IRS Examines Professional Athlete Tax Deductions
Presentation at Sports Financial Advisors Association Annual Conference – November 13, 2010
Presented by Mitchell S. Halpern, J.D. Mitchell is a principal at O’Connor & Drew, P.C., a CPA firm located in Braintree, Massachusetts, where he is the Director of the Firm’s Sports and Entertainment Accounting Practice. He is also a board member of the Sports Financial Advisors Association and a member of the Sports Lawyers Association. Mitchell authored the chapter on State and Local Taxation of Professional Athletes that appears in Gary Uberstine’s legal treatise, “Law of Professional and Amateur Sports”, has spoken at numerous national conferences on tax issues relevant to professional athletes and has been quoted in various newspapers.
Welcome to the “current events” section of our conference. I apologize ahead of time for reading something that I can easily talk about off the top of my head because I live this topic. I just want to make sure that I stay on point and within a time frame. Please save your questions and comments until I have completed my presentation.
This past Tuesday, there was an article posted on a Forbes blog entitled “Lamar Odom Seeks Tax Deduction for NBA Fines and Fitness Fees”. This article has since been referenced on many other blogs & websites including ProBasketballTalk (“Lamar Odom Sues IRS Over Deductions”) and Sports Law Blog (“Are NBA fines tax deductible? Lamar Odom takes on the IRS”).
The gist of the article on the Forbes blog is that Lamar Odom, a player on the Los Angeles Lakers basketball team, filed a tax court petition disputing the disallowance by the IRS of deductions for NBA fines, in the amount of $12,000, and training and conditioning expenses, in the amount of $178,337, resulting in federal taxes owed of approximately $87,000 (including interest, but not penalties).
I’m not here today to discuss with you the legitimacy of these deductions (both of which I believe are legit), but rather to give you the story behind the story. If any of you want to discuss typical business expenses that professional athletes should be able to deduct, feel free to come speak with me during a break or give me a call. I will also see if we can add to the “members only” section of our website a memorandum I have written, and distributed in the past, on typical business expenses of professional athletes.
What is the story behind the story? The Lamar Odom story is the result of the IRS selecting his 2007 income tax return for examination. His examination was most likely what is known as a correspondence examination in which a taxpayer is asked to provide specific documentation for certain items on their tax return. Over the past year plus, there has been a spike in IRS examinations of the “unreimbursed business expenses” of professional athletes. I, myself, have been, or am currently, involved with 8 such examinations “that I am aware of”, 3 of which have been resolved with no changes made by the IRS and 5 of which are still in the IRS pipeline.
Why did I say “that I am aware of”? I say this because not all of my clients are the most diligent at forwarding me notices they receive from the IRS or other taxing authorities. So I may have other clients that are under examination that I do not yet know about. This is where you come in as financial advisors that work with professional athletes. It is important that we are aware of what is going on, and to understand the process, so that we can advise our clients accordingly. Quite coincidentally, this past Monday, before the Lamar Odom story hit the blogs and websites, one of our members, Peter Wheeler, and I had discussed this very issue and that it would be a great topic to briefly discuss at this year’s conference. So here I am.
The IRS correspondence examination process starts out with an initial letter sent by the IRS to the taxpayer indicating that their return has been selected for examination. This letter will indicate what items are being examined and what documentation is being requested. For professional athletes, this letter will generally indicate that Schedule A – Itemized Deductions and Unreimbursed Business Expenses are being examined. The taxpayer has 30 days from the date of the IRS letter to respond. An extension of time can generally be obtained if requested within this 30 day time frame.
If I am lucky enough to be notified of a client’s IRS examination in a timely manner, I will generally obtain a power of attorney allowing the IRS to deal directly with me and which will also result in my receiving all future correspondence from the IRS with respect to the examination. Obtaining a power of attorney from the client is always my first step, even if my involvement occurs later in the process.
If I do not receive notification of the IRS examination from my client, and the client does not otherwise respond to the IRS within the initial 30 day period, the IRS will issue an examination report disallowing deductions for the items they are examining and showing a proposed tax due. Depending on the deductions involved, the proposed tax due can be substantial. I have one case in the IRS pipeline where my initial involvement occurred at this point and the proposed tax due was $319,127 (plus interest due of $34,567). This stage of the process usually gets the client’s attention. The taxpayer generally has 30 days from the date of the issuance of this examination report to disagree with the proposed changes and provide support, i.e. documentation, for the items disallowed. While the IRS may tell you, upon a request, that it has extended the period of time to respond to the examination report, its computers will sometimes still proceed to the next step of the process, regardless of any extension previously granted.
