offering a copy of a bill or an invoice from the distributor (if one is even provided) is not enough. It only proves that you owe the money, not that you actually made good on paying the bill. The IRS accepts canceled checks, bank statements and credit card statements as proof of payment. But when such bills are paid in cash as it typical in a cannabis business, you would not have any of these supporting documents but the IRS may accept the equivalent in electronic form.

Step Two: Deductibility Of The Expense.

Next you must prove that an expense is actually tax deductible. For a cannabis businesses this is challenging because of the I.R.C. §280E limitation. Recall that under I.R.C. §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law. What this means is that dispensaries and other businesses trafficking in cannabis have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses.

A cannabis business can still deduct its Cost Of Goods Sold (“COGS”). Cost of goods sold are the direct costs attributable to the production of goods. For a cannabis reseller this includes the cost of cannabis itself and transportation used in acquiring cannabis. To the extent greater costs of doing business can be legitimately included in COGS that will that result in lower taxable income. You can be sure the IRS agents in audits will be looking closely at what is included in COGS. Working with a cannabis tax attorney can ensure that you receive the proper treatment of COGS versus ordinary and necessary expenses resulting in the lowest possible income tax liability.

In addition to IRS audits, state cannabis audits are also complex and thorough and generally include all taxes specific and nonspecific to the cannabis business. Potentially at risk is the cannabis license that enables the business to operate. State audits will focus on records regarding sales and use tax, excise taxes, and seed-to-sale tracking records.

Now if your cannabis IRS tax audit is not resolved, the results may be challenged and litigated in the U.S. Tax Court or Federal District Court. The U.S. Tax Court has jurisdiction to hear disputes over federal income taxes before final assessment and collections while the Federal District Court generally requires taxpayers to first pay the liability then seek repayment through a refund request.

What Should You Do?

Considering the tax risks of cannabis you need to protect yourself and your investment. Level the playing field and gain the upper hand by engaging the cannabis tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), the Inland Empire (Ontario and Palm Springs) and other California locations. We can come up with tax solutions and strategies and protect you and your business and to maximize your net profits. And if you are involved in crypto currency, check out what a Bitcoin Attorney can do for you.

cryptocurrency-bitcoin-reporting-tax-law

10,000 Cryptocurrency Owners Will Receive Warning Letters From The IRS

10,000 Cryptocurrency Owners Will Receive Warning Letters From The IRS

After years of analyzing data from third parties involved in the cryptocurrency exchanges, the IRS announced in a press release on July 26, 2019 that it has started sending letters to cryptocurrency owners advising them to report their cryptocurrency transactions and pay their taxes. More than 10,000 taxpayers have been identified by IRS as being involved in cryptocurrency transactions but who the IRS believes may not have been compliant in reporting these transactions on their tax returns.

Taxpayers who do not properly report the income tax consequences of virtual currency transactions are, when appropriate, liable for tax, penalties and interest. In some cases, taxpayers could be subject to criminal prosecution.

Notices Being Sent To Taxpayers Are The First Step In IRS Enforcement Action

The IRS is using three types of notices to send to more than 10,000 taxpayers by the end of August 2019 – notices 6173, 6174 or 6174-A. Of all the notices, Letter 6173 requires a signature from the recipient under perjury that they are compliant with the U.S. tax code.

If you receive Letter 6173, you should consult with a tax attorney as the submission of a statement signed under penalties of perjury that is false can result in serious consequences including criminal prosecution.

Virtual currency is an ongoing focus area for IRS Criminal Investigation.

Last year the IRS announced a Virtual Currency Compliance Campaign to address tax noncompliance related to the use of virtual currency through outreach and examinations of taxpayers. The IRS will remain actively engaged in addressing non-compliance related to virtual currency transactions through a variety of efforts, ranging from taxpayer education to audits to criminal investigations.

Taxation Of Cryptocurrency

Cryptocurrency transactions are apparently wildly taxable – far more so than investors may think. Although the IRS has not issued much formal guidance, the position of IRS is that any transaction involving virtual currency can trigger a taxable event including air drops and fork transaction as well as conversions or trades from one virtual currency to another virtual currency.

The IRS in 2014 issued Notice 2014-21 stating that it treats crypto currency as property for tax purposes. Therefore, selling, spending and even exchanging crypto for other tokens all likely have capital gain implications. Likewise, receiving it as compensation or by other means will be ordinary income.

