Have you ever wondered whether you were barking up the wrong tree? That the solution to a problem may be found, not in the approach to which you were already committed and invested, but in an altogether different direction?
Query whether Congress, if it ever experienced such an epiphany or moment of realization, would be capable of changing course and adopting what may prove to be a more fruitful, though politically more challenging, solution.
Tax the “Rich”
Over the last couple of days, several news services have reported that Mr. Biden’s soon-to-be-released budget will propose tax hikes for individuals making over $400,000 per year.[i] How many times has he asked Congress to go to that well? Imagine if our legislators had obliged him?
The Tax Foundation recently published a report[ii] in which it summarized data released by the IRS for the 2020 taxable year. According to the report, “the federal income tax system continues to be progressive as high-income taxpayers pay the highest average income tax rates.”
In support of this assertion, the Tax Foundation pointed to the following data from the IRS:
“The average income tax rate in 2020 was 13.6 percent. The top 1 percent of taxpayers paid a 25.99 percent average rate, more than eight times higher than the 3.1 percent average rate paid by the bottom half of taxpayers.
“The top 1 percent’s income share rose from 20.1 percent in 2019 to 22.2 percent in 2020 and its share of federal income taxes paid rose from 38.8 percent to 42.3 percent.
“The top 50 percent of all taxpayers paid 97.7 percent of all federal individual income taxes, while the bottom 50 percent paid the remaining 2.3 percent.”
The report went on to state that:
“In 2020, the bottom half of taxpayers earned 10.2 percent of total AGI and paid 2.3 percent of all federal individual income taxes. The top 1 percent earned 22.2 percent of total AGI and paid 42.3 percent of all federal income taxes.
“In all, the top 1 percent of taxpayers accounted for more income taxes paid than the bottom 90 percent combined. The top 1 percent of taxpayers paid $723 billion in income taxes while the bottom 90 percent paid $450 billion.”
The report explained that the IRS’s figures do not include “underreported or unreported income (most notably that of sole proprietors).”[iii]
Captain Obvious could not have said it better, and it needs to be said.
Closely Held
According to a recent Treasury report,[iv] about half of the so-called individual income tax gap accrues to income streams from proprietorships, partnerships, and S-corporations – closely held businesses – where there is either little or no information available to the IRS to verify the veracity of tax filings.
The report explains that taxpayers in the 80th through 95th income percentiles account for over 24 percent of unpaid taxes; the same is true of those in the 95th through 99th percentile. In other words, almost 50 percent of the individual gap.
“Cash is King?”
Then there is the so-called underground, or cash, economy, which remains a significant non-player in our tax system. Sure, this includes illicit trade, but it also encompasses many workers and self-employed individuals who work for cash.
Because the income generated by these activities goes unreported, it is not taxed.
By some “guesstimates” the underground economy may represent more than 10 percent of our gross domestic product, which was approximately $26 trillion for 2022. That’s a lot of unreported and untaxed income.
Foreign Source
Another class of unreported income on which Congress and the IRS have focused a lot of attention (and with some success) is foreign source income. This may include investment income as well as income from services rendered overseas.
To combat the opportunities for evasion that the foreign activities of a U.S. taxpayer may afford, the federal government has, over the years, implemented a number of legislative and regulatory programs that are premised on reporting by U.S. taxpayers and certain organizations.[v]
Although these measures have had a significant impact on the ability of individual taxpayers to evade their tax responsibilities to the IRS, there are still many taxpayers who enjoy the benefits of foreign source wealth on a tax-free basis. The U.S. Tax Court recently considered one such case.[vi]
Was it a Loan?
Taxpayer received income from his overseas family business (“FB”), a foreign construction company of which Taxpayer and his father were the sole, equal owners. Taxpayer also performed services for FB, such as project oversight and contractor selection.
During the years in issue, FB borrowed money from foreign banks to conduct its general operations. Taxpayer wired approximately $2 million from FB to himself in the U.S., ostensibly to pay his family’s living expenses. The ultimate decision to transfer the money did not require approval from anyone other than Taxpayer and his father.
