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(This is the first in a series of discussions on tax-related issues entitled Taxtalk. All of the articles in the series can be found at http://lifeinnumbers.net/category/series/taxtalk/)

A recent settlement between the IRS and tax-resolution firms should better protect taxpayers from companies trying to take advantage of their desperate situations. Tax resolution firms, such as J.K. Harris & Co., advertise heavily on television, touting the ability to drastically reduce tax bills for those individuals who owe substantial sums to the government. These firms claim they will help their customers navigate the IRS’ “offer in compromise” program, intended to allow taxpayers to settle their tax debt for what they can actually afford. But for many taxpayers, these tax-resolution firms resolve nothing, usually adding to the taxpayer’s problems instead.

According to complaints reported by The Wall Street Journal, many people who sought help from the likes of J.K. Harris & Co. and Roni Lynn Deutch paid fees to these companies and received nothing in return. One former Harris customer, Susan Brennan, paid $4,550 in up-front fees, only to have the firm omit important information she had provided to them. When informed of the mistakes, J.K. Harris requested additional money. When she refused to pay, Harris refused to provide further assistance. Ms. Brennan then sought help from a local accountant, who was able to resolve her problems for substantially less than what J.K. Harris charged her. This is just one of the examples cited in by the Journal, but others interviewed reported similar experiences.

At the heart of their settlement with the IRS are the advertising practices of tax-resolution firms. Complainants accused the firms of misrepresenting their services and overstating their abilities to lower tax bills. Based on the exaggerated claims made in their advertisements, many taxpayers paid several thousand dollars in fees with the understanding that their tax bills would be drastically reduced or eliminated. For these individuals, the fees paid were not inconsequential, as these people are already in troubled financial positions. Tax-resolution firms are able to deceive individuals into paying such exorbitant fees for their services because they prey on taxpayers’ desperation and ignorance.

For a taxpayer who finds him- or herself in a situation where the services of a tax-resolution firm are appealing, the options are limited. One of the best options may be the “offer in compromise” program, which is precisely what tax-resolution firms offer their clients. Unfortunately, these firms advertise much higher success rates than their clients can expect. In 2004, the IRS accepted 20,000 of the 106,000 offers made. In 2007, acceptance fell to 12,000 out of 46,000. As part of their settlement with the IRS, tax-resolution firms must comply with advertising restrictions and better represent their success in negotiating with the government.

Sources:

• “IRS Tightens Rules, as Firm That Acts as Middleman Settles Cases With 18 States,” The Wall Street Journal Tax Report, July 23, 2008.

Every so often, the IRS announces a new reporting program intended to increase tax-law compliance. Each of these efforts is designed to reduce the tax gap, or the difference between what the IRS estimates it should collect in tax revenue and what it actually does. Much of the gap is made up of income tax on income the IRS receives no report of, namely self-employment income. For most Americans, the tax gap is a foreign concept, since our employers report our annual earnings to the IRS on form W-2. But for many self-employed individuals, their annual tax return is the only report of their income to the federal government. Clearly, this is an area open to abuse, so the government periodically cooks up a new scheme to prevent millions of Americans from understating their income. The IRS’ latest focus: eBay and its payment processors.

(eBay, while not the only online marketplace, is by far the largest. For purposes of this discussion, I will focus on eBay and its payment processor PayPal, though the regulations apply to all online payment processors.)

Beginning in 2011, processors of online payments (such as PayPal) will be required to report to the IRS the total payments they handle for any individual or business receiving in excess of $10,000 or engaging in more than 200 transactions. This information will be reported on form 1099, the government’s catch-all income reporting form. Other than interest and dividend income, form 1099 is also used to report self-employment earnings for unincorporated entities. For some eBay sellers, this change will require some careful consideration and planning.

For those eBay sellers who use the site a handful of times per year, nothing will likely change. But for casual eBay merchants, the requirement will force them to focus more closely on how many items they list and how much profit they make. This is because the vast majority of eBay sellers do not report their eBay proceeds as income. In many cases, there is no need to. Much of what is sold on eBay is used, so as long as the final selling price is less than the original purchase price, there is nothing to report on one’s individual tax return. But if the seller occasionally turns a profit, he or she may need to radically change his or her eBay usage to avoid IRS scrutiny. At issue is whether the eBay seller is using the site as a hobby or to conduct business.

If an eBay seller uses the site for the primary purpose of holding an online tag sale, the IRS is unlikely to complain. In the government’s eyes, if one would sell items on the site regardless of whether or not he or she makes a profit, the activity is considered a hobby, and the new regulations do not apply. Similarly, if the seller can demonstrate that he or she hasn’t turned a profit in at least three of the last five years, the IRS would likely deem the activity a hobby. If neither of these conditions applies, however, the seller could be in for a rude awakening. The IRS could determine that the use of eBay constitutes a trade or business subject to self-employment tax. Failure to report the income on Schedule C and pay the appropriate taxes could result in back-tax bills for the unreported income, as well as accuracy and other penalties plus interest. To avoid these problems, eBay sellers need to plan ahead. Those users who think they may approach the thresholds set by the IRS should consider meeting with a tax professional who can advise them on whether or not their eBay usage has the characteristics of a business or hobby. As the IRS has provided nearly three years for payment processors to prepare, the government is likely to aggressively go after those individuals it feels have been underreporting their income.

