Money Law Blog

Tis the time for resolutions. As an attorney specializing in the financial woes of small businesses and the self-employed in DC, VA and MD and drawing from my 22 years of experience, here are three tips to consider as you draw up your list for 2012:

1) Keep books. It's that simple. So many of the financial problems of small business could be solved simply by keeping regular books, including:

• Cash flow problems. This is almost certainly the leading factor causing a bankruptcy filing. Often, the business will actually be profitable or have positive net value, but because the managers have not managed the finances to maintain liquidity, they cannot pay bills on a current basis. This, in turn, leads to the debt enforcement actions that force the business to seek bankruptcy court protection so that it can reorganize its finances. It might have been avoided if the managers kept regular books and knew where they stood in terms of cash, account receivables and payables.


• Tax problems. Without keeping books, business may rely solely on what is in the bank account as a gauge of how they're doing. Unfortunately, the balance in the account does not take into account non-cash accruals that have built up during the year, the most critical being taxes. At year end, they don't have cash enough to pay the tax bill.


• Getting loans or selling your business. Persons evaluating the business as purchasers or lenders will not give you financing or top dollar unless there are regular books showing the business' performance over time or its ability to service the debt. (By the way, as a business owner you need to look at your business as a asset for eventually sale and not merely as a job provide you solely with income.)

Also, keep separate bank accounts for your business and personal life. This is a corollary to the first rule. If you're keeping books for your business to track your business' performance, you will have to create a separate business bank account.

2) Watch how you pay the people who work for you. Again, this is near the top of the list of small business problems seen by our DC-based tax and bankruptcy law firm. Know how the tax law distinguishes "independent contractors" from "employees," and how that law requires the business owner to withhold taxes and contribute to Social Security and Medicate for the latter, or face personal fines -- basically equal to that amount -- for NOT doing so. It's not fun.

3) Get help from professional accountants and business lawyers. No one wants to pay for advice at the front end, but when the problems hit, the cost can be much, much more. It's a cliche, but true: An ounce of prevention is worth a pound of cure.

The evidence is coming in, and it makes absolutely perfect sense: The federal and state governments are ramping up tax examinations and collections to bring in more money.

Just this morning in our tax and bankruptcy law firm: Five new cases, not including the other tax cases on my desk. I sensed this was coming. It's a no-brainer for a policy-maker: Why raise taxes and antagonize the citizenry, when you can just enforce more aggressively what's already on the books?

The difference between what is collected on time and what is legally owed to the government is known as the "tax gap." IRS has examined the problem and published its a study.

IRS estimates that, for the 2001 year studied, the federal government was losing about 15 to 16.6 percent of the dollars owed to it. (Since most states mimic the federal tax scheme, the state loss in Maryland, Virginia and the District of Columbia would be comparable.)

As a dollar figure, it amounts to between $312 billion and $352 billion. Collecting that is not chump change and would have a significant impact on public financing. Hence the collection initiative.

According to the study, there are three components making up the "tax gap":
1) Failure to file tax returns.
2) Underreporting of actual income on tax returns.
3) Underpayment of the tax stated on the tax return.

Underreporting occurs when the taxpayer files a return but omits reporting some income and/or overstates or takes deductions or credits to which they are not entitled, whether purposely or out of ignorance.

Underpayment occurs when the tax return is filed reporting the correct tax amount, but the taxpayer does not, or cannot, make full payment when due.

Many of the tax problems we see in this office can be traced to incompetent or downright criminal tax preparers. However, when the taxpayer is caught by the IRS or state tax agents the tax preparer will be of interest to them, but the tax preparer's conduct generally is not a defense for the taxpayer to the tax liability.

My advice: Avoid a tax preparer without demonstrated licensing, education, and experience. Some questions to ask:

• What are your credentials? Generally, you can trust tax preparation by a CPA, tax attorney, or a preparer with a large, national company that has been in business for a long time.


• Of what tax organizations are you a member? Membership in an organization indicates they are serious about what they do, want to keep up with developments in the field, and are not afraid to be in the company of peers.


• What education do you have? Look for a bachelors degree in accounting, finance, or business administration.


• Do you have a license? Attorneys need to be licensed in the state in which they practice or offer services, and CPAs have to pass a rigorous exam. Unfortunately, generally you do not have to be licensed to offer tax preparation services. (Although the IRS is considering licensing.) At a minimum, ask to see a business license, which is required in most jurisdictions. This will indicate the preparer is not afraid to make himself or herself known to the local government and meet some basic qualifications.

