WISE-HOLLAND CORPORATION

On June 15, 2013, Marianne Wise and Dory Holland came to your office for an initial meeting. The primary purpose of the meeting was to discuss Wise-Holland Corporation's tax situation. Marianne and Dory each own 50% of Wise-Holland Corporation, an S corporation. Dory and her husband Phil will continue to use another tax accountant for their on-going personal tax work, but Marianne wants to engage your services for her personal tax return. Marianne is not married.

Wise-Holland is a calendar year corporation established in Naples, Florida on January 1, 2001. The corporation's principal business is locating and selling unique interior design items. Marianne and Dory have been friends since college, where they were both art majors. After graduation, they each held various positions where they gained experience in interior design before joining together to start this business. They are pleased but stunned by the financial success of their business, because the initial business plan was crafted simply to focus on what they liked to do and have more flexible schedules than they had as employees of others. They feel very dependent on their accountants and other financial advisers, because they have no experience or training in financial matters.

Marianne is unhappy with the tax accountant (Amanda Klinger) who prepared her individual tax return and has advised her on tax issues for the past ten years. Specifically, Marianne is dissatisfied because she had received a notice of deficiency from the IRS disallowing deductions on her 2009 tax return from an investment she made in that year in the Lucky Partnership, a venture that operates medical clinics throughout the state. Lucky was a small partnership and not subject to the unified audit and litigation procedures. Because Lucky also was under audit, Marianne signed a waiver extending the statute of limitations for her 2009 individual return for three more years. Now, she and Dory just received an audit notice for Wise-Holland's 2008 S corporation tax return.

You have never prepared or reviewed Marianne's individual return or Wise-Holland's corporate return. After your initial meeting with Marianne and Dory, you gathered all essential information to begin your engagement. You have obtained the following documents

• Marianne's individual tax returns for tax years 2007 through 2011. These returns were timely extended and filed on October 15 of the appropriate year. Marianne's filing status was Single for all of these returns. Her annual taxable income during these years was approximately $150,000-$200,000
• S corporation tax returns for tax years 2007 through 2012. These returns were timely filed on March 15 of the appropriate year.
• An installment note for the sale of land, building, and equipment by Marianne in 2010.
• A notice of tax deficiency from the IRS for Marianne's 2009 tax return.
• An audit notice dated June 1, 2013, for Wise-Holland's 2008 tax return.
• Various information and financial records necessary to compute 2012 taxable income for Marianne Wise.

A review of these documents and discussions with Marianne and Dory provided the following additional information. None of the taxpayers has engaged in a tax shelter or other reportable transaction.

Notice of Deficiency Mariannes 2009 tax return

The deficiency notice for the 2009 return shows $20,000 federal income tax due resulting from the disallowance of loss flow-throughs from Lucky. The stated reason for the disallowance was that there was no profit motive supporting the partnership. In addition to the tax deficiency, the notice reflects interest and a 20 percent penalty for substantial understatement of tax liability.

Marianne relied on Amanda Klinger to make a good faith effort to evaluate the legitimacy of the losses from Lucky; Marianne was not negligent in claiming the Lucky losses on her individual return. Marianne is perturbed because Amanda assured her that the tax return positions were reasonable and there was little risk the IRS would disallow the deductions.

Marianne also disagrees with the penalty because she maintains that she did not intentionally understate her tax liability. When she discussed the penalty with Amanda in January 2013, Amanda told her to pay the tax deficiency, including the interest and penalties, as there was no defense available for her benefit. Marianne and Phil made that payment. The IRS disallowance affects only the 2009 tax year.

Installment Sale 2010

In early 2010, Marianne sold land, building, and equipment for $300,000 to an unrelated third party, June Lockmann. Marianne received an installment note payable at the rate of $60,000 per year for five years, ie payments would be received from 2010 through 2014. The installment sale was reported in Marianne's 2010 tax return. The basis of the property was $150,000. The total gain and character of the gain is as follows.

