BIG PRICE FOR BAD RECORDS

Making a lot of money is no excuse for keeping bad records.  And failing to give adequate documentation to your CPA takes away your ability to avoid the negligence penalty.

That’s what Joseph A. Deihl found when the court ruled that he had to shell out about $5 million in taxes and over $1 million in penalties.  On top of this $6 million, Deihl paid fees to his lawyers, who participated in rendering well over a thousand pages in stipulated exhibits placed before the court.  In addition, Deihl had to pay penalties for underpayment of taxes and interest on the $5 million in taxes.

The penalties and interest relate to the period of underpayment.  Deihl’s case covered 1996, 1997, and 1998, but the court did not make its ruling until December 2005.  Thus, Deihl’s penalties and interest problems started in 1996.  That’s a long time ago—long enough to make for a good chunk of penalties and interest.  By the way, the penalties are not deductible, and IRS regulations classify interest paid on business tax deficiencies as personal nondeductible interest.

You will find this case instructive in a variety of ways.  First, many of the issues involve what you do for your business from the time you get up in the morning until you go to bed at night.  Second, this case shows the financial cost that you bear when you

• Lack basic tax knowledge;
• Hope your accountant takes care of your taxes; and
• Ignore the recordkeeping requirements.

Deihl and his wife owned 100% of KareMor, an S corporation that sold VitaMist using a nine-tier marketing program.  The Deihls also owned 100% of Mayor, Inc., an S corporation that manufactured VitaMist.  The parties agreed on one trial that consolidated the corporations and Deihl’s issues.

How the Rolex Watch Deductions Were Lost

At one KareMor convention, Mr. Deihl gave a distributor a $13,400 Rolex watch in recognition of his outstanding performance.  Two such Rolex watches were purchased before the convention, one in May and one in September.  The court could not determine what happened to the watch purchased in May and said that it would have granted a deduction for the watch purchased in September, but the documentation trail failed to show that the watch was counted as compensation to the distributor.  Thus, the court granted zero deductions for the two Rolex watches.

How the Boss Day Planner Deductions Were Lost

In one of the years under review by the court, KareMor, an accrual-basis S corporation, deducted $113,544 as the cost of giving each new distributor a Boss Day Planner.  The court noted that to claim a deduction for an accrued expense,

• The existence of a liability must be fixed;
• The amount of the liability must be determined with reasonable accuracy; and
• The performance for which the liability is owed must have occurred.

The court further noted that in the case of a breach of contract, the performance rule for deduction is changed, and performance is deemed to occur only when the bill is paid.

In most cases, the deduction for an accrued expense is a straight-forward exercise.  Not so here.  KareMor had a dispute with the Boss folks.  The court noted that it did not have the dispute information it needed to determine

• if the three elements for accrual were satisfied, or
• if there was a breach of contract.

Based on this lack of information, the court allowed no deduction for the planners.

How the Clothing Deductions Were Lost

The Deihls were big on image.  When distributors came for meetings, the Deihls went all out to appear affluent.  Dress was part of this image.  According to Mr. Deihl, the Deihl women were instructed to

• shop at high-end clothing stores and buy high-end clothing;
• wear that high-end clothing only one time to one corporate event; and
• give the once-worn clothing to charity or other third parties.

The Deihls also had standards for their men, but the men were allowed to wear the same high-end tuxedos to more than one event.

The court granted zero deductions for the clothing because there were no written or other formal standards for this supposed wear-once policy and no systems in place to ensure that only wear-once items were purchased.  Further, the court noted that these standards by themselves might not have been enough, as the court has consistently disallowed deductions for clothing suitable for ordinary street wear, noting that the Deihl’s formal wear in most cases was suitable for other dress-up social events.  (The court did note that a few of the ladies’ gowns might have qualified as costumes.)

How the Travel Deductions Were Lost

Mr. Deihl testified that he sent his marketing people and lawyers on business trips to Brazil, Ireland, and Iceland.  He stated that he also took a trip to Ireland at the invitation of the Irish government.

The court had an easy time disallowing the travel because neither the Deihls nor the corporations could produce the documentation required by section 274 as to business purpose or any receipts for the expenses.  When you fail the travel documentation tests, the law makes it clear that you get no deductions, no matter how good you sound in court.

How the Computer Deductions Were Lost

Mrs. Deihl supposedly bought corporate computers that she charged to a corporate credit card and that accounting classified as electronics/appliances.  She did not give the accounting department a receipt for the computers, and when questioned under oath she had trouble recalling what she had bought.

The court ruled that the computers were personal to the Deihls and not corporate property because

• no receipts existed to back up the purchases of listed property (e.g., the computers) as required by law;
• no records existed to prove that the computers were located on the corporate premises (which would have exempted the computers from the listed property category); and
• if the computers were listed property because they were located at the home, there was no log of business use as required by the law.

How the Deihls Remained Liable for the $1 Million in Negligence Penalties

The Deihls claimed that they employed a lawyer/CPA to maintain the books and records of their corporations and help them with their taxes; therefore, they should not be liable for negligence penalties.  The court ruled that the Deihls were liable for the $1 million in negligence penalties because they

• did not provide the lawyer/CPA with receipts and invoices for purchases;
• did not document their business travel;
• probably limited their instructions to their advisors to blanket statements like “All charges to that credit card are business” (as they attempted to do with this court); and
• showed a general lack of respect and care in the maintenance of their business and tax records.

Summary

This case goes on and on.  The court took over 30 pages to summarize and issue its finding.  It’s a fair guess that this is not the end of the Deihls’ tax problems.

You have to wonder what made the Deihls disregard the tax law and get themselves into this type of fix.  The little time it takes to get receipts and document business purposes could have saved them $1 million in negligence penalties.

Who knows?  With documentation, the Deihls might have convinced the court to allow a clothing deduction for the wear-once gowns.  The court gave a hint in this direction, albeit only a hint.

Don’t end up like the Deihls.  Here are some tactics to follow:

• Issue 1099s for prizes and awards you give to your people (like the Rolex watch in this case).
• Create a trail that shows what happens to the purchases (avoid a failed trail like the Rolex watch purchase in May that disappeared from the records).
• When a dispute or lawsuit puts a payment or collection in doubt, make sure you know the rules and claim the deduction or report the income in the correct year.
• Document the business purpose of all business travel.
• Obtain receipts for all business travel expenses of $75 or more.  (You really should try to keep them all.  You lose nothing by keeping receipts for travel expenses that are less than $75.)
• When purchasing with a personal or business credit card, always keep the receipt to back up the purchase.  (The receipt shows what you bought.  For example, the restaurant receipt shows two steaks, one dessert, etc.)
• Document the business-office location of computers, VCRs, televisions, and printers to prove that such property is not located in your home and is, therefore, not listed property (or if it is located in your home and classified as listed property, keep the required log of use).

Information provided by Tax Reduction Letter, April 2006, Volume 15, Number 4