Blame It on the Software…

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A recent Tax Court decision, illustrates, once again, the folly in filing inaccurate income tax returns and taking deductions that are unsubstantiated!

The taxpayer, Barry Bulakites, is an insurance consultant in California. Though he worked for a firm whose clients are mostly accountants, Bulakites relied only on TurboTax when he prepared his own returns.  After examining his returns, the IRS questioned the number of unsupported tax deductions that he had claimed in 2011 and 2012. Bulakites contended that he had sufficient evidence to prove some of the deductions, but blamed others on the software he used.

The taxpayer had a rough couple of years leading up to the years at issue, and some of the events came into play in the case.

Several years prior, Bulakites was involved in a lawsuit that arose when 401(k) plan participants at Wasley Products sued the company where Bulakites worked at the time. He was named as a defendant for his work on the plan, and in 2007, he was required to pay $500,000 as part of a global settlement. To pay the settlement, the taxpayer took out a loan that was secured by his home. The promissory note was due in less than a year, but Bulakites planned to sell his home and use the proceeds to pay the note when it came due in October 2008. However, the Great Recession affected his ability to sell his house for a profit, and Bulakites could only pay back part of the amount.

In 2009, Bulakites and his ex-wife legally separated and were divorced a year later. As part of their separation agreement, Bulakites was to pay his ex-wife $2,000 per month for spousal support until the sale of the marital residence, at which point his payments would increase to $8,000.Since he had previously been unsuccessful in his attempts to sell the house, Bulakites claimed at trial that there was no hope of a sale. Though no formal agreement was signed, he agreed to increase payments to his ex-wife to $5,000 per month. In 2011 and 2012, the taxpayer paid her approximately $50,000 per year.

By trial in the Tax Court, the remaining issues included:

  • Whether Bulakites is entitled to deduct the payments that he sent his wife in the 2011 and 2012 tax years;
  • Whether he is entitled to deduct business-interest expenses for the 2011 and 2012 tax years;
  • Whether he is entitled to deduct other business expenses for the 2011 tax year; and
  • Whether he is liable for the accuracy-related penalty under section 6662(a)2 for the years at issue

With respect to the first matter, the court looked to Section 215(a) of the Internal Revenue Code, which allows as a deduction an amount equal to alimony paid. Section 71(b) defines alimony, and part of the definition requires that the payment be required by a “divorce or separation instrument,” which is defined legally in specific terms.

Even though Bulakites was able to prove that he paid his ex-wife well over the $2,000 amount required by his separation agreement, the court found that Bulakites’ oral modification of his written separation agreement did not meet the requirements of Section 71.  Thus, the deduction for all additional amounts was disallowed.

With respect to the business interest deductions for 2011 and 2012, the court found that the evidence did show that Bulakites made payments to his lender; however, the amounts did not match those that he claimed on his tax returns, and he did not explain this discrepancy at trial. Bulakites also did not provide the court with any business records regarding the loan, any loan statements, or any loan-repayment schedules. Without this type of documentation the court was unable to tell whether these payments were made on the original 2007 loan. As such, the court found that the taxpayer’s testimony was not credible and sustained the disallowance by the Internal Revenue Service.

The third issue related to other business expenses, supposedly incurred by the taxpayer in an earlier year and brought forward into 2011 as a “deduction for other expenses.” At trial Bulakites testified that this amount was actually a net operating loss carryover from an earlier tax year that he mistakenly put on the wrong line of his return. However, he failed to contest the issue on brief, which the court would normally be deemed by the court to be concession.

Interestingly, the court addressed the matter anyway. The court noted that, under Treasury regulations, a taxpayer substantiates his claim to such a deduction by filing with his return “a concise statement setting forth the amount of the net operating loss deduction claimed and all material and pertinent facts relative thereto, including a detailed schedule showing the computation of the net operating loss deduction.”

During trial, Bulakites submitted a tax return for a previous year, though not the one that generated the net operating loss. Even with his testimony, it is not enough to substantiate his entitlement to a loss carryforward.  Because he did not provide the appropriate substantiation, the disallowance of the loss carry forward was confirmed.

Lastly, the Internal Revenue Service assessed an “accuracy related” penalty for both 2011 and 2012, which can be imposed for “any substantial understatement of income tax.” It then falls to the taxpayer to demonstrate that the mistakes were reasonable and made in good faith.  The court found that Bulakites was unable to overcome that burden of proof.

Bulakites admitted at trial that he did deduct items that he should not have deducted, and that he overstated certain losses. However, his primary defense was that his mistakes were caused by the tax software that he used to process his return.  The court responded  by citing an earlier case that noted, “[t]ax preparation is only as good as the information one puts into it,” and let the penalty stand.

This is a classic case of overreach by a taxpayer with insufficient documentation to support deductions taken on his return. The sure way to lose credibility upon examination is to fail to create and maintain quality records describing the essence of the deductions and including detail explaining the numeric amounts.

Taxpayers can overcome some lack of support by making use of the “Cohan rule” (named for an early case involving George M. Cohan; Give My Regards to Broadway). This rule requires the Internal Revenue Service to allow taxpayers to deduct some of their business-related expenses even if the receipts are not available so long as the amounts deducted are “reasonable and credible.”  However, the reach of this rule is always unknown when applied to a particular fact situation, and the most reliable route is to always maintain quality and contemporaneous recordkeeping.

Questions and comments can be directed to Bob Grossman or Don Johnston at 412-338-9300.