Originally published on Forbes.com.
What happens when an entrepreneurial family catches a tough audit? It is not a pretty picture, but it can be instructive to the rest of us. The case of Embroidery Express and the McMinn family is not an easy read, but it is one that I recommend. I did not do any investigation beyond reading the case, so I’m speculating in my assessment of what happened, but here goes. It looks like the McMinns are really decent people who have a creative entrepreneurial streak that makes for a lot going on in their lives. They had the misfortune to run into a character I have thankfully only encountered a couple of times in my career. I call him (although it could be a her) the Agent From Hell.
The Agent From Hell
AFH is convinced that your clients are crooked and will dig and dig until he comes up with something, rather than taking the reasonable approach. The reasonable approach is, having seen the neat package of material that the taxpayer’s representative has put together, everything ticked and tied and what a mensch the representative is, the revenue agent decides it is best to move on and fight crime elsewhere. No change.
My reading of Tax Court decisions and long experience have convinced me that the best representative for the initial stage of an audit is an accountant. The reason is that revenue agents are trained as accountants. If they only work for the IRS, though, they never develop the intimacy with entrepreneurs that allows accountants from local and regional firms to translate the vision into ticked and tied schedules.
Several Businesses
The core of the McMinn empire was the embroidery machine business. They find embroidery machines, buy them, refurbish them and sell them. Quite a few go to Mexico. They also capitalize on their expertise in knowing how to move these machines around. It is a profitable business. There is more than one entity involved and I am going to gloss over those details. Read the case if you are interested.
Then there was the cattle business, which did not do too well, so they were converting that to deer ranching. And the resort. Not to mention the juice business. Juice Plus. a multi-level marketing operation. The McMinns ended up getting hammered on three issues, Section 183, the so-called hobby loss rules, wages that they paid their numerous children, and substantiation. The substantiation piece is the most important lesson that the decision holds for us. If you have mixed personal and business use of expensive assets, keep logs.
The Hobby Loss
The Tax Court did not allow losses from the cattle leasing business that was being transformed into a deer farm. It is easy to see the Tax Court’s viewpoint.
Mr. McMinn grew up working on a farm, where his family raised cattle. Before the years at issue petitioners acquired 176 acres of land that surrounded their residence, to raise cattle. However, by the years at issue Mr. McMinn had decided that raising cattle was no longer profitable, and he decided to use the land for a deer hunting preserve. Therefore, during the years at issue petitioners no longer had any cattle.
Petitioners did not have a written business plan or consult with experts for advice on developing a deer hunting preserve but instead relied on acquaintances for advice. They had no experience in developing a deer hunting preserve. They had a separate bank account for the deer hunting preserve and maintained records of the activity’s assets to deduct depreciation expenses. As petitioners were considering the development of a deer hunting preserve, they intended to continue deducting previously incurred depreciation expenses for assets related to the cattle activity.
On the other hand, Mr. McMinn was not following the general rule in hobby loss cases of failing to make changes when something does not prove profitable. The IRS happened to catch him in the transition. Given his success in other endeavors, I bet his entrepreneurial instinct would have led him to make money letting people blaze away at Bambi’s mom or give it up before losses got out of hand.
Then there was Spring Lakes Resort. They had purchased some land with a lake and made improvements to create campsites to rent. It does not seem that they took it much further and losses were again disallowed on the hobby loss principle. Losses for three years were in the $10,000 range. This is an instance where it might have been wiser to capitalize expenses until things were really going.
The Kids
The McMinns had six children living with them ranging in age from 8 to 21. They all worked in the business and were all paid. The problem was the way they were paid.
The children were generally paid small amounts throughout the year for the jobs that they completed, and bonuses in December of each year. Petitioners placed little economic value on the jobs their children completed throughout the year but paid them significant bonuses at yearend, partially on the basis of the performance of petitioners’ embroidery business. Although Mr. McMinn testified that he paid the children on the basis of what he would pay an unrelated party, petitioners introduced no evidence proving that an unrelated party would receive a similar bonus for the same work. The bonuses were the largest part of the children’s wages and were paid at yearend after petitioners had the opportunity to determine the financial status of the business. The Court is therefore not convinced that unrelated parties would act similarly.
The aggregate amount they were paid was less than $10,000 per kid per year, so the whole thing might have flown if it had been done more conventionally. Year-end bonuses for teenagers greatly in excess of what they received during the rest of the year is probably not such a hot idea. This issue was not a total loss for the McMinns, but they probably lost more than they would have with a more conventional approach.
Substantiation
For this part of the discussion, I have to remind myself of Reilly’s First Law of Tax Planning “It is what it is. Deal with it.” My favorite tax principle outside of my own laws of tax planning is called the Cohan rule. Back in the day, many of the young staff at Joseph B Cohan and Associates thought that the rule had been named after our managing partner, Herb Cohan or his father the eponymous founder of the firm. Being bookish and introverted, I learned that the rule was actually named after George M. Cohan, whose statue stands in Times Square.