What the most current tax scams we are seeing perpetrated by fly-by-night tax preparers:

• Taking TWO head of household deductions by having the couple do two tax returns claiming they live in separate residences. Often they use a relative's address.


• Qualifying for the earned income credit or taking more exemptions by claiming children who do NOT reside with the taxpayer.

It's up to you to be informed. Be careful and seek out competent counsel.

Undoubtedly, as tax day approaches, there are people right now who are struggling with the question: "I haven't filed in [fill in the blank]____ years. Should I file this year?" As a tax and bankruptcy lawyer serving individuals and businesses in Maryland, Virginia and DC, this law firm is very familiar with this taxpayer's quandary.

On the whole, it's better to file -- even if you can't pay -- for a number of reasons:

• IRS, and the state tax authority, make a distinction when it comes to charging you with civil tax infractions. There are a separate set of penalties added to your tax bill for "failure to file" and "failure to pay." Go ahead and file, at least. You'll save yourself some money in penalties.
• If you can't pay the tax bill all at once, you can always ask for an installment agreement to pay over time. For tax debts of $25,000 or less in combined tax, penalties, and interest, you are virtually guaranteed an installment plan and at a monthly payment you propose and can afford. Note that you will still be accruing interest and penalties so that the tax debt grows at about a 25% rate. You will need to make a large payment to actually pay down the tax bill. Don't end up like a lot of the taxpayers who come into our office and lament: "We've been paying IRS for several years now, and it's not going down!" Otherwise, at most, you are buying time.
• If you can't pay at all, you can always ask to be placed in "uncollectible status." However, if successful, that only forestalls the day of reckoning. Eventually, it's hoped, you will be earning more, and when that happens the taxman will see it from W-2s sent to the agency, and he will come a-knocking for what's owed.
• Three years from now, if you're still in a financial fix, you can completely discharge the tax debt in a bankruptcy. One of the key requirements to discharge a tax debt is that you must have filed a tax return for that tax year more than TWO years before the bankruptcy filing. The two-year rule for tax returns causes a serious problem for serial non-filers. We often see taxpayers who have not filed for many years who now want to resolve the back tax problem. We can help them to freeze the last three years of taxes from growing and pay them off in a Chapter 13 bankruptcy, but there is no discharge, unfortunately, for the other years. There are solutions, but it's much more complicated, expensive and uncertain.

There's a saying you've surely heard before, but it is very, very true: Nothing's as certain as death and taxes. If you have a social security number, IRS knows where you work, have bank accounts or maintain investments. Eventually, IRS will prepare a taxreturn for you, but with minimal, if any, deductions such that your tax bill will be much larger than if you prepared it yourself. Also, before IRS or the bankruptcy court considers tax relief in your case, you will have to get all the missing tax returns prepared and filed. So, why wait? Just get it done.

It feels like another kick in the teeth: You lose a home or rental property in a foreclosure or short sale, get a Form 1099-C from the mortgage company, and now you have to pay income taxes on it, too? Like a lot of things in the law, it depends.

It's a curious, but absolutely-settled principle of tax law, that a debt that is forgiven by a lender becomes taxable income to the borrower. Basically the accounting works like this: When you took out the loan it's not considered income because you have an obligation to pay it back. When, however, that obligation is removed, you become richer by the amount of debt that you will not have to pay, and the tax law says that must be recognized and you must pay income taxes on it.

Unfair, you may say, but it's the law. In late 2007, federal lawmakers decided to give SOME relief to taxpayers losing personal residences and changed the law so that the resulting income could be excluded from income tax, if the forgiveness (also known as "cancellation in indebtedness" and
"cancellation of debt" ("COD") income) meets key requirements:

1. The mortgage debt was for a principal residence (that is, the property was the taxpayer's "home" under the law) and,
2. The mortgage debt was the original loan used to purchase the home, or, if the loan was a refinance of the original loan, the proceeds from the refinance were used to make improvements to that property.

Note that the author of this blog emphasizes the term "some" because there is a lot of misinformation out there, probably propagated by commission-hungry, short-sale realtors, that there is a blanket exclusion from COD income for all primary residence mortgage debt forgiven in short sales (or foreclosures, which, for the tax law, are functionally the same).

Nope, doesn't work that way. If the loan was a refinance or second mortgage where part of the proceeds was used to pay off car loans, credit cards, take vacations, etc., those proceeds will NOT qualify for income tax exclusion under the tax law.

Your tax preparer will need to fill out Form 982 and see if the COD income reported to IRS on the Form 1099-C can be excluded under the exceptions available. Our DC-based tax and bankruptcy law firm has prepared an guide to the tax effects of foreclosures and short sales explaining the issue.

