Tax Court Results

A recent Bankruptcy Court decision emphasizes the need for compliance with all IRA rules to avoid nasty surprises.

In In re: Willis (Bankruptcy Court FL 2009), Mr. Willis lost his IRA protection from creditors because he engaged in a “prohibited transaction” with his IRA. Specifically, Mr. Willis took a loan from his IRA and used it for personal reasons. This act was a prohibited transaction and by doing so he was unable to protect his IRA assets from creditors, which would have been the case had he not engaged in a prohibited transaction. This case again demonstrates the need for all taxpayers with self-directed IRAs to make sure they understand the tax laws before engaging in any IRA transactions.

The Tax Court also issued a decision against a taxpayer in Ortega v. Commissioner, T.C. Summary Opinion 2009-120.

In Ortega, the taxpayer was a psychologist and was employed in a State of Nebraska prison to provide mental health counseling. She had a Bachelor’s degree, along with a Master’s degree, in clinical psychology. She also began taking courses for her Doctorate degree and eventually was awarded this degree.

At issue in the Tax Court was her deduction of tuition and other fees for her doctoral degree.

The IRS argued, and the Court agreed, that these expenses were not tax deductible because the new degree qualified her for a new career. Thus, the Court rejected her claim that they were deductible because she worked as a mental health counselor both before and after the doctoral degree and thus the educational expenses did not qualify her for a new career but were a continuation of her previous career. The Court noted that she could not be a licensed psychologist without the doctoral degree and thus the education did qualify her for a new career. This case is a good lesson in the rules for educational expenses: they are NOT deductible if the education is

(1) Needed to meet the minimum job requirements (thus ruling out a bachelor’s degree)

(2) If the education is used to fulfill general education aspirations or other personal needs or

(3) Is part of an educational program to qualify the student in a new trade or business. For example, a law degree is NOT tax deductible because it prepares a student for a new career (and they could not have this career without a law degree). However a Master of Law degree would potentially be deductible because it does not prepare for a new career (they are already a lawyer) but simply adds to the professional degrees.

Another case, Rosemann v. Commissioner, T.C. Memo 2009-185, deals with worker classification issues. In this case, Mr. Rosemann was employed as an outside sales representative for a business in which he was paid both a base salary and commissions.

He worked out of his home and car and was required to work at least 40 hours per week. He received life and health insurance, retirement benefits, along with three weeks of vacation, for his efforts. He also used a company car for his sales calls, although he also used his own vehicle for some company business for which he was not reimbursed. He was paid via a W-2 and not a Form 1099. The Form W-2 did not list him as a “Statutory employee” (a “statutory employee” is permitted to claim business expenses on a Schedule C and is treated as a business).

On his tax returns, he listed himself as a “statutory employee,” which was advantageous because it allowed him to deduct all of his business expenses on a Schedule C as opposed to claiming them as “unreimbursed employee business expenses” on Schedule A (for which there was a 2% limitation and other potential phase outs of these deductions). The IRS challenged this tax reporting and the Tax Court agreed Mr. Rosemann was an employee and NOT entitled to claim his expenses on Schedule C. The court noted that there are eight (8) factors in determining if a worker is a common-law employee or not:

(1) The degree of control exercised

(2) Which party invests in the facilities used by the worker

(3) Opportunity for profit or loss

(4) Right to fire

(5) Employment benefits

(6) The permanency of the relationship

(7) The type of work (i.e. is it performed within the regular line of business for the employer?); and

(8) The parties’ beliefs.

The court found that all factors weighed in favor of employee status and thus ruled in favor of the IRS. By so doing, the Court moved all expenses from Schedule C to Schedule A and then disallowed all automobile expenses due to the fact that Mr. Rosemann did not maintain an automobile mileage log and thus couldn’t substantiate how much of his personal automobile was used for business purposes. The court did decline to impose a penalty on most of the adjustments but did penalize him (an accuracy-related penalty) for not keeping proper records to support the automobile use.

IRA Conversions

If you converted your regular IRA to a Roth IRA in 2008, you have until October 15, 2009, to undo the change for tax purposes. There are two common reasons for why you would want to do this:

(1) If your Adjusted Gross Income was over $100,000, you were not eligible to make this conversion

(2) If you were eligible to make the conversion but the value of the Roth has fallen since making the conversion (a somewhat likely event), you can undo the conversion and eliminate the need to pay taxes on the conversion amount.

You can then wait 30 days (the minimum time) and then make another conversion to the Roth, this time with a lower value and hence a lower tax bill.

If you have already filed your 2008 tax return and did not make the switch back to a regular IRA and now want to make this switch, all is not lost. You can file an amended tax return (Form 1040X) and undo the tax treatment on the Roth IRA Conversion. You may want to handle the re-characterization first and then wait 30 days, make the conversion and then file the amended tax return, as there still could be a tax bill due on the conversion (just a smaller tax bill).

Please also remember that all taxpayers, regardless of income, can convert their regular IRAs to a Roth IRA beginning in 2010. This is one of the better tax plans for those who have been previously ineligible.