While reading can aid in learning, there is no substitute for doing. Reading about what steps should be taken to solve a tax problem is no different than reading about how to ride a bicycle. In the same way that the only way to learn how to ride a bicycle is by experiencing it firsthand – i.e., by physically getting on it (and perhaps falling off it more than once) – the only way to become proficient at solving tax problems is by trudging through a multitude of hypotheticals. Therefore, my motto is, “Learning by doing.”

So why not test your problem solving skills out on a true-to-life hypothetical? Below is a fact pattern based upon a real case. While the analysis is quite detailed, it is nonetheless very practical in the sense that it covers issues that come up with the greatest frequency for tax preparers who are “on the front lines.” In fact, if I had to venture a guess, I’d say that most, if not all, tax preparers have — for better or for worse — encountered similar issues at some point in their careers. Of course, the names and dates have been altered in order to preserve the anonymity of the parties.

Jack and Janet have been married since 2004. Since 2001, Jack and Janet have operated an unincorporated business under the name, Brookdale Garden Center. According to an interview with Carl, Jack’s father, they acquired the assets in the following manner. Carl had been operating a business under the name of Sunnydale Sod Center.

One morning in 2001, Carl arrived at work to find all of his movable assets gone. Jack and Janet had taken them and moved them to a new location. They then established a new business using these assets. The assets had a total value of approximately $ 50,000 at the time. Although he felt betrayed, Carl decided not to take any recourse against Jack and Janet because he was afraid of Jack and because Sunnydale had been only marginally profitable throughout its existence. Carl essentially retired in 2001 upon the theft of the assets.

Carl later asked his son why he resorted to steeling all of the business assets from him. Jack responded that he and Janet knew a way to make the business more profitable.

Jack and Janet have filed joint federal income tax returns since 2002. Neither filed any federal income tax returns for prior years. Their 2004 and 2005 returns reported the following:

 

 

 

Although they reported zero taxable income in each of 2004 and 2005, their returns actually showed itemized deductions in excess of their adjusted gross income for each year. The $ 2,000 and $ 1,400 reported tax liabilities were for self-employment tax, not regular income tax, and these liabilities were paid along with the timely filed 2004 and 2005 returns.

Neither Jack nor Janet maintains books and records for their business. The receipts items on their returns were calculated from information Jack and Janet provided to their accountant. For the years in question, Jack and Janet’s returns were prepared by the accounting firm of Dewey, Cheatem, and Howe.

Jack and Janet furnished information on their income to Sherry Smith of that firm. Whenever Ms. Smith had a question about an item, she would check it with Jack or Janet. The owner of the firm, Alfred Dewey, prepared the returns from Ms. Smith’s work.

After preparation, Mr. Dewey reviewed the returns line-by-line with Jack and Janet. He asked if there was any additional income or if there were any additional expenses not listed on the returns. Jack and Janet then reviewed the returns, signed them, and mailed them.

Based on her investigation thus far, Special Agent Holmes has tentatively concluded the following:

(1) Mr. Dewey calculated Jack and Janet’s business income from deposits into three accounts (Accounts A, B, and C) they maintained at Wells Fargo Bank. However, Jack and Janet also maintained two accounts (Accounts D and E) at Bank of America. Total deposits into and withdrawals from Accounts D and E in 2004 and 2005 were as follows:

 

(2) In 2004, Jack received dividends of $ 2,000 on stock he owned in a public traded U.S. corporation. The 2004 return did not report any dividend income.

(3) In 2005, Jack received $ 40,000 as a result of selling the stock referred to in (2). The 2005 return did not report any capital gains.

(4) In 2004, Jack and Janet purchased a new home for $ 200,000. In 2005, they added a pool and a satellite television dish to their residence. In March 2005, they took a seven-day trip to Las Vegas.

(5) The individual Schedule C expenses claimed on the 2005 return total $ 18,000. However, the figure appearing on the total line for such expenses was $ 22,000, and $ 22,000 was the amount subtracted from receipts to obtain 2005 net Schedule C income.

(6) Special Agent Holmes interviewed Jack and Janet. They told her that at the start of 2004, they had $ 16,000 in cash which they kept in their home. They kept such a large amount of cash at home, they said, because they don’t trust banks.

To be continued…

In accordance with Circular 230 Disclosure