So what is behind this new reporting requirement? Only about $9.5 billion in tax revenue over 10 years, by government estimates.

Source: “Tax Report: Online Sellers Face New IRS Rules,” The Wall Street Journal, July 30, 2008.

A recent Tax Court ruling highlights the importance of errors and omissions insurance for accounting professionals. At issue is the valuation of stock that the taxpayer donated to charity.

The taxpayer owned stock in a variety of medical service corporations and was in the process of consolidating the corporations into a single entity. During this process, the taxpayer donated stock to charity and took a deduction which valued the stock at $401 per share. The Internal Revenue Service challenged the accountant’s valuation because it treated the entities as going concerns, even though they were being consolidated into the single corporation. The Tax Court agreed with the IRS and revalued the donated stock to $37 per share. In addition, the Tax Court imposed accuracy-related penalties on the taxpayer. Undoubtedly, the taxpayer is now looking to his valuation expert for relief.

It is for these situations that accountants have errors and omissions insurance. Even the most minor of mistakes can cause substantial problems for clients, and without such coverage, a firm would certainly not survive the first claim against it.

Source: Bradley Bergquist, 131 TC No. 2 (Tax Ct.).

In the coming days, look for the first post in an occasional series called “Taxtalk.” The series will look at a variety of issues related to taxes, but will not provide advice for preparing tax filings. Instead, Taxtalk will be a sort of insider’s account of what it’s like to be a “tax professional.” The first post in the series, “Praying on Desperation,” deals with the recent settlement between the Internal Revenue Service and so-called tax-resolution firms.

To comply with Internal Revenue Service regulations as codified in Circular 230, the following disclaimer is made:

Pursuant to U.S. Treasury Department Regulations, I (we) must inform you that any tax advice contained in this communication, including any attachments and enclosures, is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding tax-related penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Last month, I wrote a piece about how the Financial Accounting Standards Board (FASB) contributed to the current economic malaise. In “How FASB Caused the Credit Crisis,” I looked at how rules regarding fair value accounting forced companies to write down billions in subprime mortgage debt. Yesterday in his report, Lehman Brothers analyst Bruce Harting implicated FASB as further contributing to the problems that have prevented many Americans from obtaining mortgages. As reported by CNN Money, Mr. Harting cited a proposed rule change that would require Fannie Mae and Freddie Mac, which guarantee half of all US mortages, to move off-balance-sheet securities onto their balance sheets. Harting’s report indicates that doing so would require Fannie and Freddie to raise $46 billion and $29 billion in new capital, respectively, to support their balance sheets. Such a move comes at a time when neither government-backed lender can raise adequate capital to support its current operations, let alone the additional capital needed to support the proposed rule change. Just last week, The Wall Street Journal reported that Freddie Mac, which announced plans in May to raise $5.5 billion by issuing new shares, would likely not complete the rights issue until after it releases second-quarter earnings in August. Fannie Mae, in similar straights, raised $7.4 billion in April and May; it seems unlikely that Fannie could return to the market in the near term to raise additional capital, as the FASB rule change would necessitate.

Mr. Harting’s report, for all its doom and gloom, does indicate that the rule change is unlikely. He doesn’t foresee FASB acting so recklessly given current economic conditions. Fortunately for Fannie and Freddie, analysts seem to be in agreement that the likelihood these changes would be implemented is small. Nonetheless, FASB risks damaging its credibility and relevance with such a move. Congress would likely step in to prevent the change from effecting Fannie and Freddie, and could go so far as to strip FASB of its ability to function as an independent accounting regulatory body. We have already seen this with the Public Company Accounting Oversight Board, or PCAOB, which the Sarbanes-Oxley Act created following the Enron/Arthur Anderson scandal.

Sources:

• “Fannie Mae and Freddie Mac plunge,” CNNMoney.com, July 7, 2008.
• “Heard on the Street: A Delay-of-Pain Penalty,” The Wall Street Journal, July 3, 2008.
• “Mortgage Giants Take Beating On Fears Over Loan Defaults,” The Wall Street Journal, July 8, 2008.

This week, I start the process of becoming a CPA. So begins what will likely be a yearlong process of studying and taking exams while maintaining some semblance of a normal life. I’m excited, really, but the procrastinator in me is looking for ways to screw this up. Look for future posts on the process and my experience with it, along with any tips I might come across during my studies. For those future CPAs in the audience, I’ll try to pass on anything I find useful for the process. I’d also welcome your input, in comment form, on your experiences with the exam.