Some would think that if bitcoin is property, trades should be tax deferred under the like-kind changes rues of I.R.C. §1031. Under that theory someone who owned Bitcoin could diversify their holdings into Ethereum or Litecoin, and plausibly tell the IRS it created no tax obligations. Unfortunately, the new Tax Cuts & Jobs Act of 2017 does away with that loophole making it clear that “like kind exchanges” which lets people swap an asset for a similar one without triggering a tax obligation are not available for non-real estate assets.

While Bitcoin receives most of the attention these days, it is only one of hundreds of crypto currencies. Everything discussed with regard to bitcoin taxation applies to all crypto currencies.

Here are the basic tax rules followed by IRS on specific crypto currency transactions:

  • Trading crypto currencies produces capital gains or losses, with the latter being able to offset gains and reduce tax.
  • Exchanging one crypto currency for another — for example, using Ethereum to purchase an altcoin — creates a taxable event. The token is treated as being sold, thus generating capital gains or losses.
  • Receiving payments in crypto currency in exchange for products or services or as salary is treated as ordinary income at the fair market value of the coin at the time of receipt.
  • Spending crypto currency is a tax event and may generate capital gains or losses, which can be short-term or long-term. For example, say you bought one coin for $500. If that coin was then worth $700 and you bought a $700 gift card, there is a $200 taxable gain. Depending on the holding period, it could be a short- or long-term capital gain subject to different rates.
  • Converting a crypto currency to U.S. dollars or another currency at a gain is a taxable event, as it is treated as being sold, thus generating capital gains.
  • Air drops are considered ordinary income on the day of the air drop. That value will become the basis of the coin. When it’s sold, exchanged, etc., there will be a capital gain.
  • Mining crypto currency is considered ordinary income equal to the fair market value of the coin the day it was successfully mined.
  • Initial coin offerings including certain forks do not fall under the IRS’s tax-free treatment for raising capital. Thus, they produce ordinary income to individuals and businesses alike.

Given the limited guidance by IRS, there are still tax positions that can be advocated or structured so that taxpayers dealing with crypto currency can defer gains and minimize taxes. That is why it is essential you seek qualified tax counsel.

Penalties For Filing A False Income Tax Return Or Under-reporting Income

Failure to report all the money you make is a main reason folks end up facing an IRS auditor. Carelessness on your tax return might get you whacked with a 20% penalty. But that’s nothing compared to the 75% civil penalty for willful tax fraud and possibly facing criminal charges of tax evasion that if convicted could land you in jail.

Criminal Fraud – The law defines that any person who willfully attempts in any manner to evade or defeat any tax under the Internal Revenue Code or the payment thereof is, in addition to other penalties provided by law, guilty of a felony and, upon conviction thereof, can be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than five years, or both, together with the costs of prosecution (Code Sec. 7201).

The term “willfully” has been interpreted to require a specific intent to violate the law (U.S. v. Pomponio, 429 U.S. 10 (1976)). The term “willfulness” is defined as the voluntary, intentional violation of a known legal duty (Cheek v. U.S., 498 U.S. 192 (1991)).

And even if the IRS is not looking to put you in jail, they will be looking to hit you with a big tax bill with hefty penalties.

Civil Fraud – Normally the IRS will impose a negligence penalty of 20% of the underpayment of tax (Code Sec. 6662(b)(1) and 6662(b)(2)) but violations of the Internal Revenue Code with the intent to evade income taxes may result in a civil fraud penalty. In lieu of the 20% negligence penalty, the civil fraud penalty is 75% of the underpayment of tax (Code Sec. 6663). The imposition of the Civil Fraud Penalty essentially doubles your liability to the IRS!

What Should You Do?

The IRS has not yet announced a specific tax amnesty for people who failed to report their gains and income from Bitcoin and other virtual currencies but under the existing Voluntary Disclosure Program, non-compliant taxpayers can come forward to avoid criminal prosecution and negotiate lower penalties.

With only several hundred people reporting their crypto gains each year since Bitcoin’s launch, the IRS suspects that many crypto users have been evading taxes by not reporting crypto transactions on their tax returns. 