Marianne brought a $75,000 capital loss carryover into 2010. Therefore, Amanda decided to prepare Marianne's returns reporting $30,000 of 1231 gain in 2010 and $20,000 in 2011, to utilize the capital loss carryover as quickly as possible. Amanda reported the transaction in this way.

RETURNS AS FILED--EFFECT ON GROSS INCOME

	2010	2011	2012
Total Gain Recognized	$30,000 = $150,000 / 5 tax years	$30,000	$30,000
Section 1245	$0	+$10,000	+$30,000
Section 1231	+$30,000	+$20,000	$0
Capital Loss Carryforward	-$30,000	-$20,000	$0
Net Effect on Gross Income	$0	+$10,000	+$30,000

Audit Notice Wise-Hollands 2008 tax return

The audit notice for Wise-Holland questions certain deductions claimed on the return on the basis that they are nondeductible personal items. Based on your review of the detail and discussions with Marianne and Dory, you conclude that certain deductions for materials and supplies should have been characterized as personal expenditures and are not deductible by the S corporation.

When Wise-Holland's return originally was prepared, Marianne and Dory believed that these deductions were valid business expenditures, and they made a good-faith effort to segregate their personal expenditures from their business expenditures. You do not believe the IRS can make any adjustment at this time, because it has been more than three years since Wise-Holland filed its 2008 tax return.

Ambiguous Tax Issue Wise-Hollands 2011 tax return

In your review, you identified an expense in the financial statement that presents an ambiguous tax issue for the S corporation's 2011 tax return the corporation deducted an item that might be interpreted as being capitalizable. The amount of tax relating to this issue is approximately $10,000, and you estimate that it will exceed 10% of the total tax liabilities for Marianne and Dory for the year.

In reviewing the relevant facts and law, you found six trial court cases that support the IRS position (to capitalize). One old federal District Court decision in Florida supports the taxpayer's position (to deduct in full in the current year). The only appellate court decision (10^th Circuit) supports the IRS position (reversing a Tax Court decision). The Wise-Holland expenditure is quite similar to those discussed in the court cases, although none of the court cases represent a fact pattern identical to Wise-Hollands. In your view, there is a meaningful distinction between the Wise-Holland expenditure and that presented in the 10^th Circuit case.

You have assessed that Wise-Holland's chances of prevailing on the issue would be very small if the matter were litigated. After you explained your preliminary evaluation of the weakness of their position, Marianne and Dory stated that they want you to prepare the return taking the immediate deduction, which will require disclosing the position on the return. Your discussion with them included only an analysis of the tax issue, and not other matters like the low probability of the return being audited by the IRS.

Professional Issues

In considering whether to take on Wise-Holland and Marianne Wiser as tax clients, you have done some research that indicates that in certain circumstances, the preparer of a passthrough entity's tax return and Schedules K-1 can be deemed to be the preparer of an individual's Form 1040 on which the data from the passthrough entity's return was entered. Tax return preparer includes any person who prepares a substantial portion of a return for compensation.[1] Whether a schedule, entry, or other portion of a return is a substantial portion is determined by:

• whether the preparer knew or should have known that the resulting tax result is a substantial portion of the tax to be shown on the return.
• the size and complexity of the item relative to the taxpayers gross income.
• the size of the attributable understatement relative to the taxpayers reported tax liability.[2]

The question then is whether the K-1 numbers constitute a "substantial portion" of the return.

Today it is September 1, 2013. You hold a valid CPA license in your state, and you are classified by the IRS as a tax return preparer.

Please answer the following question:

Evaluate the first three issues (Notice of Deficiency, Installment Sale, and Audit Notice) from the perspective of the taxpayer, taking into account the pertinent tax practitioner responsibilities and penalties.

Hint to help you answer the question from above: Was there an error on Mariannes return concerning the installment sale? What are the proper responses to the discovery of an error on a tax return?

• Recompute the 2010 2012 taxable income amounts regarding the installment note, by correcting the error. What now is Mariannes capital loss carryover into 2013?
• Does the audit notice fall within the statute of limitations period?