I’ve opted for the self-study route, hoping to use my excessive downtime at work to further my study. So far, I’ve procrastinated on that one. But I’m hopeful…

Stay tuned…

The Wall Street Journal today reported that PricewaterhouseCoopers has won the right to appeal its tax-fraud case related to now-bankrupt Russian oil giant OAO Yukos. Russia’s Federal Arbitration Court for the Moscow District ruled the auditor can appeal a tax-evasion ruling against it. PwC is accused of actively helping Yukos evade Russian corporate taxes between 2002 and 2004, actions which the country’s top prosecutors allege led directly to the back-tax claims that forced Yukos into bankruptcy and eventual nationalization. This is good news for PwC, which could have lost its auditing license were the charges upheld. Already, the audit giant was forced to withdraw its opinions on Yukos’ financial statements under official pressure and threat of back-tax charges of its own. PwC has announced that as part of the court’s decision, it will appeal the back-tax charge as well.

This ruling is good news for the accounting industry as a whole, which this decade alone has seen a spate of tax fraud and evasion charges, an options backdating scandal, the collapse of a “Big Five” firm, and the introduction of sweeping legislation reforming public company financial reporting.

Source: “PWC Wins Right to Appeal Ruling on Russian Tax Case,” Wall Street Journal, June 24, 2008

As I discussed at DisparateNews.com, Congress passed and the President signed legislation to close a loophole that allowed private contractors working in Iraq to avoid paying employment taxes for its employees. You can find the full post, “Congress Closes Loophole Allowing Private Security Contractors to Avoid Paying Employment Taxes,” at http://disparatenews.com.

While my firm does provide tax services, the majority of our work falls under the audit and attestation side of accounting. Audit and attestation covers just about anything involving financial statement preparation, the focus of my firm. For many of our clients, we perform the most basic level of service—the compilation. This involves the least amount of work, really nothing more than taking the client’s data and putting it into the form of financial statements. For others, particularly those with bank debt, a review is required. Reviews, the middle of three levels of service, involve inquiring of the client and some third parties, and then presenting their financial information in the form of financial statements. Still, not all that complicated. The third level is audit, the beast of all accounting engagements. Here, we basically check every number on the financial statements against either independent, third-party-provided information or apply a battery of analysis and management inquiry to establish whether or not management is being fair in its presentation of financial data. As one could imagine, the level of detail involved in planning any of these engagements is relative to its level of service, with compilation at the low end and audit at the other. That notwithstanding, the planning for these services is fairly broad. We establish basic goals for our procedures, but we do not detail each step that we will apply in, for example, auditing the client’s cash. Among other reasons, the vagueness allows us to adapt our procedures based on our findings. If, for example, we found a problem with cash, we could apply additional procedures. Conversely, if we are comfortable with the client’s abilities to record investments properly, we may apply fewer procedures to this area. Essentially, the auditor is required to use his or her professional judgement in determining the extent and timing of the engagement. Recently, though, I was introduced to a new type of service which falls outside of this neat little hierarchy I’ve just described.

Not too long ago, my firm was engaged to perform agreed-upon procedures on our client’s rental activities. Prior to this, I had encountered only one other engagment of this type. I quickly learned that performing this engagement will be unlike anything else I have encountered in my short tenure (To make matters worse, this is the first engagment where I’ve been put in charge, but that’s a whole different story). As the name implies, an agreed-upon procedures engagement involves my firm performing procedures specified by the client and reporting our findings. Whereas normally we control the methods of executing an engagement, here the client is in control. Every single aspect of the engagement, from the number of personnel files to review to the number of accounts payable invoices to vouch, is specified by the client. Even our response to problems uncovered during our engagement is different. Normally, we would inform the client of the problems and then modify our procedures accordingly to provide the required level of assurance. In an agreed-upon procedures situation, the problems are brought to the attention of management, who must then tell us how we should respond. For someone involved in a number of audits over the past year, this is a strange situation to be in. Normally, we control the process because we need to be sure we can support our opinion on the financial statements. In this case, we aren’t issuing an opinion, so satisfaction falls to the client. If the client decides not to investigate the problem further, then we must do just that. If questions are raised later, liability for the misstatement, misapropriation, or other problem lies with management. This is, I suppose, one upside to this engagement. All in all, I’d rather just perform the audit or review. Generally, it is easier and can be more cost effective. Because we must plan every exacting detail beforehand, agreed-upon procedures can run into the thousands of dollars just in the planning stage. Besides, I like to be in control.

Check out this article in today’s Wall Street Journal describing recent graduates’ tactics for extending their health insurance after graduation. For those out their not fortunate enough to have insurance through their employers, there may be some useful tips here. Health insurance is sure to be a major issue facing our generation as we graduate and enter the workforce. With the problem already facing many millions of Americans, a solution is needed soon as many more enter the ranks of the uninsured.

The article, entitled “Graduates Get Creative to Find Health Coverage” was written by Mary Pilon and appeared in the June 17, 2008 issue of The Wall Street Journal.