And now that likeexchange treatment is prohibited on non-real estate transactions that occur after 2017, now is the ideal time to be proactive and come forward with voluntary disclosure to lock in your deferred gains through 2017, eliminate your risk for criminal prosecution, and minimize your civil penalties.  Don’t delay because once the IRS has targeted you for investigation – even if it is a routine random audit – it will be too late voluntarily come forward. Let the Bitcoin tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), San Francisco Bay Area (including San Jose and Walnut Creek) and offices elsewhere in California get you qualified into a voluntary disclosure program to avoid criminal prosecution, seek abatement of penalties, and minimize your tax liability. Additionally, if you are involved in cannabis, check out what a cannabis tax attorney can do for you.

The Four Ways That IRS Selects Tax Returns For Examination

The Four Ways That IRS Selects Tax Returns For Examination

I have yet to meet anyone who looks forward to having their tax return be selected for an audit by IRS so you should know the four main ways that the IRS selects returns for examination.

  1. Potential participants in abusive tax avoidance transactions — Some returns are selected based on information obtained by the IRS through efforts to identify promoters and participants of abusive tax avoidance transactions. Examples include information received from “John Doe” summonses issued to foreign and domestic banks, credit card companies, businesses and participant lists from promoters ordered by the courts to be turned over to the IRS.
  2. Computer Scoring — Some returns are selected for examination on the basis of computer scoring.  Computer programs give each return numeric “scores”. The Discriminant Function System (“DIF”) score rates the potential for change, based on past IRS experience with similar returns. The Unreported Income DIF (“UIDIF”) score rates the return for the potential of unreported income. IRS personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review.
  3. Related Examinations — Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for examination. In examinations that include undisclosed foreign bank accounts, the IRS will look for family relatives who may have the same involvement in foreign accounts and also failed to make the proper disclosures.
  4. Information Matching — Some returns are examined because payer reports, such as Forms W-2 from employers or Form 1099 interest statements from banks, do not match the income reported on the tax return. Starting this year the IRS is getting this same level of information from foreign banks who have U.S. account holders.

Information Matching Most Common Reason Why A Return Is Selected For Audit

When a tax return’s information does not match data reported to the Internal Revenue Service by employers, banks and other third parties, the IRS will send a letter to the taxpayer. The letter is called an IRS Notice CP2000, and it gives detailed information about issues the IRS identified and provides steps taxpayers should take to resolve those issues.

This is not a formal audit notification, but a notice to see if the taxpayer agrees or disagrees with the proposed tax changes. Because this verification process and notice generation is done by IRS computers without the need for an agent to actually work the case, these IRS notices are quite common.

Taxpayers should respond to the CP2000, usually within 30 days from the date printed on the notice.

Consequences Of Failing To Respond To IRS Or If Your Response Is Inadequate

If a timely response to the CP2000 is not made or if the IRS cannot accept the additional information provided, a second IRS notice is generated. That follow-up notice is called an IRS Notice CP3219A or “Statutory Notice of Deficiency”. This notice gives detailed information about why the IRS proposes a tax change and how the agency determined the change. The notice tells taxpayers about their right to challenge the decision in Tax Court by filing a Petition with the Tax Court no later than 90 days from the date of the Statutory Notice of Deficiency.

If a taxpayer timely files a Petition, the additional liability remains “proposed” and cannot be sent to collection enforcement by IRS. Instead the taxpayer will have the opportunity to show that the proposed changes are wrong and if agreement is not reached, it will be the Tax Court judge that will have the ultimate say in this matter.

If a taxpayer does not file a Petition, then the proposed changes become final, a tax bill will be generated by the IRS and the IRS can proceed with collection enforcement.

How Does One Find Out If The IRS Does Select Your Tax Return For Examination?

This is where one must be careful because there are scammers out there who are calling people saying they are the IRS and threatening them with arrest and deportation unless they pay right away. If you are selected for an audit by the IRS, the initial contact will always be in the form of a letter sent by the assigned agent under official IRS letterhead.

An official letter from the IRS will give you the contact information of the agent and what IRS office the agent reports to. The letter will also tell you how the examination is to be conducted – this can be by mail, or through an in-person interview and review of the taxpayer’s records at the agent’s office or outside the agent’s office such as the taxpayer’s business. Finally, the letter will tell you which years are being audited and what records will be needed. Taxpayers may act on their own behalf or have a tax professional represent or accompany them. 

What Should You Do?

