The White House released a statement on February 8, 2018 that President Trump nominated Charles Rettig as the new Commissioner of Internal Revenue Code for the remainder of a five year term that began in November 2017.  Unlike other recent presidential nominees that may have ignited fierce debate among political parties, Rettig’s nomination has been universally praised across party lines and by both the public and private sector of tax practitioners.  Rettig spent over thirty-five years in private practice defending clients against the IRS, but also recently published an article discussing the pitfalls of tax collection today and encouraging greater tax enforcement.  Although Rettig’s professional experience is in the private sector, he has consistently encouraged and advocated for voluntary tax compliance and tax enforcement.  Rettig will likely bring this perspective to his new position as IRS Commissioner.

Professional Experience

Rettig spent the last thirty-five years at Hochman, Salkin, Rettig, Toscher & Perez, P.C. in Beverly Hills, California representing clients in a variety of tax matters.  His peers and other national sources have deemed Rettig as a leading practitioner in tax fraud, tax law, and tax litigation and controversy.  See Charles P. Rettig, Biography, Hochman, Salkin, Rettig, Toscher & Perez, P.C.  Throughout his career, Rettig represented thousands of individual, business, and corporate taxpayers involved in civil examinations, tax collection matters, and criminal tax investigations, often representing clients against the IRS.

Concurrent to defending clients in tax matters, Rettig was appointed by the IRS to serve as Chair of the IRS Advisory Counsel (“IRSAC”), and was an active member since 2008.  The IRSAC receives commentary from the public regarding the public’s perception of IRS activities.  The IRSAC then advises the IRS Commissioner on its findings to encourage the public’s involvement regarding tax administration policy, programs, and initiatives.  See Internal Revenue Service Advisory Council Facts, IRS.

With Rettig’s professional backdrop in mind, an analysis of Rettig’s recent publication regarding IRS tax enforcement paints a full picture of Rettig’s viewpoints.  These viewpoints will most likely follow Rettig to his position as IRS Commissioner.

Viewpoint on the IRS and Tax Enforcement

In a fall 2017 issue of the Journal of Tax Practice and Procedure, Rettig published an article entitled A Lesson in Accountability and IRS Enforcement.  Overall, Rettig sets a tone for the need for a new era of increased tax enforcement. The article addresses three main areas: (1) facts on the IRS and current tax collection efforts; (2) the underlying causes of the problems with tax collection and enforcement; and (3) proposed solutions to increase tax collection.

Tax Facts

After providing statistics on the billions of tax dollars collected by the IRS, Rettig explains the current tax gap.  The gross tax gap is the difference between the amount of tax imposed on taxpayers in any given year and the amount that taxpayers voluntarily and timely pay.  The gross tax gap from 2008 to 2010 is about $458 billion.  The net tax gap is the portion of the gross tax gap that never gets paid.  It is the gross tax gap less the tax that the IRS will subsequently collect, either through voluntary payments or IRS enforcement.  Rettig says that it is estimated that the IRS will be able to collect $52 billion of the gross tax gap, leaving a net tax gap of $406 billion.

Problems with Closing the Tax Gap

Rettig addresses three issues that lead to the tax gap.  First, Rettig explains the direct causes of the tax gap: underreporting income, underpaying taxes owed, and not filing taxes at all.  Of those three, underreporting accounts for the greatest portion of the tax gap: $387 billion.  Underpayment accounts for $39 billion and non-filing accounts for $32 billion.  In addressing underreporting, Rettig explains that IRS research shows that people that have federal taxes withheld from income report 99% of their income.  Taxpayers that have reporting requirements under the law also tend to report almost all of their income (96%).  The problem lies with taxpayers that are not subject to withholding or information reporting, with that group only reporting only 68% of their income, and sole proprietors often reporting only 48% of their income.

Second, Rettig highlights that the IRS currently has a historically low number of enforcement agents, which is most likely attributable to the IRS budget.  Rettig cautions that the resource-challenged IRS impacts tax enforcement efforts, which in turn explains another contributing factor to the billion dollar tax gap.

Lastly, Rettig explains that the IRS relies on voluntary compliance.  Rettig states that research shows that increasing civil tax penalties do not increase voluntary compliance by taxpayers.  With IRS examination of taxpayers operating at low rate, Rettig suggests that this may only encourage tax payers to “push the compliance envelop” because it seems like there is not much risk of detection from the IRS.

