IRS Sets Offset Limits on Ordinary Income With Capital Losses

The following is a real life example of day trading activities and how the IRS and the Tax Court handle every day reporting mistakes.

In the case of Shahrooz Jamie who was a physician who was also a day trader of securities, buying and selling on his own account. He was looking for a profit on short-term fluctuations in the market by buying and selling the same stock within a few days. There were no other customers he traded for, he earned no commissions for the activity, and he did not maintain a place of business for this trading activity. He did not hold the securities to earn dividends. For Federal tax purposes, Shahrooz was not a dealer in the securities he traded.

During the tax years of 2000 to 2002, he reported his day trader activities on a Schedule C, claiming an ordinary loss on the sale of the securities. He used these losses to offset the income from his medical practice reported on a separate Schedule C, and also reported net operating losses for 2001 and 2002.

The stocks held by Shahrooz were determined to be a capital asset because he only purchased and sold securities on his own account and had no other customers. Losses from the sale of capital assets only allowed as capital losses.

The IRS determined that Shahrooz was trader holding capital assets and could only offset $3,000 of his ordinary income with his capital losses each year.

This case was held before the Tax Court in Shahrooz S. Jamie v. Commissioner, TC Memo 2007-22.

Self-Employment for the Shareholders

A basic principle of taxation is that anyone who earns income should pay tax on it. “The existence of a validly organized and operated corporation does not preclude taxation of income to the service provider instead of the corporation.”

A taxpayer and his wife, who is a realtor, each owned S corporations. The taxpayer ran his construction business through one corporation while his wife runs her business through another corporation. The S corporations recognized the income and operating expenses of their businesses. Neither the taxpayer nor his wife received a salary from the S corporations. No payroll taxes were paid on moneys distributed to them. They did report income flowing through (pass-through income) to themselves from the corporations and paid income tax on the amounts, but no FICA or self-employment tax.

In this case, the IRS and the Tax Court has determined:
· The person providing the service is an employee of a corporation that has the right to instruct or control the employee in some meaningful sense.
· There exists a contract or similar arrangement between the corporation and the service provider that recognizes the right to instruct or control.

Both of these factors were absent in this case. Therefore, it has been upheld by the Tax Court to subject the taxpayers’ income from their S corporations to self-employment tax.

If you have an S corporation where the shareholder(s) are performing services for the S corporation, they should be drawing a reasonable salary and reporting it on IRS Form W-2.

Further reading:

Corporations

S Corporations

Tax Information for Corporations

Publication 542

Does the IRS have a "Blind-Eye" for Federal Employees?

The Senate Finance Committee found in April that more than 450,000 federal employees and retirees owe back federal taxes (totaling about $3 billion), including almost 5 percent of the employees and retirees of the U. S. Tax Court. [U. S. Senate Committee on Finance (press release), 4-25-07].

Tax Advocate groups and Tax Protestors are having a field day with this issue. With the IRS cracking down on middle class American's tax debt, it appears to me that there is a double standard with the IRS.

Spreadsheets obtained by Washington, D.C., radio station WTOP under the Freedom of Information Act show that hundreds of thousands of government employees failed to file a tax return for the 2005 tax year. No federal agency was exempt, though "tax compliance" varied from one agency to another.

Seventy-one employees in the Executive Office of the President, which includes the White House, owe $664,527 in taxes for 2005. Approximately 20 of those employees have entered into an IRS payment plans, bringing the EOP balance down to $455,881 owed by 50 employees.

"In the past, IRS officials have been quick to compare the federal workers' rate of compliance with the general public's. But this year, the IRS is not able to track the compliance rate for the general public." - WTOP

Documents proved that one-third of the employees, or 149,500, entered into payment plans with the IRS. The United States Postal Service was the highest level of noncompliance, and the Treasury Department had the lowest level.

The IRS enters into a contract with new employees that make it a requirement to keep their 1040 filings and payments current or it is automatic grounds for discharge. If the IRS does not enforce the provisions of their own employment contracts, how can they expect and pressure taxpayers to enter into payment arrangements. Instead, they issue an IRS Levy, Garnishment and even attach personal property?

As a veteran Tax Advisor/Preparer, I have seen how the IRS deals with delinquent filers/payers.....smells like double standards and a "blind-eye" to me!

S. Raines

Senior Tax Preparer/Advisor

Effectur, Inc. (www.effectur.com)