One of the most important exceptions is the "insolvency" exclusion. You can exclude the COD income from taxable income to the extent your net worth calculation shows you are insolvent.

If you use that exclusion, it's a good idea to keep the documents you use to calculate your net worth. Generally, the government has three years to audit your tax return. Values of assets and debt balances can change significantly in the interim and determining them years later will be impossible.

Remember, finally, that a discharge in bankruptcy avoids the tax issue entirely. So, if you're not sure the lender will forgive the debt after the foreclosure, or if you know the debt will be forgiven but are unsure or worry about the tax consequences, you may want to consider that option.

The Internal Revenue Service reported this week that IRS audits are up 11% for this year. Frankly, it's not real surprising.

It's during hard times that taxpayers feel the pinch and are more likely to cut corners and try to pay a little less into the public fisc. Likewise, as tax revenue goes down, the government will look for more income by increasing audits, publicizing that fact, and thereby scare more taxpayers into compliance.

This tax law firm expects to have more than the usual number of cases in the near future as more unlucky taxpayers get caught in the taxman's web.

Here are tips to avoid an audit, especially for the self-employed and business owners, who tend to be favorite enforcement targets for IRS:

1. Be scrupulously honest. Report all income, even when you don't get a 1099 or W-2. Deposit all cash, religiously, into the business account. Don't take cash, bypass depositing it into an account, and use it to pay expenses. If the agent sees a lot of this, it'll make the case easier for unreported income. Remember: The burden of proof is on the taxpayer. Ignorance and sloppiness are not an adequate defense. Regarding deductions, don't try to reach. Always ask yourself: Is this a defensible position? Am I clearly entitled to the deduction? Here's an expression one hears often: "Pigs get fat, hogs get slaughtered." I'm told it was first uttered by a judge -- in a tax case.
2. Speaking of deductions, beware of "constructive dividends." This is a favorite of the IRS. Small business owners often use the corporate account to pay for personal goods or services, such a car used for the personal errands of the owner, non-business meals, vacations, home improvements, and so on. IRS and the state tax agents know it, and look for it. If it's personal, report it in your personal income tax return or reimburse the company and make sure to give it only the correct tax treatment as compensation, or dividend, in consultation with your accountant. This is often one of the charges in a tax criminal case.
3. Use a reputable tax preparer. Tax is very complicated. Furthermore, the law changes every year. The person preparing your return should have credentials (education and experience). Mistakes, including math errors, in one part of the tax return increase the odds that the whole return will be audited. Don't pick someone because they promise to get you the biggest refund or the lowest tax bill. That's a red flag signaling a fraudster. You don't want to be questioned by the IRS when they investigate this scammer's entire client list.
4. Keep good records. Of course this is something you should have done throughout the year, but you can still heed this advice for the coming year. Keep your receipts, especially for expenses you deduct. You will be asked for them on audit. Remember: To deduct actual mileage you must keep a "contemporaneous" log, i.e. at the time of the trip, not a reconstruction weeks afterward. Likewise, you want to have invoices for an payments you make. (Otherwise, on audit, how do you prove the deduction you took for office supplies wasn't just money you pocketed? Bring the paid bills from Staples.) Meticulously deposit all your income into an account and pay your bills out of that account or designated credit cards. If you're self-employed, or have a side-line business in addition to your employment, DO NOT commingle income and expenses of your business with your personal. Keep and use separate accounts, ATM cards, and credit cards for your personal transactions and your business transactions. One of the biggest problems we face as tax practitioners working with small businesses is the lack of good record-keeping. Just keeping "books" makes such a difference for business planning and profits, as well as defending an IRS audit
5. Keep regular books if you have a business. It's good business practice, too, to keep books during the year. Many of our clients get into tax trouble because they didn't pay estimated taxes during the year and so don't have the cash (or available credit) to pay when they file the tax return for the year. Had they paid estimated taxes during the year, this would have been avoided. From a business point of view, they would also had a better idea of profitability had they taken into account tax "accrual" expenses building up during the year. So many contractors under-bid because they don't take taxes into account, and end up subsidizing the buyer with the tax liability they will later face!

Good luck, but if you end up getting snagged, for individuals or businesses with tax problems in Maryland, Virginia and DC, we're happy to talk to you about ways you can minimize or eliminate tax problems and get back on track.

Except for the occasional expletive, this poor man's tale of woe sounds just like the ones I hear all the time from unlucky tax debtors who'd been burned by the mill at J.K. Harris. Below is his text.