Most of the deposits to Taxpayer’s account originated with FB. Taxpayer contended that these transfers were loans to him from FB, but he also testified that they were advances on future earnings “intended to fund his lifestyle.”
The IRS Didn’t Think So
Taxpayer timely filed income tax returns for the years in issue which reported modest tax liabilities. Notably, Taxpayer did not report as income the wire transfers received from overseas for those years.
Most of the income that Taxpayer reported was on Schedule C, Profit or Loss From Business. Taxpayer also claimed deductions for various Schedule C expenses. Taxpayer described his Schedule C business as “consulting.”
Bank Deposit Analysis
The IRS examined Taxpayer’s returns. During the examination, Taxpayer failed to produce books and records from which to determine their income and expenses, so the IRS computed Taxpayer’s income using a bank deposits analysis.[vii] Through the bank deposits analysis, the IRS uncovered unreported deposits, most of which were wire transfers from overseas.
The IRS issued a notice of deficiency for each of the years in question in which it asserted, on the basis of the deposits from overseas, that Taxpayer had total unreported income of approximately $2 million. In addition, the IRS disallowed all of Taxpayer’s Schedule C expense deductions on the basis of lack of substantiation.[viii]
Taxpayer timely petitioned the U.S. Tax Court for a redetermination of the notice of deficiency.
Taxpayer’s Burden
Taxpayer did not dispute the total amount of deposits but contended that most of them were nontaxable loans from FB. Taxpayer also argued that the IRS’s disallowance of expense deductions was erroneous.
Unfortunately for Taxpayer, he provided little documentary evidence to support his case, and none at all regarding the expenses reported on Schedules C.
The Court found that Taxpayer’s evidence regarding the wire transfers from overseas was unreliable and often conflicting. Taxpayer testified that he borrowed money from FB but he also testified that the transfers represented advances of income from FB. At times, Taxpayer referred to the advances as a salary; for example, he testified that “the incoming wires that I sent over to my personal bank account here in California . . . [were] to take care of the family. . . I took some of my salaries to help pay for my expenses here.” At other times, Taxpayer referred to the advances as part loan, part salary.
Taxpayer’s trial exhibits were no better – the Court described them as unreliable. Two exhibits purported to be loan agreements between Taxpayer and FB. Taxpayer signed the agreements both on his own behalf as the borrower and on behalf of FB as the lender. Neither agreement was dated.
The agreements were identical except for the loan amounts and effective dates. Both provided that the loans were due at the end of 2024. They required Taxpayer to pay interest at a fixed annual rate following receipt of an annual invoice from FB. Taxpayer testified that he made payments but did not provide any documents evidencing those payments.
The Court’s Opinion
The Court explained that the IRS’s determinations in a notice of deficiency are presumed correct, and taxpayers bear the burden of proving error.[ix]
Here, the Court continued, the IRS determined unreported income on the basis of bank deposits, which the Court stated is prima facie evidence of income.
The Court then explained that “gross income means all income from whatever source derived,” including compensation for services such as wages and salaries, gross income derived from business, and dividends, among others.
According to the Court, all taxpayers must maintain books and records sufficient to establish their income and expenses.[x] If they fail to do so, the IRS may reconstruct income through any reasonable method that clearly reflects income.[xi]
“We have long accepted the bank deposits method for this purpose,” the Court stated. “The bank deposits method assumes all deposits are taxable, but the Commissioner must account for any nontaxable source or deductible expense of which he has knowledge. Taxpayers bear the burden of proving a nontaxable source for deposits.”
Taxpayer argued that most of the deposits were not taxable because they were proceeds from a loan from FB to Taxpayer. Of course, a loan is not taxable income when received because the taxpayer has an obligation to repay it – the taxpayer has not experienced an accretion in value.
By comparison, the Court stated, “an advance for future services is taxable in the year it is received.”