My personal restatement of the Cohan rule is “If you don’t have documentation, at least have a plausible story.” Sadly the Cohan rule has been eroded in the area of entertainment, vehicles and charity. If an IRS agent goes after you in this area and you are not prepared, it is like shooting fish in a barrel.
Under section 274(d), a taxpayer must satisfy strict substantiation requirements before a deduction is allowed for certain items. To deduct expenses related to travel, meals and entertainment, gifts, or listed property, the taxpayer must substantiate by adequate records or by sufficient evidence corroborating the taxpayer’s own statement: (1) the amount of the expense (e.g., mileage); (2) the time and place of the expense; (3) the purpose of the expense; and (4) in the case of entertainment, the business relationship between the taxpayer and the person being entertained
The three passenger automobiles are: a 2004 BMW, a Toyota Avalon, and a Toyota Corolla. The passenger automobiles are listed property, see sec. 280F(d)(4)(A)(i), and thus Embroidery Express must satisfy the strict substantiation requirements of section 274(d) to deduct the expenses. Embroidery Express did not produce a mileage log for the vehicles. Mr. McMinn vaguely testified that he used the BMW to pick up clients from the airport and entertain them. Although the Court finds Mr. McMinn’s testimony credible with respect to the BMW, his explanation is insufficient to satisfy the strict substantiation requirements under section 274(d). Mr. McMinn did not explain the uses for the Toyota Avalon or Toyota Corolla. Therefore, respondent’s determination is sustained.
There was also a motor home.
Petitioners did not provide a mileage log for the motor home and have provided no evidence that complies with the substantiation requirements of section 274(d). Mr. McMinn testified generally about the number of conventions he attended and some of the conventions’ locations, but his testimony alone is insufficient to substantiate the depreciation expenses. Respondent’s determination with respect to the motor home is therefore sustained.
This determination also meant that a loss on the sale of the motor home was disallowed.
Then there were the cell phones.
Petitioners did not produce logs showing personal and business use of the cellular phones. Because cellular phones are listed property, see sec. 280F(d)(4)(A)(v), and petitioners presented no evidence that complies with the section 274(d)
Who keeps a log for her cell phone?
Charity
The McMinns are very charitable and many of their contributions were allowed, but they lost on a few either for technical reasons or substantiation problems.
Kayit’s Children’s Home Petitioners claimed a charitable contribution deduction of $2,600 on their 2004 return for a donation to the Kayit’s Children Home, a children’s home in Mexico. Respondent disallowed the deduction because Kayit’s Children’s home is not organized as a charity within the United States.
To illustrate that it probably was AFH working the case, we have this.
Children’s Research Foundation Petitioners claimed charitable contribution deductions of $112, $129, and $381 for donations to CRF in 2004. Petitioners also claimed charitable contribution deductions of $168 and $1,356 for donations to CRF in 2005. The parties stipulated that “he Children’s Research Foundation, which is linked to the Juice Plus program, is shown on the Forms 1099 issued to the McMinns.” Respondent contends that the Court should not allow the deductions because petitioners did not introduce the Forms 1099 or provide contemporaneous written acknowledgments
There were also donations to another unregistered charity. So it goes.
The Good News
As is routine, the IRS asserted the accuracy penalty, but the Tax Court did not sustain it. The hero there is the CPA who tries to keep all this stuff straight.
The CPA credibly testified that the process of preparing the tax returns was extensive, and that Mr. McMinn had provided the CPA with all the necessary documentation to prepare the returns. To calculate the depreciation deductions for the vehicles, the CPA either received a report from the bookkeeper showing the percentage of business and personal use derived from mileage logs, decided that the vehicle was 100% for business use, or discussed with Mr. McMinn the ratio of business and personal use of the vehicle. The CPA also testified that he believed the 2002 Chevy Suburban deduction was properly substantiated.
The record indicates that Mr. McMinn relied heavily on both his bookkeeper and his CPA of 19 years to maintain financial information and properly substantiate deductions. Mr. McMinn believed that his tax positions were conservative and that he had properly complied with the Code.
The lesson here is that there would have been a better result if the CPA had been more assertive on insisting on substantiation for the listed property and the charitable contributions. Or actually the real lesson might be that,it is better to be lucky than good.
Other Coverage
Paul Neiffer of Farm CPA Today focused on the payments to the kids – How To Pay Your Children. The Jewish Federations of North America focused on the disallowed charitable contributions. Although part of it is due to other distractions, I found this a tough case to summarize, which accounts in part for my low productivity this month and, perhaps, the dearth of other coverage.