Tax theory, history and over-regulation, part 2

In Part 1, I claimed to have witnessed over-regulation and abuse by the IRS in my 40-year career. I also presented my quick 6-point introduction to taxation and listed the many laws (taxes) imposed by Britain on colonial Americans before the Revolutionary War. In response, the First Continental Congress met in Philadelphia in the fall of 1774.

Historically, the extreme tax burdens repeatedly imposed on settlers (without any contribution or representation) have pushed them into a corner. In the end, the colonists chose to risk their lives in armed conflict against Britain. The Declaration of Independence marks the beginning of our country and ends with this closing sentence and proclamation: “And for the support of this Declaration, with firm confidence in the protection of divine Providence, we mutually pledge our Lives, our Fortunes, and our sacred honor.

In Part 2, I will begin to validate my accusation that the IRS is the worst abuser of the tax code. I will provide facts and cases that support this premise and show how the IRS distorts the common understanding of the words used in the tax code to deny tax deductions, which were inserted into the tax code by Congress. (Remember that Congress uses tax laws to motivate citizens to take certain actions to obtain tax relief. It is fraudulent to promise citizens tax relief [for taking or refraining from certain actions]only to be told later by the IRS that they are ineligible for “technical reasons”.)

Example 1, the Shellito case. I clearly remember the cover of the June 2011 issue of Taxpro Monthly stating in large red type: “IRS denies employee benefits program deduction for housewife”. The subtitle was “The taxpayers’ employment contract was not valid”. Next to the title was a color photo of a married couple on a red off-road vehicle with their farm in the background. The official title of the case is: US Tax Court, TC Memo 2010-41, Milo L. and Sharlyn K. Shellito, Petitioners v. Commissioner of Internal Revenue, Respondent.

The article then summarized the facts and the decision of the Tax Court, which upheld the IRS’ arguments. IRC Section 105 covers Health Reimbursement Agreements (HRAs), which are widely used by independent farmers and business owners. During the 2001 and 2002 tax years, Milo officially hired his wife, Sharlyn, to do the bookkeeping and other duties related to Milo’s farm business. To legally deduct medical expenses and save taxes, he set up a Section 105 HRA plan with TASC.

The plan allowed Sharlyn to be reimbursed for all of her family’s medical expenses, which included 100% of the cost of health insurance, copayments and deductibles. Milo was also covered under the family HRA and the reimbursements to Sharlyn were legitimate deductions from her farming operation. During an audit of those two tax years, the IRS rejected the Section 105 plan deductions.

The IRS argued and the Tax Court upheld the following: 1) Sharlyn listed her occupation as “housewife” (not “farm worker”), 2) “Ms. Shellito does not was not a bona fide employee”, and 3) “she provided services in connection with a joint marriage enterprise”. Fortunately, the Tax Court dismissed the 20% accuracy penalty because the Shellitos relied on their accountant’s advice. That’s how this front page article ended.

After the Tax Court loss, the case was appealed and the Shellitos again lost. Finally, the taxpayers prevailed in the Tenth Circuit Court. Three judges unanimously overturned the Tax Court’s decision. They reprimanded the previous ruling saying that Section 105 is settled law. With respect to the employment contract, employment documents and work diary, the Shellitos had “crossed all the t’s and dotted all the i’s”. The documentation was perfect, but the IRS and the Tax Court ignored it.

A few months after the case was quashed by the Tenth Circuit Court, Taxpro published a new article containing facts ignored by the Tax Court: 1) Sharlyn kept a daily diary of time spent on farm work, 2 ) an accountant performed tax preparation and payroll services, 3) the accountant assisted with an employment contract, 4) the HRA Section 105 plan was obtained by TASC, the industry expert , and 5) the accountant correctly reported salaries and benefits.

Luckily for the Shellitos, the TASC Audit Guarantee helped them stay the course and ultimately win. However, the lesson is sobering. A Kansas Ag couple did everything right, but the IRS deliberately twisted the plain meaning of the tax code and rejected this statutory tax break. They had to fight to stop the big bully of the government (aka, IRS) from stealing a deduction clearly allowed by the tax code.

The Shellito case is a vivid example of how the IRS works. They ignore the established law and deceitfully manipulate the facts. The result is always an increase in taxes. To summarize the lessons of the Shellito case, the IRS:

1. Wants you to pay more taxes,

2. Deliberately distorts the tax code to produce a higher tax burden,

3. Takes unethical positions, hoping most taxpayers who owe around $11,000 will settle and pay, rather than incur costly legal fees,

4. Continue to bully compliant taxpayers because they know most people will pay a lot of money to take away the emotional pain and stress of an IRS audit, and

5. The third-party audit guarantee was essential. Without TASC taking over the legal tab (over $100,000), the Shellitos would have settled down, paid the tax, and not become a landmark case illustrating the injustice of the IRS and its evil practices.

Aric Schreiner, CPA, PFS, Certified Tax Strategist, helps successful professionals and small business owners develop strategies to reduce tax and audit risk.

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