Closely Held Business
Whether an advance is a bona fide loan is a question of fact that turns on whether the borrower and lender intended to make and enforce monetary repayment at the time the advance was made. To answer this question, the Court considered various objective factors that it explained were indicative of subjective intent. The Court added that special scrutiny is warranted where, as in the present case, a taxpayer sits on both sides of the advances.
The Court found no evidence that Taxpayer intended to repay the advances at the time they were made; thus, they were not loans. The loan agreements were “unenlightening” as to intent at the time the advances were made because they did not indicate when Taxpayer executed them.
Moreover, there was no meaningful oversight of FB’s decisions to make the advances. Taxpayer gave no collateral; and because he approved the purported loan to himself on behalf of FB, there were no real adverse interests between the lender and the borrower.
The Court found it “unlikely” that Taxpayer or his father would enforce monetary repayment if Taxpayer could not satisfy the obligation through his services or otherwise. Further, Taxpayer’s intent to satisfy the advances through future services or future income from FB disqualified them from being bona fide debt. Finally, other than Taxpayer’s testimony, which the Court did not find credible, there was no evidence that he made any repayments.
Thus, the Court concluded that the advances were not loans, and that Taxpayer failed to otherwise establish a nontaxable source for the unreported deposits.
The Court also concluded that Taxpayer failed to carry the burden of proving that he was entitled to the claimed deductions. That burden requires substantiation. Taxpayer did not produce records sufficient to establish the deductions.
Look to Your Own Experience
I’d like to say that Taxpayer’s activity was out of the ordinary but it wasn’t. In fact, transfers that purport to be loans to owners are frequently used to withdraw value from a closely held business, as are payments of an owner’s non-business expenses.
Recall how many clients or prospective clients you’ve met over the years who regularly engaged in transactions – whether directly with family members or with related companies, or which otherwise involved such persons – that obviously merited greater scrutiny.[xii]
I’m not talking about billionaires here but, still, most of these folks are business owners who, by almost any standard, are very well-off.
When confronted regarding the basis or support for the transaction in question, the response is almost invariably rooted in the “every business does it” defense.[xiii] Relatedly, the response may include something to the effect that the accountant for the business did not question the transaction or, worse, that, the idea for the transaction originated with the tax adviser.
Tax professionals have to be the first line of defense in eliminating the use of abusive, tax-motivated transactions by closely held businesses. If such practices continue or proliferate, the eventual remedy out of Congress may be much worse than paying what is owed now.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Impractical and political.
[ii] https://taxfoundation.org/publications/latest-federal-income-tax-data/.
[iii] I can’t tell you how many times tax return preparers have said to me that they avoid individual ownership of single member LLCs that are disregarded for tax purposes – basically, sole proprietors that file Sch. C with their Form 1040. They believe such business entities are much more likely to be examined than are other forms of business entity. Thus, they will often add an S corporation as a 1% member, with its sole shareholder being the 99% member.
In response, I ask them what they’re hiding.
[iv] https://home.treasury.gov/news/featured-stories/the-case-for-a-robust-attack-on-the-tax-gap.
[v] For example, FBAR, Form 3520, Form 8938, Form 8858, etc.; more recently, Schedules K-2 and K-3.
[vi] Nath v. Commissioner, T.C. Memo. 2023-22.
[vii] For more on the bank deposits method, see IRM 9.5.9.7. https://www.irs.gov/irm/part9/irm_09-005-009#idm139929133061424.
[viii] The IRS also determined that an IRC Sec. 6662 accuracy-related penalty applied for each year in issue for either a substantial understatement of income tax or negligence.
[ix] Tax Court Rule 142(a). The Court found that the record did not support shifting the burden back to the IRS. IRC Sec. 7491(a).
[x] IRC Sec. 6001; Reg. Sec. 1.6001-1(a).
[xi] IRC Sec. 446(b).
[xii] Have you ever asked what a particular withdrawal of funds from a business represented only to be asked, in turn, which characterization would generate the best tax result?
[xiii] For example, hiring family members for no-show jobs so they can participate in a business-sponsored retirement plan.