The Manning brothers are successful day traders – not Payton and Eli; Jim and John. But make no mistake, the IRS went after these boys with all the aggression of a 250lb middle linebacker. The tax year at issue is 2003.
The Tax Court’s opinion is pretty long, but the facts are pretty straightforward. Jim Manning – the taxpayer in the suit – ran a day trading office in Austin, TX for Assent, LLC, a broker-dealer. Jim was not Assent’s employee, he operated the office through his own LLC.
Customers (other day traders) paid commissions to Assent for making stock trades. The normal commission paid was $5 per 1,000 shares traded. Customers with very large trading volumes would receive discounts. But even if a customer did not achieve high trading volumes, Jim could ask Assent for commission reduction to stay competitive – there were other broker-dealers day traders could go to. Out of those commissions paid to Assent Jim would receive a cut.
In addition to individual accounts, Jim also brought in other entities to conduct their day trading through his office. One of these entities was Warrior, LLC, formed by Jim’s brother John. Warrior was the office’s biggest customer and paid average commissions of $3.75 - $4.25 per thousand shares traded. Assent kept $2 profit and Jim’s cut was the rest
Sometimes it took so long to get Assent’s approval to lower commission rates, that Jim would enter into “outside” agreements to take less of a cut and pass the savings on to the customers. Jim entered into just such an agreement with Warrior. For example, Warriors commissions were reduced to $2.25 per thousand shares traded. In this situation Warrior would still pay Assent $3.75 per thousand shares. Assent would keep $2.00 and pay $1.75 to Jim. Jim in turn would pay $1.50 to Warrior and net $.25.
For tax reporting purposes, Jim treated all “outside” commission adjustments the same. He reported the commission rate adjustment payments to each customer on a 1099-B (Proceeds From Broker and Barter Exchange Transactions). He then took a deduction on his Schedule C. Warrior reported all the commission rate adjustment payments it received as income for tax purposes.
The IRS challenges Jim’s deduction for the rate adjustments related to Warrior. Conversely, they allowed deductions for rate adjustments to unrelated parties. The IRS asserts the payments to Warrior were (1) not ordinary and necessary under section 162(a), (2) illegal payments under section 162(c)(2), and (3) lacked economic substance. The Tax Court rejects all three arguments.
The payments are ordinary because it is a common occurrence to lower commissions in the day trader industry. It did not matter whether the adjustment was paid by Assent or Jim so long as the adjustments were negotiated at arm’s length. The payments were necessary because Assent was slow to adjust rates. The Tax Court states, “an expense may be necessary even where the taxpayer could have avoided it by pursuing a different course of conduct.”
Illegal payments under section 162(c)(2) are those that specifically violate “federal statutes, including state laws which are assimilated into federal law by federal statutes, and legislative and interpretive regulations thereunder.” Here, the IRS relies on an ethics rule promulgated by the NASD (National Association of Security Dealers) against commission-sharing as foundation for its illegality argument. First, these were not commission-sharing arrangement as that term is defined. Moreover, since the IRS did not cite any federal statute that was violated, the payments are not illegal under section 162(c)(2).
Finally, the IRS argues the commission adjustments lacked economic substance because the agreement was not at arm’s length. Taxpayer Manning provided enough evidence to show the Court that Warrior could have received the same rates elsewhere.
Just goes to show you, when dealing with the Service, the best offense is a good defense.