Proposed Solutions to Close the Tax Gap

Rettig offers three solutions that will target this billion dollar tax gap.  First, Rettig suggests that the IRS should “hunt” for under-reporters and non-filers.  He suggests that technology can help target the taxpayers that fall in the categories of significant underreporting through electronic programs designed to identify these tax payers.  Technology can also be used to identify those tax payers that underreport foreign income, with the cooperation of foreign governments.

Second, Rettig discusses the need for tax practitioners to enhance professional responsibilities within their own fields.  Although the IRS is the governmental tax enforcement agency, Rettig suggests that tax practitioners also play an important role in the voluntary compliance aspect of our tax system.  Specifically, Rettig states that attorneys, accountants, and other tax practitioners must make sure their clients follow the law and observe the appropriate standards set within each profession.  Rettig states, “Tax returns are not to be perceived as an offer to negotiate with the government–information set forth on a tax return, signed by a paid return preparer, must be accurate with a reasonable foundation and reasonable support for the characterization of items set forth within the return.”

Lastly, Rettig suggests that the only way to increase voluntary tax compliance is to increase tax enforcement.  If tax payers know that there is a significant risk of IRS detection associated with underreporting, underpayment, or non-filing, tax payers will be more likely to voluntarily comply.  Because Rettig stated that research shows that increased civil penalties alone do not create the needed effect of increased compliance, only increased tax enforcement through civil examination, field (in-person) examination, and investigation will create the needed effect of increased voluntary compliance by taxpayers.

Conclusion

In sum, Rettig offers both sides of the coin: extensive experience in advocating from the taxpayer’s point of view against the IRS and extensive experience with the inner workings of the IRS and the contributing factors to the billion dollar tax gap.  With this two-sided experience, taxpayers can expect a new frontier of the IRS focusing its resources on targeting the greatest causes of the tax gap, increasing examination of these taxpayers, and hopefully adding millions, if not billions, of uncollected tax revenue to the federal treasury.

Tax Court

The issue before the Tax Court in Huzella v. Commissioner, T.C. Memo. 2017-210, centered around a coin business on eBay, and whether the petitioner, Thomas Huzella, could substantiate his cost of goods sold and expense deductions for his business.

The petitioner had been collecting coins as far back as 1958.  The problem was that the petitioner did not keep records to establish the basis in any of his coins.  In 2013, the petitioner actively bought and sold coins on eBay and was paid through PayPal.  PayPal issued the petitioner a Form 1099-K, Payment Card and Third Party Network Transactions, which reflected the payments he received from PayPal.  The petitioner earned $37,000 from almost 400 separate transactions in 2013.  But he also incurred eBay fees and Paypal fees, as well as packaging and shipping costs.

When he filed his tax return, the petitioner did not report anything on his Schedule C, and the IRS audited his return and issued a notice of deficiency.  The IRS alleged that the petitioner had unreported income of $37,000 from his eBay business and asserted penalties.  At trial, the IRS conceded that the petitioner was engaged in a trade or business in 2013.  The IRS also conceded that the petitioner was entitled to deduct the eBay and PayPal fees, and the Tax Court held that he was entitled to deduct $700 of postage and packaging costs.  The petitioner conceded that he earned – but did not report – gross proceeds of $37,000 from his eBay business.

The court then turned to the cost of goods sold issue.  Taxpayers are required to substantiate any amount they claim as cost of goods sold, and they must maintain sufficient records.  If a taxpayer with insufficient records, however, proves he incurred expenses but cannot substantiate the exact amount, the Tax Court may, in certain circumstances, estimate the amount.

Here, the Tax Court (and the petitioner) relied on the Cohan decision.  See Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).  In that case, the taxpayer was an actor, playwright, and producer who spent large sums travelling and entertaining actors, employees, and critics.  Although Cohan did not keep a record of his spending on travel and entertainment, he estimated that he incurred $55,000 in expenses over several years.

The Board of Tax Appeals, now the Tax Court, disallowed these deductions in full based on Cohan’s lack of supporting documentation.  On appeal, however, the Second Circuit concluded that Cohan’s testimony established that legitimate deductible expenses had been incurred, holding that “the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making.”  The Cohan rule has been followed by the Tax Court and other federal courts in numerous decisions.

