It all started innocently enough. Stories were rolling around in my head so I decided to publish financial horror stories from my office for benefit of the readers. It turned out to be one of the most popular posts of the year. People, you see, love a good horror story. And now that Halloween is upon us it is time for another set of financial horror stories. So hide beneath the covers and read this with a flashlight.
Horror stories are always fun. Everyone loves a good scare. There is a biological reason we need these scary stories so much. It’s because we learn the most when things are worst. Success breeds arrogance. Soon we mistake luck for skill. It is at this point where we get our head handed to us.
Smart people are eager students of the fallen. Over the years I shared many of my personal failures. In the previous “horrors” post I shared a few to make your hair stand on end. Today I will make your blood curdle.
But this time we at least get one good ending.
Letters from the IRS scare the bejesus out of taxpayers. Unless you can see a check through the envelope window it is doubtful it is good news.
Office policy is straightforward. When a client comes in with the nasty-gram from the IRS (or state taxing authority) we immediately get a power of attorney (POA). Once the POA is signed we contact the taxing authority to get what they have and determine what they are looking for.
Income tax audits are most feared. However, the real audits that require a fresh Depends are the state sales tax audits. Sales tax has so many moving parts and is so complex it is virtually impossible in many states to avoid running afoul of the rules. Wisconsin is one of those states.
A longtime bar owner client received a special letter from the Wisconsin Department of Revenue (WDOR) for a sales tax audit. Bars are pretty straight forward so I didn’t expect many surprises.
WDOR loves to visit establishments prior to sending the audit notice. The skunks, ah, I mean very professional and nice auditors gather information for an accurate audit assessment in advance.
In Wisconsin there is a special gambling rule. Bars (and certain other establishments) can have up to 5 slot machines (video gambling machines). Most bars and restaurants in my area use Amusement Devices out of Green Bay. Amusement Devices provides the machines, collects the money and pays out the profit share to the business owner. The business owner does have to report the income and pay sales tax.
Unfortunately, my client somehow ended up with 6 machines. This is really, really bad.
To make it worse, the sixth machine was owned by the bar owner (ahem) and the income was not claimed, nor sales tax paid.
WDOR had my client by the throat. They threatened to pull his bar license.
They tallied the damages and penalties. It ended up around $40,000, payable yesterday.
WDOR was not impressed by my POA. My reputation preceded me. The auditors from Madison did not possess a sense of humor. They informed me my client needed to pay the balance due within 30 days or face closure. My client was scared for good reason.
I pulled my client to the side and asked if he could pay at least $28,000. He said if he cleaned everything out he could just make that payment.
I turned back to the auditor (there was actually three big ugly, ah, professionally dressed guys handling the shakedown, I mean audit) and said, “My client is a cash basis taxpayer. He hereby elects to be treated as an accrual basis taxpayer going back to the first year sales tax and penalties are assessed. He will also elect the same on his federal tax returns. The refunds on the federal and state income tax returns will leave approximately $28,000 after refunds. He will pay that amount immediately.”
Were the goons professionals from the state tax office mad! If looks could kill I would not have been identifiable at my funeral. They wanted to make an example out of my client in the worse way and I cut 30% off the top with a single sentence.
They huffed and puffed, but backed down as they knew they must. (I’m not against filing a court petition if the government steps outside the letter of the law.) They left.
With severe words from me I impressed upon my client to have his payment in the mail TODAY! He did and all went well. He is still a client to this day.
Let me explain what happened under the hood with this financial nightmare with a somewhat happy ending.
Most small businesses are cash basis taxpayers. This means they report income when received and deductions when paid. An accrual basis taxpayer reports income when earned, regardless if received, and expenses when owed, regardless if paid.
Businesses with an accounts receivable higher than their accounts payable always want to be a cash basis taxpayer. If the payables are higher than the receivables then you want to be an accrual basis taxpayer.
Taverns are cash and carry businesses. They might have some accounts payable, but rarely do they have any accounts receivable as patrons pay as they drink. As a result, changing from cash to accrual was a non-event, except for this little audit issue going on.
WDOR was so irritated because by changing the accounting method both the tax AND penalties were reduced. I caught them with their fly unzipped and they had no recourse.
This is a one-time trick. Switching to accrual from cash is automatic and IRS (or WDOR) approval is not needed. However, if you want to switch back to cash basis you need permission and really good reason for doing so. Sometimes I can pull a rabbit out of my hat. And sometimes that trick is a one-act show. You go to the well again at your own peril.
For the record, my client has 5, count them, 5 slot machines in his bar, all run by Amusement Devices. I am pleased he was a fast learner.
Enough to Make You Sick
It is hard for me to even comprehend this financial horror story.
In the early 1990s a client who worked as a janitor at a local hospital made two trades in his mutual fund and destroyed almost all of his gains from the preceding 15 years.
