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YOUR DEDUCTION ASSUMES AN ATTORNEY/CPA WOULD FAIL TO COLLECT A $65,000 BILL? GET REAL!

March 05, 2003

Q. What would be more unusual than an attorney adjusting a taxpayer's books to accrue a $65,000 fee to himself, reducing net income to just under $76,000, without the taxpayer even noticing?

A. The attorney not attempting to collect the fee for four years.

This surreal combination of circumstances drew the IRS's attention to Interex, Inc., a Chestnut Hill, Massachusetts designer of trade show exhibits. George Coupounas, the attorney (and, alas, also a CPA), prepared the C corporation return for Interex for 1994, its second year of operation. In the same year the preparer accrued the $65,000 fee, the sole shareholder/president drew a salary of $42,000; the total payroll for all other employees was only $6,723.

Of course, as any attorney or CPA would attest, a $65,000 fee isn't necessarily excessive. The IRS seemed to realize this, so it asked the tax preparer for an explanation. In a remarkable show of modesty, the preparer declined to toot his own horn, not even to explain what exactly he did for the $65,000. Tax Court Judge Cohen notes "Coupounas declined to cooperate... and there are no documents in the record reflecting services allegedly performed by Coupounas for petitioner other than the tax return prepared by him."

A DREAM CLIENT. Any tax preparer would love clients as trusting as Tamara Olbres, the President of Interex. Judge Cohen asked her about the accrued fee:

Q. When did you first become aware that the corporation owed Mr. Coupounas $65,000 for professional fees from the calendar year 1994?

A. It was some time in August 1998.

Q. And how did you become aware of that?
A. Mr. Coupounas arrived at my office one day and told me that the corporation owed him $65,000 for services rendered that was claimed on the 1994 tax return, and he asked me to write him a check.

Q. Now, at the time Mr. Coupounas came to you in August of 1998, and said "You owe me $65,000 for legal and accounting services," were you aware that Mr. Coupounas had rendered services to Interex, Inc. for which he had not been paid?
A. Yes, I was.

Q. When he told you owed him $65,000 or the corporation owed him $65,000, did you ask him what services is this for, or what did you do for this money?
A. No, I didn't.

Q. Did you ask him whether he had kept any time records or any other types of records which would support that amount of $65,000?
A. No, I didn't. The Tax Update cannot recall a similar conversation with any of its clients.

THE TAX COURT IS UNCONVINCED. The situation was too odd for Judge Cohen to swallow:

"Olbres's testimony concerning her unquestioning reliance on Coupounas is either improbable or indicative of unreasonable conduct. Her testimony that she did not look at anything other than the bottom line on the tax return that she signed is also improbable or indicative of negligence. According to the return, the professional fees claimed during the year in issue exceeded 150 percent of the compensation that she received as the executive and operating employee of the corporation. Although Coupounas was an accountant and an attorney, under the facts of this case we do not believe that Olbres reasonably relied on him with respect to the propriety of deducting $65,000 in accrued professional fees that were allegedly payable to Coupounas. Under these circumstances, a penalty for negligence under section 6662(a) is appropriate."

THE APPELLATE COURT WEIGHS IN. The First Circuit Court of Appeals reviewed the case from a loftier perspective: whether the deduction was proper under the accrual method of accounting. The Circuit Court notes that an expense must meet three tests to be deductible by an accrual-basis taxpayer:

1. all of the events that establish the fact of the liability must have occurred;
2. the amount must be able to be determined "with reasonable accuracy";
3. economic performance must have occurred.

The Appellate Court questioned whether the amount owing could be determined "with reasonable accuracy" under the circumstances:

"The absence of documentation also makes it unlikely that the amount owed could have been determined with reasonable accuracy. There was no evidence as to how many hours Coupounas worked or to his billing rate for accounting or legal services."

The Appellate Court made the unkindest cut of all with this brutal comment: "the services... that Coupounas performed could not reasonably have been valued at $65,000." Doh!

WHAT IS "ECONOMIC PERFORMANCE?" This concept, one of Bob Dole's contributions to the tax system, came into the law in 1984. Prior to 1984, only the "all events" and "reasonable accuracy" tests applied. Economic performance for an expense item occurs, in general:

-If for services, when the services are performed;
-If for the use of property, when the property is used; or
-If for the transfer of property, when the property is provided.

Special rules apply to some situations; for example, economic performance of tort liabilities occurs upon payment.

BUT THERE'S A MULLIGAN! In a bow to reality, the economic performance test can be waived at the election of the taxpayer for "recurring items" if economic performance occurs within 8 ½ months of year-end. If this election isn't made on the taxpayer's initial accrual-basis return, a taxpayer must file for an accounting method change to use this "recurring item" exception.

BUT EVEN MULLIGANS HAVE MULLIGANS: The 8 ½ month rule does not apply to compensation; wages, salaries and bonuses have to be paid within 2 ½ months of year end to be deducted by accrual-basis taxpayers. It also does not apply to transactions with related parties; expenses owed to a cash-basis related party can be deducted only as paid.

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