The petitioner in Huzella did not have any records to establish his cost or bases in the coins.  He purchased some coins and inherited others.  But the Tax Court relied on Cohan and, after evaluating the evidence and the petitioner’s testimony, held that the petitioner could substantiate a cost of goods sold of $12,000.  Thus, the petitioner had taxable income of just under $20,600 (gross receipts of $37,000, less cost of goods sold and deductions).

In a case of first impression, the Tax Court held that the U.S.–Canada Tax Treaty (Treaty) did not exempt a Canadian citizen from U.S. income tax on the unemployment compensation she received from the State of Ohio. Pei Fang Guo v. Commissioner, 149 T.C. No. 14. The taxpayer came to the U.S. in 2010 as a post-doctoral fellow at the University of Cincinnati. She worked at UC from 2010 through 2011 on a nonimmigrant professional visa. When her employment contract ended in November 2011, she returned to Canada after she was unable to find other work in the U.S., where she stayed through 2012. When her UC employment contract ended, the taxpayer applied to the State of Ohio for unemployment compensation, which she received in 2012. When the taxpayer filed her 2012 U.S. tax return, she took the position that her unemployment compensation was exemption from income tax under Article XV of the Treaty. Instead, she reported the unemployment compensation on her Canadian tax return. The IRS disagreed, and the taxpayer filed a petition in Tax Court.

Tax Court SealThe Tax Court said that the taxpayer was a nonresident alien in 2012, which means she was neither a U.S. citizen nor resident. Generally, nonresident aliens must pay U.S. tax on their U.S.–source income. Everyone agreed that the taxpayer’s unemployment compensation was U.S.–source income. As a result, the only question left for the Tax Court to decide was whether the taxpayer’s unemployment compensation was exempt from U.S. income tax under the Treaty. But the Treaty does not mention unemployment compensation, except to say it does not count as social security.

The taxpayer focused her argument on the term “remunerations” in Article XV of the Treaty. Article XV governs the treatment of “salaries, wages, and other similar remunerations derived . . . in respect of an employment.” But the Treaty does not define “remunerations” either, so the Tax Court turned to the Code. “Remuneration” appears twice in the Code. Section 3401(a) says that “the term ‘wages’ means all remunerations . . . for services performed by an employee for his employer,” and section 3121(b) says that the “term ‘wages’ means all remuneration for employment.”

The Tax Court held that, just as unemployment compensation is not the same thing as “wages,” unemployment compensation does not constitute “similar remuneration derived. . . in respect to employment” under Article XV. The taxpayer wasn’t employed by UC when she received her unemployment compensation. And she did not receive it from her former employer.  She received it from the State of Ohio. As a result, the Tax Court concluded she was required to pay U.S. taxes on her unemployment compensation.

Tax and accounting issues you should not ignore when setting up your cannabis business:

The Trouble With Cash-Based Businesses

  • Internal Controls – any cash-based business is closely scrutinized by the IRS and other taxing authorities. Having robust internal control procedures, in writing, which are strictly enforced, will go a long way in establishing credibility with taxing authorities.
  • Form 8300 requirements – educate yourself or hire an accountant who can work with you to comply with this filing requirement.
  • Bank Secrecy Act – take precautions to avoid violations

Find Good Help

  • Hiring reputable Certified Public Accountants (CPA) and legal counsel to assist you in operating your business is very important.
  • CPAs often do not have guidance from their licensing boards regarding representation of marijuana businesses and many are therefore reluctant to offer advice.
  • Many large law firms are still reluctant to assist marijuana businesses despite actions by numerous state bar associations to assure attorneys they will not be violating state ethics rules when representing businesses in the legalized marijuana industry.
  • However, sophisticated advisers are starting to work with the industry, both in-house and as external advisers.

Comply, Comply, Comply

  • Abide by Internal Revenue Code section 280E – this requires knowledgeable and diligent accounting advice.
  • Be ready for an audit and for dealing with very aggressive revenue agents. Even though federal law enforcement in many cases is easing up on enforcement under CSA, the IRS has not adopted that view – marijuana businesses have a huge target on their back and the IRS is holding marijuana businesses to a very high standard.
  • Be timely and fully pay your taxes – tax liens can create issues with licensing authorities.