There are those who make things happen. They are usually the ones doing what it takes even when doing so is difficult, tiring, and draining. They are the ones that often make personal sacrifices and take risks to succeed. They are the ones that had the luck or grit to stick with something to see it to fruition. Whether it’s a true entrepreneur or an investor or business owner who has gotten past the start-up phase, we know these clients. The IRS spends most of its audit resources in examining these taxpayers.
One common challenge presented during these audits involves tracking and classifying amounts transferred between related entities. Many of these taxpayers have several business ventures and, from a tax perspective, the businesses are either disregarded entities, partnerships, or S corporations that flow through to the owner’s individual income tax return.
The IRS’s first step in these audits is to do an income probe to identify any omitted gross receipts. In doing so, they also raise questions about inter-company transfers, such as basis limitations for entities with losses, constructive dividends for personal transfers from corporations, etc.
The worst outcome is when an item of income is taxed twice or more than twice as the income is picked up and treated as taxable income in multiple entities. The recent Kohut v. Commissioner, T.C. Memo. 2022-37 is a case where this appears to have happened. It shows how important it is for small and medium-sized businesses to keep records that will pass IRS scrutiny.
Facts & Procedural History
This case involves several disregarded and flow through entities.
The top level entity was an S corporation. It in turn owned an interest in several disregarded entities and partnership entities.
The entities held real estate and provided medical funding for plaintiffs in personal injury lawsuits.
The taxpayer prepared the accounting for these entities using Quickbooks Desktop software installed on his personal computer. He did this with the input and advice from a CPA who had previously worked for one of the big four accounting firms.
The IRS audited the taxpayer’s returns and, in 2017, it issued a notice of deficiency.
The case was set for trial in the U.S. Tax Court in September of 2019. It was reset to a later date. But one month before the September 2019 time period, the taxpayer hired a CPA to reconstruct its books.
The court noted that the original Quickbooks Desktop files were not available at the time of trial as the taxpayer’s computer crashed in January of 2020 and the files were lost. This was several years after the IRS audit and several months after he had hired a CPA to reconstruct the books.
One of the issues in the case was whether the taxpayer overstated its gross receipts. In reconstructing its books, the taxpayer determined that it had overstated its gross receipts on its tax return.
Business Gross Receipts
The general rule is that all income received is taxable unless an exception applies. For businesses, contributions, loans, and even gifts are all exceptions.
Also, generally, transfers between bank accounts owned by the same taxpayer are not taxable.
Once these type of items are eliminated, in theory, all deposits into bank accounts should equal gross receipts that are reported on the tax return.
This case involved questions about transfers. The IRS agent apparently could not tie out all of the transfers. As explained below, there were some bank accounts where records were not provided. It does not appear that the IRS issued administrative summonses to the bank to get these records, as it typically does, or the banks did not respond. The IRS has broad powers to fish for records.
The Evidence: Before & During Court
The taxpayer presented various types of evidence of its transfers.
The taxpayer’s evidence included testimony from the CPA who reconstructed the books. The court discounted this evidence as he testified that he relied on the taxpayer’s characterizations for different expenses. The court also noted that the reconciliation did not include some bank accounts that were identified in the records as receiving transfers.
The taxpayer’s evidence also included the reconciliations prepared by the CPA. The court concluded that these records were not admissible. It cited Federal Rule of Evidence 1006 which says that “[t]he proponent may use a summary, chart, or calculation to prove the content of voluminous writings, recordings, or photographs that cannot be conveniently examined in court.” The court noted that the bank statements were short enough that they could be reviewed in court.
The taxpayer’s evidence also included testimony from the taxpayer. The court stated that his testimony was ” testimony was vague, conclusory, and contradictory in certain material respects.” This was no doubt due in part to the complexity of the entities and the accounting and the number of years that had passed since the events.
This left just the bank records. Since some of the records identified other bank accounts that received transfers and records were not provided for those other accounts, the court was not able to confirm the taxpayer’s testimony using the records.
Here the taxpayer was asking for a refund as it overstated the amount of gross receipts on its tax return. The court had to balance this evidence against the gross receipts reported on the taxpayer’s tax return. Ultimately, the question was which number appears more correct. The law generally treats the number reported on a tax return as correct absent some evidence to the contrary. The taxpayer was likely correct in that its gross receipts were overstated; however, the court concluded that the evidence presented was insufficient to overcome this presumption of correctness for the tax return.
This case shows how important it is to keep books and records for businesses. This is particularly important where you have flow through entities and transfers between entities. It can be extremely difficult to go back and reconstruct books and records if the entities have a lot of inter-company transfers. This is why it is often advisable for those who own multiple entities to limit or avoid making inter-company transfers.
This case also shows how important it is to diligently contest IRS audit results. With hindsight, the case may have turned out differently if the taxpayer had acted to reconstruct the books during the audit or shortly thereafter. The court’s footnote about reconstructing the books one month before trial shows that this impacted its view of the evidence presented in this case.