Tax problems are usually a serious matter and must be handled appropriately so it’s important to that you’ve hired the best lawyer for your particular situation. The tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), the Los Angeles Area (including Long Beach and Ontario) and elsewhere in California are highly skilled in handling tax matters and can effectively represent at all levels with the IRS and State Tax Agencies including criminal tax investigations and attempted prosecutions, undisclosed foreign bank accounts and other foreign assets, and unreported foreign income. If you are involved in cannabis, check out what our cannabis tax attorney can do for you.

Tips For Taxpayers About The Sharing Economy And Taxes From renting spare rooms and vacation homes to car rides or using a bike…name a service and it’s probably available through the sharing economy which is proliferating through many online platforms like Uber, Lyft and Airbnb.

Top Four Tips For Taxpayers About The Sharing Economy And Taxes

Top Four Tips For Taxpayers About The Sharing Economy And Taxes From renting spare rooms and vacation homes to car rides or using a bike…name a service and it’s probably available through the sharing economy which is proliferating through many online platforms like Uber, Lyft and Airbnb. Here are four tips you should know about […]

IRS Now Targeting Taxpayers With Unreported Foreign Income And Undisclosed Foreign Bank Accounts

IRS Targeting Taxpayers With Unreported Foreign Income And Undisclosed Foreign Bank Accounts

Are You A Business Owner With Incomplete Books And Records Facing An IRS Audit?

Your business records are lost or damaged and now you get selected by IRS for an audit if your income tax returns. Just because you can’t back up all your business expenses with receipts does not mean that you lose deductions. Here is a case of a coin dealer who still prevailed despite his lack of sufficient receipts and records.

The Huzella Case

In a recently published Tax Court case, Thomas R. Huzella v. Commissioner, TC Memo 2017-210 (October 23, 2017), the taxpayer, Mr. Huzella who resided in Virginia, bought and sold coins on eBay. All payments he received for the coin sales were processed through PayPal and those payments were reflected on a Form 1099-K, Payment Card and Third Party Network Transactions, issued by PayPal. This Form 1099-K reported for calendar year 2013 aggregate payments of $37,013 from 399 separate payment transactions during the year.

Mr. Huzella has been collecting coins since 1958. His father also collected coins, and some of those coins eventually were gifted to or inherited by Mr. Huzella. He did not keep any records to establish his basis in any of his coins which the IRS regardless of how and when he acquired them. He also did not keep any of his receipts for his business expenses including internet costs, packaging and shipping costs.

Mr. Huzella’s 2013 income tax return was selected for audit. That audit was likely triggered by the 1099-K income that was reported by PayPal which was not reported on the taxpayer’s return. The IRS auditor increased Mr. Huzella’s gross income by the proceeds of the coin sales and gave no credit for any cost of goods sold or expenses he incurred in this activity. So the taxpayer ultimately appealed to the U.S. Tax Court seeking credit for cost of goods sold and business expenses that were denied.

Tax Code Requires Substantiation Of Expenses

Taxpayers bear the burden of proving that claimed business expenses were actually incurred and were “ordinary and necessary”. IRC Sec. 162(a). Taxpayers also bear the burden of substantiating expenses underlying their claimed deductions by keeping and producing records sufficient to enable IRS to determine the correct tax liability. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Reg. § 1.6001-1(a), Reg. § 1.6001-1(e)). The failure to keep and present such records counts heavily against taxpayers’ attempted proof. John E. Rogers & Frances L. Rodgers v. Commissioner, TC Memo 2014-141.

But Unsubstantiated Expenses May Still Be Recognized Under The Cohan Rule

If a taxpayer with inadequate business records proves that he incurred certain expenses but cannot substantiate the exact amount, the Court in appropriate circumstances may estimate the amount allowable. George M. Cohan v. Commissioner, 39 F.2d 540, 542-544 (2nd Cir. 1930). Under this so called “Cohan Rule”, the Court “bears heavily…upon the taxpayer whose inexactitude is of his own making.” This means that the taxpayer must provide some reasonable evidentiary basis for the estimate. The Tax Court should then only allow you to deduct the least amount of money that you could have possibly spent. Although this may not be the entire sum you are claiming, it is better to get something than nothing when you do not have the receipts to back up your expenses.

