ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – HOW MUCH CAN YOU DEDUCT FOR PROFESSIONAL FEES IN THE PREPARATION OF PERSONAL INCOME TAX RETURNS IN CALIFORNIA? – THE FELIPE CASE
By Robert S. Schriebman
Mr. and Mrs. Felipe paid the huge sum for the preparation of phony tax returns that initially generated substantial refunds. When the FTB audited these returns they disallowed the refunds and assessed the Felipe’s substantial deficiencies together with penalties. The Felipe’s wanted to offset the assessments by claiming a theft loss for the fee paid to the crooked return preparer. The case was brought before the Office of Tax Appeals (OTA). The decision spelled out the rules required for deductions or refunds based upon the amounts paid in fees for the preparation of personal income tax returns for the years 2009 – 2014. (2021-OTA-026, OTA Case No. 18053219)
This article will discuss the Felipe case and set forth the rules relating to the FTB’s allowance of reasonable tax return preparer fees.
The Felipe Case
- Felipe Jr. and T. Felipe were born and educated in the Philippines. They were not well versed in matters of US taxation. Prior to the tax year 2009, they had hired a reputable tax return preparer who charged them only a few hundred dollars to prepare their annual FTB and IRS income tax returns. When these returns were prepared, they paid substantial additional taxes over and above their withholdings. They did not receive any refunds.
They had real estate investments in California and Nevada, but during the Great Recession in 2008 and 2009, their Nevada property went into foreclosure and they loss quite a bit of money. In 2010 they retained a new tax advisor, Ms. S., who was recommended by a friend and co-worker. They did not undertake any other kind of due diligence to investigate the bona-fides of Ms. S. Ms. S. charged them a contingency fee of 20% of any tax refunds received. Ms. S. prepared tax returns for the years 2009 through 2014. Each return was filed late. Each return prepared by Ms. S. claimed phony theft/casualty losses totaling over $1.5 million. In each of the returns that Ms. S prepared she did not sign any of the returns as the preparer. This should have raised a red flag with the Felipe’s, but they ignored it.
Instead of paying Ms. S. 20% of the amount of refunds, the Felipe’s only paid about $62,000 between 2014 and 2016. They sought a miscellaneous itemized deduction of $26,000 paid in 2014. A deduction for tax return preparer services is allowed pursuant to IRC § 212(3). However, the check was made payable to Ms. S.’s son, at her request, and was designated as payment for an “audit reconciliation.”
The FTB audited the Felipe’s for the years 2009-2014 and in each year assessed an average of $20,000 in additional taxes together with an average of $4,000 in accuracy-related penalties. The FTB allowed only a foreclosure loss for 2009 in the amount of $156,000,
The Felipe’s challenged these assessments before the OTA but limited their argument to a deduction of the $26,000 paid in 2014 as a fee paid for the preparation of tax returns.
Deducting Expenses for the Production of Income
The basic law for the deduction of expenses relating to the production of income is found at IRC § 212. In California these deductions are set forth in R&TC § 17201. This section simply says that the FTB will follow the rules set forth in the Internal Revenue Code.
IRC § 212 states that in the case of an individual there shall be allowed as a deduction all the ordinary and necessary expenses incurred as follows:
- For the production or collection of income;
- For the management, conservation, or maintenance of property held for the production of income; or
- In connection with the determination, collection or refund of any tax.
The question for the OTA was whether a 20% contingency fee is considered ordinary and necessary?
The OTA’s Decision
The job of the OTA was to determine if over $26,000 was a reasonable sum for a contingency fee for the preparation of tax returns for the years 2009-2014. The Felipe’s argued that the sum was reasonable because at the time the agreement was reached, no one had any idea of how much the taxpayers would owe or how much they would receive in refunds. The phony returns prepared by Ms. S. generated over $401,000 in IRS refunds and over $132,000 in FTB refunds. If you do the math a 20% fee would be close to $107,000. The Felipe’s paid Ms. S. $62,000 between 2014 and 2016. In the hearing they sought to deduct only $26,000 for the year 2014.
IRS Regulations under §212(3) state that the charges to prepare tax returns must be reasonable and bear a reasonable and proximate relation to the determination, collection, or refund of any tax, Treas. Reg. § 1.212-1(d). The OTA found no authorities or guidelines for what constitutes a reasonable fee for tax return preparation. So, the OTA looked for other authority under other provisions in the Internal Revenue Code. They found guidance in the area of ordinary and necessary business expenses pursuant to IRC § 162, and specifically rules relating to contingent compensation agreements. Generally speaking, these agreements must be reasonable under all circumstances. The regulation states,
“In any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is, in general, just to assume that reasonable and true compensation in only such amount as would ordinarily be paid for like services by like enterprises under like consideration. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned. (Treas. Reg. § 1.162-7(b)(2)(3))
The OTA found there was no written agreement between the Felipe’s and Ms. S. Because the check stated that the payment was for an audit reconciliation, it was impossible to tell how much of the $26,000 was paid for tax return preparation. The Felipe’s did not do any investigation to determine the bona-fides of Ms. S. It was clear that fraudulent refund claims were made to both the FTB and the IRS. Prior to hiring Ms. S., the Felipe’s paid between $500 -$600 per year for the preparation of honest returns where they wound up paying additional taxes above and beyond their withholdings.
The OTA found that the 20% contingency fee paid to Ms. S. was not ordinary, necessary or reasonable. Instead, they allowed a deduction of only $400 per year for 6 years for a total of $2,400 as an allowable deduction for the preparation of the Felipe’s returns.
Most deductions under both the IRC and the R&TC must be ordinary, necessary, and reasonable. It does not matter if the deduction is for business expenses, travel and entertainment or the preparation your tax returns.
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 50 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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