The Tax Court has just ruled against a CPA in a case involving income tax, self-employment tax, deductions for personal expenses, fraud, and other items.1 The CPA at issue, Al Benavides, had previously been criminally convicted for assisting a client in evading income tax liabilities.2 Although there are a number of substantive issues in the case, what is very clear from a reading of Judge Pugh’s opinion is the lack of evidence Mr. Benavides provided to support his positions.
Mr. Benavides ran two accounting systems at his CPA firm. One was to track accounts receivable and receipts (PACS). The other was to track the CPA firm’s taxable income (ATB). When the firm would receive payments deposited into the firm bank account, payments would be tracked in PACS. Then, Mr. Benavides would decide whether the payments were for work he personally performed (i.e. not through the firm), work performed by a related partnership, or work performed by the firm. Then, for work performed by the firm, the income would be entered into ATB. Other receipts never appeared on the firm’s tax return. Rather, they were reported elsewhere.
Mr. Benavides’ CPA firm was a C corporation, subject to double taxation. A C corporation pays tax on its earnings, and the shareholder pays tax on dividends. The primary exception is that compensation paid by the firm to Benavides would escape double taxation, but would be taxed as ordinary income and there would be other consequences relating to the ability of that income to offset other costs.
The IRS argued that the receipts recorded in PACS all constituted income to the firm and could not be used to offset deductions incurred by Benavides’ related partnership. The result was a disallowance of a number of deductions, an increase in self-employment tax,3 and an increase in taxable income. Largely due to Benavides’ training and experience as a CPA, the Tax Court sustained the IRS’ imposition of 75% civil fraud penalties against Mr. Benavides.4 His wife escaped fraud penalties. The finding of fraud also opened the returns up for assessment after the general three-year statute of limitations.5
Important in the outcome of the case was the lack of supporting information and the lack of credibility of Benavides as a witness. Throughout almost every issue resolved by the Court, Judge Pugh noted Benavides self-serving, vague testimony. For example, Benavides testified that even without the payments he allocated to himself or other entities, he would have “stripped” out the profits as compensation anyway. However, this contradicts how he filed his return, any records he could produce, and any evidence as to what reasonable compensation would have been. In support of many of his positions, the only proof he had were the firm’s tax returns. As pointed out by the Court, those documents are “merely statements of its position.” Those returns are not independent evidence proving expenses or other facts to support Benavides’ contentions. With respect to claimed expenses of Benavides’ related partnership, no receipts, invoices, canceled checks, or other evidence was presented. Certain expenses appeared personal in nature, making this substantiation even more important. Failure to have anything of substance to support these claimed business expenses proved fatal to Benavides’ case.
It was this lack of supporting documentation backing up Benavides contentions, along with his “disorganized and confusing presentation,” years of practice as a CPA, and previous criminal conviction for tax crimes, that was Benavides’ downfall. While few cases we review involve a history of tax crimes by a CPA, we routinely see cases where lack of organization and documentation is a taxpayers’ (and particularly a tax professional’s) undoing.
Recent Cases with Similar Outcomes
I recently wrote about a Tax Court case where purported debt was found to constitute equity, largely due to the taxpayer’s failure to properly document and substantiate the intended treatment.6 In that writing, I cited to a number of other cases with similar outcomes.
In another recent case7, the Court addressed whether certain payments made to an S corporation should be allocated directly to the shareholders rather than the S corporation. The shareholders alleged that services they performed were on behalf of their 100% owned S corporation. Invoices were on the S corporation’s letterhead and most payments were by checks made out to the S corporation. Also, at least one service recipient issued a 1099-MISC to the corp. However, the Tax Court noted that: (1) no employment agreement existed between the S corporation and the shareholders (which was specifically contemplated in the bylaws); (2) the S corporation’s return did not show any compensation paid to the shareholders; (3) there was nothing showing that the service recipients intended to hire the S corporation versus the shareholders individually; and (4) although checks were written to the S corporation they all were deposited directly in the taxpayers’ bank account. In the end, the taxpayers lost largely due to failure to properly deposit payments into the S corporation’s account and to produce adequate documentation at trial.
In a case out of the Rhode Island U.S. District Court,8 the Court sustained the IRS’ denial of a personal-injury attorney’s expense deductions following admission of a new partner to his law firm. Mr. Morowitz formed his firm in 1999, electing taxation as an S corporation. In 2009, he admitted a second partner. Expenses and fees for preexisting clients were to remain with Morowitz. However, they did little to effectuate this agreement. The clients did not sign a new engagement letter with Morowitz, certain client fees were paid by the firm, client funds were deposited into the firm’s trust account, etc. Morowitz filed a personal income tax return claiming personal deductions for expenses related to preexisting clients. The IRS denied his deductions claiming they belonged to the firm and had to be handled pro rata between Morowitz and his partner per the requirement that S corporation tax items be handled pro rata. All that appears to have been needed was for Morowitz and his partner to properly plan for, document, and act in conformity with their intentions. Once again, while they were not the only factors, depositing funds into the wrong account and failure to provide substantiating evidence at trial was the taxpayer’s undoing.
In the end, Mr. Benavides may have had tax problems anyway. Certainly, he had problems with his tax positions. However, from a review of the opinion, it appears he could have potentially sustained a number of his positions simply by producing adequate support. For example, with respect to what he claimed to be valid business deductions, he could have entered receipts, invoices, cancelled checks, etc., into evidence. His failure to do so together with his failure to administer his business in conformity with his claims and his training and experience as a CPA resulted in opening of the statute of limitations to assess otherwise closed years and the ability to assess a 75% fraud penalty.
The other cases discussed above are similar in that taxpayers failed to live by the facts they claimed. One critical element that often reappears is depositing funds into the account other than where the taxpayer claims the tax burden should fall. Anyone who wants the IRS and Tax Court to believe income is properly reportable by a specific entity would be well advised to actually deposit the taxable funds into that entity’s account. Of course, this is in addition to properly documenting and administering planning as intended. Doing so can make-or-break results from an audit.
- Benavides & Co., P.C. v. Commissioner, TC Memo 2019-115.
- The increase in self-employment tax was attributable to the denial of deductions claimed by the related partnership.
- See Benavides at 39, 40.
- Notice of Deficiency was issued in 2014 on 2003, 2004, and 2005 timely filed returns. This is well past the general three year statute of limitations. Without a finding of fraud, the IRS would have been unable to render these assessments.
- Edmondson, Gray, “Moore: What is a Bona Fide Debt?”, August 29, 2019, https://esapllc.com/moore-debt2019/.
- Ronnie J. Smith v. Commissioner, TC Memo 2018-170.
- Morowitz v. U.S., 2019 WL 1077284 (D. Rhode Island 2019).