5 MYSTERIES THAT GIVE EVEN THE EXPERTS FITS

The tax code is so complex that it’s difficult to be sure just what all its provisions mean. That can put you at risk if you want to claim gray-area deductions.

America’s federal tax code has grown so complex over the years that there are some questions even the IRS can’t answer.

Among the code’s 2.8 million words in 6,000 pages are unsolved mysteries that have persisted for years and even decades.

Most of the problems start when Congress writes new tax laws that are ambiguous, poorly worded or downright indecipherable. The IRS is left to clean up the mess and write rules that bring clarity to these gray areas.

While the rules are evolving, usually at glacial speed, auditors and courts in different jurisdictions wrestle with the details and often come to opposite conclusions. In some cases, the confusion is compounded by the IRS itself, when it issues conflicting guidance.

“You can have two almost identical situations, and the IRS itself has ruled two different ways,” said tax analyst John W. Roth of CCH Inc., the tax-research company.

Here are five tax mysteries that still give preparers — and their clients — fits:

What’s an “Unforeseen Circumstance”?

In 1997, Congress gave home sellers a great new tax break: they can now avoid taxes on up to $250,000 per person of home sale profits, as long as they’ve lived in the house for at least two of the previous five years.

People who didn’t quite make the two-year mark could get a proportional break based on how long they lived in the home, provided the move was due to a change in employment, a change in health or because of “unforeseen circumstances.”

The IRS waited until 2004 to provide definitions of those terms. The agency listed the following reasons for home sales as “safe harbors” — circumstances where taxpayers and their preparers could feel on solid ground taking a partial exemption:

The IRS also said “change in employment” meant that the new job was at least 50 miles from the old job — of anybody in the household (not necessarily one of the homeowners) — and it defined “change in health” as a doctor-recommended relocation for you or another “qualified person,” typically a sick relative (not necessarily a household member).

But what if you didn’t consult a doctor before moving? Or you got unexpectedly pregnant in a much-too-small house? Or (as happened to some friends of mine in Venice, California) a gang war erupted near your home, making a once-safe neighborhood seem less so?

The IRS has said the causes of your move should not have been “reasonably foreseeable” when you bought the house, but otherwise it says it will look at the “facts and circumstances” to determine if a partial exclusion could be taken.

“When you see the phrase ‘facts and circumstances,’ the red flags go up,” Roth said. “The IRS is saying, ‘I won’t guarantee you anything. Are you willing to roll the dice?’”

Another glitch is that the regulations the IRS issued haven’t been finalized. Taxpayers can rely on them for now, Roth said, but that doesn’t mean the agency won’t change its mind later.

Is Your Business Real or Just a Hobby?

Multilevel marketers, horse fanciers and others who run money-losing sidelines have learned to their peril that the IRS doesn’t consider what they do a real business.

That’s important because real businesses can deduct losses that exceed their incomes, while the IRS limits hobby losses to the amount of money the hobby generates. Deciding which is which, though, can be tricky.

The IRS does provide one firm guideline. The agency presumes you’re running a real business if you make a profit in at least three of the previous five years.

If you can’t meet that test, though, you may have to prove you’re in business to make money and that you’re operating your sideline in a business-like way.

Just how hard you need to try is open to debate. One set of legal minds — the U.S. Tax Court — has said the profit motive must be primary, the driving reason you have the business. Another set, the U.S. Claims Court, has said you just need to show you had a reasonable chance of making a profit. (If you want more guidance about which court to file in when you fight with the IRS, you might first read the accompanying article on this web site, 3 Ways to Fight IRS in Court.)

How much pleasure you take in your sideline may or may not be a factor. When ruling against two married certified public accountants who claimed $190,000 in losses relating to their Amway distributorship, the Tax Court pointed to the “significant elements of personal pleasure” involved in the couple’s activities. The court decided the couple was in it for social reasons and for the discounts they could get on Amway and other products. The same court, however, has said that you don’t have to suffer or dislike the work for a business to be legitimate.

Interestingly, one way to prove your activity is really a business is to stop doing it when it’s clear you’re not making money, said Mary Kay Foss, chairwoman of the California Society of CPA’s tax committee.

Is This Worker an Employee or a Contractor?

This battle has been raging for years, and the IRS still hasn’t issued hard-and-fast rules for companies, workers and tax pros to follow. “They have been trying to come out with guidelines since 1978,” Foss said.

It’s no small issue whether a worker should get a W-2 — with payroll and income taxes withheld by an employer — or a 1099-MISC, which means the worker is treated as an independent contractor.

The latter treatment is usually much cheaper for employers, who don’t have to provide benefits or pay Social Security and Medicare taxes for contractors. It’s more expensive for employees, who have to pay self-employment taxes. Some workers prefer to be contractors, Foss said, so they can deduct more of their uncompensated work-related expenses. Others, obviously, would prefer to be employees but may not have the clout to demand such treatment.

The IRS says the general rule is that workers can be classified as contractors if the company has the right to direct only the result of the work they do, but not “the means and methods of accomplishing the result.”

Compelling arguments often can be made for both treatments for a single job, Foss said. So, mighty battles have been waged with IRS auditors and in the courts over the issue.

What Is “Obese”?

The IRS announced last year that obese people could deduct their weight loss expenses as a medical expense, since obesity is considered a disease.

Just when you’re fat enough to qualify, though, is an open question.

It’s pretty clear that a doctor must authorize the weight loss program for the treatment to be deductible, said tax expert Bob D. Scharin. But medical treatments are generally deductible for the prevention as well as the treatment of disease, so tax pros are debating how close to obese someone needs to be to get the deduction.

If someone is a couple of pounds overweight, he probably can’t take the deduction, said Scharin, who edits “Practical Tax Strategies,” a monthly journal for tax professionals published by Warren, Gorham & Lamont/RIA.

If you’re close to being obese, you probably can, Scharin said, but the IRS has yet to make that clear.

Where Is Your Tax Home?

You need a “tax home” to determine certain deductions, such as how much business-related mileage you can write off. That’s no problem for the vast majority of taxpayers, who have a single physical address.

It’s much tougher for long-distance truckers, traveling salespeople, full-time RVers, live-aboard boaters and others who may not have a house or apartment.

Some of these travelers have done everything the IRS says is needed to establish a tax home — such as consistently registering their cars in a city or town where they also voted and maintained a mail delivery address — yet still the IRS denied that the location was their tax home, CCH’s Roth said.

Coming out on the wrong side of such an audit can be expensive. The IRS often doesn’t cut much slack for taxpayers trapped by this or any other gray area of the law.

“The IRS says, ‘Here’s your new tax bill, here’s your interest, here are your penalties, and oh, by the way, you’ve got 30 days to pay it,’” Roth said. “You’re now talking about a substantial sum of money.”