"If you're thinking about using J.K. Harris, my personal opinion (based on experience with them) is run like hell. Go find a local attorney that specializes in tax and can't hide behind call centers. They took $7500 and would not refund my money even though they had performed very poorly, dragging my case out over a year and ultimately I had to hire another attorney to keep the IRS from exercising their wrath on me. The JK Harris CPA contact that told me he'd be right there with me the whole way did NOT return phone calls. Their boiler room customer service was a nightmare to deal with. Don't believe me? Look up all the State DA lawsuits against them. Their valuation of my business was a joke and cost me a couple of thousand."

He pretty much says it all, so I won't embellish except to add:

• He most likely did NOT meet with a CPA. People report to me the first contact is a salesman, probably commission-based, and likely to tell you anything to make a sale.
• Yes, he's probably right about the matter being handed off to hourly people, and yes, I expect there is high turnover. Given the nature of the operation, anyone with a conscience probably would not last long.
• Even if they are enrolled agents, which is suspect, they certainly are not attorneys and cannot offer what could be better options to resolve the matter in court.

Our law firm offers a range of options for tax debtors in DC, Virginia and Maryland facing back tax problems with the IRS or state tax agency.

Hardship withdrawals from retirement plans, such as 401K plans, nationwide have reached a ten-year high, according to a report issued last week by Fidelity Investments which administers about 17,000 plans across the country covering some 11 million participants.

In the second quarter of this year, about 62,000 workers asked for withdrawals from retirement plans to pay medical expenses, costs to purchase or repair a primary home, tuition and education expenses, burial or funeral expenses, or to prevent an eviction or foreclosure on a primary home.

Even worse, besides withdrawals, more and more people are taking loans from retirement plans. A two percent increase in the second quarter now means that 22 percent - almost a quarter of all participants -- have outstanding loans against their accounts.

It's a risky and sometimes financially-disastrous game for consumers. Too often, in my fifteen years of bankruptcy practice in the Washington-DC area, I have seen people needlessly lose their retirement, and worse, dig themselves into a deeper hole.

There are several typical scenarios:

• To stop collectors from hounding him, the debtor takes a lump sum withdrawal to pay off his bills. Unfortunately, many do not subtract withholding taxes from the withdrawal. When the end of the year comes, the debtor does not have the cash to pay the income tax plus the additional 10-percent penalty. The debtor has now turned his debt problem into a more serious tax problem.
• The debtor takes a loan to pay off debts or make payments on debts, and then as his income situation deteriorates, he defaults on the 401K loan payments. At the end of the year, a "distribution" (equivalent to a withdrawal) is declared. The full tax and 10-percent penalty on the loan is now due.
• To stop a foreclosure or mollify creditors, the debtor takes out a loan or withdrawal to make the minimum payments on installment loans or pay the mortgage. The saddest cases are person who drain retirement funds, which are generally protected in bankruptcy, to make minimum payments on debts that never go away, or the house goes into foreclosure anyway when the money runs out. In most cases the debt could have been discharged in bankruptcy from the very beginning and he still would have kept the tens and hundreds of thousand he had saved for retirement. The debtor "ate his seed corn" for nothing!

Continue reading "Hardship 401(k) Withdrawals: Be Careful. You May Be Digging a Deeper Hole!" »

As the economy falters, local governments also are feeling the pinch since tax revenues decline. Virginia and Maryland had two-month tax amnesty windows last year. Now it's the District of Columbia's turn.

Running August 2 to September 30, 2010, under the temporary tax amnesty taxpayers who owe taxes to DC will be able to pay without penalties. No questions asked.

The savings can be substantial, especially if no return was ever filed, since there are "failure to file" penalties, as well as "failure to pay" penalties. With interest and penalties, the effective growth rate of a tax debt can be approximately 25 percent a year!

DC's new tax amnesty initiative indicates there will be no criminal tax prosecution. But, if under the facts of your situation, there is any possibility the government could make a case for PURPOSEFUL tax evasion, you may want to consult counsel before coming forward. Interest will not be waived, and usually cannot be under the law.

The types of taxes qualifying for the amnesty are:

• Income
• Gross receipts (a business tax)
• Estate
• Tobacco
• Toll communications

Real property tax does not qualify.

The website has a handy interest calculator to add up your the total you owe once you've figured your tax.

Note that the information will be shared with the federal government, so expect a bill from IRS that you will have to deal with.

Continue reading "DC Tax Amnesty: If You Can, Take It Now!" »