This young man was a long-time client. He started investing in Fidelity’s Magellan Fund, managed by the investing legend Peter Lynch.
Lynch managed an impressive 29% average annual return while he managed the Magellan Fund from 1977 to 1990.
My client started investing around 1980. When the stock market crashed in 1987 he panicked and sold. Once the market recovered he bought back in.
I reviewed his decisions with him when I prepared his tax return, encouraging him not to sell when the market sells off.
In the early 1990s the first Iraq war gave the market a jolt. Once again my client panicked at the market bottom. When the market recovered he felt it was time to buy back in.
Again I reviewed these decisions with my client over his tax return. He should have enjoyed at 20+% average annual return (if he did nothing), but because he sold twice in a panic his return averaged just over 2% per year on average. Money market accounts at that time did better.
I did my best to deliver the news (and lesson) with gentle hands. But I must have been too harsh. The client never returned.
To this day I remember vividly the actions of this client. It has always been a reminder to never time the market. And never get scared out of a market when it declines, especially if you are in broad-based index funds (or even actively managed mutual funds).
A stellar performance was turned into a return worse than money markets produced back then. The lesson always stayed with me: two simple mistakes over 15 years can wipe out decades of wealth.
I lost a client and gained a valuable lesson. I had to try to help my client; it was my duty. The client left. That was his choice. I made more money from the lesson he provided than my business has produced in profits since that time. The lesson is that powerful.
No Horsing Around
This financial horror story will be told in videos. I’ll give some details, but the videos give more details.
It is possible to commit no mistake and still suffer from a financial horror story as the story of Rita Crundwell shows.
Here is the trailer to the documentary of her embezzlement:
Crundwell was the treasurer and controller of the small town of Dixon, Illinois. Over 22 years she embezzled around $53.7 million. She used the money for her horse business.
The damage was extensive as the link in the above paragraph shows. Services were cut, wages froze, budgets cut. Money was borrowed to cover the budget shortfall. All this will be paid, plus interest, by the people of Dixon regardless the fact they are innocent victims. The damage will last far longer than the 22 years the embezzling took place.
A major accounting firms signed off on the municipalities finances. Taxpayer protections were nowhere to be found. Never feel comfortable. Hold your government accountable. (Yes, I take affirmative action in my townships finances. We also have a really big nest egg, too. You can do this by reviewing the published financial reports and calling out inconsistencies.)
Some money was recovered as this video shows:
All the Queen’s Horses is a fascinating documentary covering the story in detail. You can purchase the documentary from Amazon (affiliate link) or borrow from your library.
Rita Crundwell may have pulled off the largest municipal fraud in history. Local residents didn’t even know it was possible to misappropriate that much from such a small community. The fine people of Dixon will pay for Crundwell’s crime for a very long time.
Financial horror stories come in all flavors. It can be as simple as one or two foolish market timing trades over a decade or an attempt to pull a fast one on the government and getting audited. Some are hard to avoid. When a local government suffers a loss the whole community pays the price.
In the case of Crundwell the warning signs were there, yet nobody took notice for two decades. Even those close to the situation didn’t notice until the very end things had gone so wrong. You might be in a position to protect your community. Do not abscond your duties.
Breaking the law never ends well as we saw with our bar owner. Audits are a pain. Giving the government ammunition to disrupt or even destroy your life’s work and finances is insane.
Stephen King has made a career out of scaring people. It is all fun and games until someone pokes an eye out. Learn the lessons from those who made poor financial decisions and lost. Don’t let their horror story become your reality.
Happy Halloween. Spend, save and invest safe.
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Decline to Provide
Wednesday 30th of October 2019
https://www.thetaxadviser.com/issues/2018/dec/updates-automatic-accounting-method-change-procedures-small-businesses.html to clarify, accrual to cash is now an automatic change for most. Realize that your story appears to be from a period where the parameters were different, however to avoid misleading readers thought it was worth mentioning
Monday 28th of October 2019
As someone who has spent the last decade of my career specializing in sales/use tax, it unfortunately is an area of compliance that a lot of smaller businesses overlook -especially if they deal in more niche areas (like the slot machines). That said - sales tax is a fun little niche of the accounting/tax world.
If the client in the first story had been collecting sales tax but intentionally not remitting it to the state, then it really would have been a horror story. States often criminally pursue people that pull that steal trust-fund taxes (sales tax & withholding tax) and they can pierce the corporate veil to go after the owners/officers personally for the debt if the business can't pay up.
Monday 28th of October 2019
You understand correctly, Matt. Sales tax on the gambling machines is built in so he got the cash and did not report. He is one very lucky client.
I never thought of sales tax as a niche to pursue. That could be a fun and profitable avenue. My personal feeling is the small firms need to narrowly focus and work together as a team. It would be much more efficient.