Anti-Cohan Rule

But there are some types of business expenses that will not benefit under the Cohan Rule. The “Anti-Cohan Rule” found in IRC Sec. 274(d) requires taxpayers to produce receipts and logs in order to deduct expenses for business use mileage, entertainment and promotion and travel. The government added this provision to require substantiation because of the difficulty to estimate these items and the high level of scrutiny that such expenses include items that are not fully related to the business.

So Back To Mr. Huzella’s Case …

By applying the Cohan Rule, the Tax Court through the taxpayer’s testimony establishing a reasonable evidentiary basis for estimated business expenses, can find for the taxpayer deductions which ordinarily would be denied by IRS.

Mr. Huzella maintained no records of any kind to establish his cost or other bases in the coins that he sold on eBay. At trial he could not present any documentation from eBay to establish his acquisition cost for any of the coins but he was able to submit eBay records of his sales and listing transactions, which provide a detailed description of each item listed for sale. He also submitted coin catalogs from 2011 and 2013 and charts tracking the market prices of silver during 2010 to 2013. He testified that he turned over his inventory fairly quickly and that he had purchased fairly recently on eBay many of the items he sold there. The eBay sales records supported his testimony to some degree.

Evaluating Mr. Huzella’s testimony and the evidence as a whole, the Court found that he substantiated a cost of goods sold of $12,000. Furthermore, the Court also found he was entitled to deductions of $942 for PayPal fees, $2,188 for eBay fees, $600 for internet charges, $600 for postage and $100 for packaging costs.

What Should You Do?

Just because you fail to maintain adequate records or your records got lost or damaged should not mean that your business expenses are disallowed in an IRS audit. Taxpayers who hire an experienced tax attorney in audits and tax appeals who at the earliest opportunity introduces and applies the Cohan Rule should result in the least possible audit adjustments and avoiding costly litigation. Let the tax attorneys of the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County, Long Beach and other California locations get you the best possible result in your tax audit.

The Consequences Of Violating The Five-year Probationary Term After Getting An Offer In Compromise

The IRS offers a program called an Offer In Compromise (“OIC”). An OIC allows you to settle your tax debt for less than the full amount you owe. It may be a legitimate option if you can’t pay your full tax liability, or doing so creates a financial hardship.

With a properly completed application for an Offer In Compromise and required financial disclosures, the IRS will consider your ability to pay, income, expenses and asset equity. Only when it can be shown that the amount offered represents the most the IRS can expect to collect within a reasonable period of time will the IRS approve an OIC.

What people do not realize is that if your OIC is accepted, you are subject to certain terms over the next five years that if any term is violated the IRS reserves the right to revoke your OIC and thus put you back to where you originally started subtracting the payments made under the OIC and adding the accrual of more penalties and interest to the current date.

So it is important that anyone with an accepted OIC be aware of these terms and follow compliance:

1. You must comply with all provisions of the internal revenue laws, including requirements to timely file tax returns and timely pay taxes for the five year period beginning with the date of acceptance of the OIC and ending through the fifth year, including any extensions to file and pay. This is what I refer to as the “Five-year Probationary Period”.

2. Youmust promptly pay any liabilities assessed after acceptance of the OIC for tax years ending prior to acceptance of the OIC that were not otherwise identified in your application for an OIC.

So if your OIC included the Form 1040 liability for 2015 and later after your OIC was accepted you got audited for 2015 and that audit resulted in a liability, you would need to promptly pay that liability or else face a revocation of your OIC.

Likewise, if your OIC covered only individual income taxes and you were later assessed with unpaid employment taxes of a business, the failure to pay those new liabilities could result in a revocation of the OIC.

If the OIC was being submitted for joint tax debt, and one of the taxpayer-applicants does not comply with future obligations, only the non-compliant taxpayer will be in default of the OIC. This situation could occur where husband and wife who filed joint income tax returns and jointly secured an OIC later gets divorced and one party defaults on the OIC terms listed above.

An accepted OIC will not be defaulted solely due to the assessment of an individual shared responsibility payment made against another liable taxpayer. This situation could occur where two business owners have personal liability for unpaid employment taxes of the business and one of the owners defaults on the OIC terms listed above.

Now if you find that you cannot keep up with any of these terms, early intervention by your tax counsel with the IRS may still prevent your OIC from getting revoked. Once you receive a final determination by IRS that your OIC is revoked, any new OIC that may now be submitted will be based on your then current financial situation which if it has since improved would lead to an even higher Offer amount with no credit for what was paid under the prior OIC.