Failure to respond to the examination report within the time frame allowed will generally result in the issuance of a Notice of Deficiency in which the IRS will assess the taxes it believes are owed and that gives the taxpayer 90 days to either pay the tax or file a petition with the U.S. Tax Court. During this 90 day period, the taxpayer can still try to resolve the matter with the IRS, but if the matter is not settled and a tax court petition is not filed within the 90 day period, the taxpayer must pay the tax and then file suit for refund if they wish to pursue the matter further. Oftentimes the tax court petition is filed to protect the taxpayer’s rights, but attempts to resolve the matter directly with the examiner or an appeals officer will continue.
The bottom line for success in responding to the IRS at any stage of the process is to provide the information requested in a timely and orderly manner that makes it easy for the examiner to follow. The key is to have some document that supports each item in question. Failure to be able to provide back-up for any particular item may lead to disallowance of that item. Usually the biggest item in question, in terms of dollar amount, is the agent fees paid by the athlete during the year. For example, the client I mentioned earlier that was awakened from his slumber by a proposed tax due of $319,127 had paid $1,040,000 of agent fees in the year being examined. This accounted for 95% of his disallowed expenses. This should not be too difficult to document by obtaining an invoice from the agent and either cancelled checks showing payment of the invoiced fees or a receipt from the agent showing the amount has been paid. Properly documenting agent fees will generally substantially reduce any amounts of additional taxes assessed by the IRS.
How are these returns being selected for examination? I have spoken with one CPA that has a sizable practice working with professional athletes that believes it is the deduction claimed for agent fees, which as I just explained can be a rather large number, that is triggering the examinations. He thinks that if we can somehow make the IRS aware of this, perhaps it can set their computers to not “red flag” for examination returns simply because they contain a large deduction for agent fees. While this may be one of the triggers, I do not believe it is the only trigger or that the IRS will agree not to “red flag” these returns for examination. I believe that the IRS has determined that professional athletes, as a group, claim many unreimbursed business expenses that it believes are either not allowable or not properly substantiated pursuant to IRS guidelines. I believe these examinations are a fact of life for professional athletes as long as the IRS believes it is having success at assessing and collecting enough taxes to make these examinations worthwhile.
So, where do you all come in? As financial advisors working closely with professional athletes, and oftentimes in contact with the athlete more frequently than any other advisors, you should be proactive and educate your clients that the IRS is performing examinations of professional athletes’ income tax returns and that if they receive correspondence from the IRS, or any other taxing authority, it is critical that the correspondence gets in the hands of their tax advisor as soon as possible. This will help their advisor to protect their rights and can minimize your client’s costs in terms of taxes, interest, penalties and professional fees.
You would be amazed the amount of times I receive IRS and state correspondence from prior years when a client sends me his/her information for the current year. They simply set it aside in their “tax” pile, oftentimes not even opening it. One suggestion that can be made to a client is that the address of the tax preparer or the address of their financial advisor be used on the return. When I do this for clients, I simply include a statement with the return indicating that the address on the return is that of their tax or financial advisor and then I provide the taxpayer’s address for the tax year. I include this “extra” statement because it provides further documentation with respect to any potential residency issues. While this greatly increases the likelihood that correspondence from the IRS or state taxing authorities is handled in a timely manner, not all preparers or financial advisors will agree to put themselves in this position for fear of potential liability if something is not handled in a timely manner that results in taxes, interest or penalties that the client would not have otherwise incurred. This can more easily occur in a larger firm environment where these tasks are delegated and not carefully monitored.
Additionally, at the time your client’s tax returns are initially prepared, you can help your client gather the necessary documentation to support the expenses they wish to claim on their return. It is a lot easier, and far more cost effective, for me to respond to these examinations when I already have the information in our files or the financial advisor has the information in his/her files.
Please use this opportunity to contact your clients, educate them and show them that you are “in the know” about current issues that can significantly impact their financial plans. Doing so should strengthen your relationship with your professional athlete clients and further enhance your image as their “go to” person. Who knows, it may even lead to referrals if they are aware of other athletes facing these issues with little guidance from their advisors.