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Tom Talks Taxes - October 9, 2023
Maximizing tax deductions for professional tax services
A tax professional tells a prospect that the services required will be $8,000: if they clearly explain the value the taxpayer will receive for those services, the prospect should be eager to sign the engagement letter.
It is even better if you can tell the prospect that the entire $8,000 price is tax-deductible; depending on their tax bracket, and considering it is also likely a state tax deduction, that can easily shave at least 25% off of the net cost to the prospect.
For an individual taxpayer not engaged in a trade or business activity, Treas. Reg. §1.212-1(a)(1)(iii) provides that an ordinary and necessary expense paid or incurred by a taxpayer in connection with the determination, collection, or refund of any tax may be deducted under §212.
Treas. Reg. §1.212-1(l) further expands this statement by stating that
Expenses paid or incurred by an individual in connection with the determination, collection, or refund of any tax, whether the taxing authority be Federal, State, or municipal, and whether the tax be income, estate, gift, property, or any other tax, are deductible. Thus, expenses paid or incurred by a taxpayer for tax counsel or expenses paid or incurred in connection with the preparation of his tax returns or in connection with any proceedings involved in determining the extent of his tax liability or in contesting his tax liability are deductible.
§212 expenses are miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) floor. Congress has suspended these deductions federally for tax years 2018 through 2025; however, some states continue to allow these deductions for state income tax purposes. For example, California and New York, two states with high income taxes, continue to allow these itemized deductions.
Some examples of expenses that would fall under this category include
Generic Form 1040 tax preparation expenses,
Individual tax planning and advice expenses,
Representation costs relating to unpaid personal income taxes,
Representation costs relating to a Form 1040 examination,
Submission of Form 1040 refund claims,
Legal costs for criminal defense related to the evasion of individual income taxes (see Rev. Rul. 68-662), and
Tax-related publications (see Contini v. Comm., 76 T.C. 447 (1981)).
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If a taxpayer has Schedule C, Schedule E, or Schedule F activities on their Form 1040 returns, the tax-related expenses directly related to those activities may be deducted on those schedules and reduce the taxpayer’s adjusted gross income. Temp. Treas. Reg. §1.62-1T allows an above-the-line deduction for:
Deductions allowable under chapter 1 of the Code (other than by part VII (section 211 and following), subchapter B of such chapter) that are attributable to a trade or business carried on by the taxpayer not consisting of services performed as an employee…
Deductions allowable under part VI, section 212, or section 611 that are attributable to property held for the production of rents or royalties…
Temp. Treas. Reg. §1.62-1T(d) states that for the §162 trade or business expenses
To be deductible for the purposes of determining adjusted gross income, expenses must be those directly, and not those merely remotely, connected with the conduct of a trade or business. For example, taxes are deductible in arriving at adjusted gross income only if they constitute expenditures directly attributable to a trade or business or to property from which rents or royalties are derived. Thus, property taxes paid or incurred on real property used in a trade or business are deductible, but state taxes on net income are not deductible even though the taxpayer's income is derived from the conduct of a trade or business.
In Rev. Rul. 92-29, the IRS relied on the above regulation to hold that expenses incurred for form preparation or resolving asserted tax deficiencies relating to Schedule C, Part I of Schedule E, or Schedule F, are deductible on those schedules.
Using the same logic, any tax planning or advice directly connected with a business or a rental activity would also be deductible on those schedules.
It is critical for the tax professional to reasonably allocate all tax-related expenses on an invoice or engagement letter to any business or rental activities covered and then deduct those amounts in the proper year. A reasonable allocation would, in the author’s opinion, shift a significant portion of the tax preparation cost to the business and/or rental activities. For a cash method taxpayer, tax return preparation costs for a tax year may be paid and deducted in the following tax year.
If a tax professional offers bundled tax service packages, the bundle price must be reasonably allocated to any business or rental activities covered (including separate entities such as corporations) to deduct the costs appropriately. Each entity, business activity, or rental activity should pay or reimburse for their allocated cost. Some of the price must be allocated to personal tax costs; assigning no value is unreasonable.
There are two additional questions to ask before deducting tax-related expenses.
Do the expenses have to be capitalized? Almost all tax-related services will avoid having to be capitalized; however, it is still a consideration in some situations. In Technical Advice Memorandum 8108008, the IRS explained that
The Court differentiated between the work done by the C.P.A. and that done by the attorney involved in acquiring the property. In making its judgment, the Court looked to the intent of the person rendering the service. The Court determined that the services of the C.P.A. were strictly to obtain the best tax advantages for his client and that the fee paid for those services were deductible under section 212(3) of the Code. However, the Court stated that the services performed by the attorney who drew-up the documents of sale and performed the legal services to accomplish the acquisition of property were not deductible under section 212.
What if a taxpayer pays for unsound tax advice? In this world of rampant employee retention credit (ERC) fraud and so-called Internet “experts” promoting questionable (possibly fraudulent) tax positions, it is an essential question since many of these promoters charge taxpayers hefty fees for their poor advice.
In Crowder v. Comm., T.C. Memo 1984-543, the Tax Court held that a deduction is only permitted for legitimate tax advice and planning:
In order for this expense to be deductible under section 212, the payment must be either a cost of managing and conserving income-producing property under section 212(2) or incurred for legitimate tax advice and tax planning under section 212(3). The trust itself was devoid of economic reality, and was used as a mere device to assign income and avoid taxation… Petitioners must prove that a specific portion of the $1,610 was allocated for the payment of a deductible item. As petitioners have failed to meet their burden of proving that any portion of the payment to the promoters was for any deductible purpose under section 212, the Commissioner's determination is sustained.
In Hoye v. Comm., T.C. Memo 1990-57, the Tax Court held that a tax seminar that promoted a fraudulent tax shelter scheme was nondeductible:
Petitioners contend that they should be allowed, as a deduction pursuant to section 212(3), expenses incurred in connection with attending a tax planning seminar. Petitioners deducted in the taxable year 1983 $2,804 in expenses incurred in attending a tax planning seminar in Orlando, Florida. Respondent contends that the expenses are not deductible because the seminar promoted a fraudulent tax shelter scheme which ultimately resulted in criminal prosecution…
Section 212(3) provides a deduction for payments incurred for legitimate tax advice and tax planning. It is incumbent upon petitioners to prove that a specific portion of the expenses incurred in connection with the seminar were allocated for the payment of a deductible item. The tax planning seminar that petitioners attended promoted fraudulent tax shelters. Petitioners have failed to prove that any portion of the $2,804 was for any deductible purpose under section 212(3). With respect to this amount we sustain the Commissioner's determination.
Similarly, a business that pays for tax advice could have a §162 deduction for that advice disallowed if it was a sham transaction or if the advice rendered was fraudulent or illegitimate.
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