The Tax Law Report

Constructive Dividends to C-Corporation Shareholders

Tyson v. Comm'r, T.C. Memo 2009-176 (T.C. 2009).

Mr. & Mrs. Tyson operate a painting business and a Shaklee distributorship out of RS Tyson, a C-corporation. The Tysons each owned 50% of the Corporation's outstanding shares.

During 2003, RS Tyson deducted rent expense, employee benefit expense, laundry expenses, travel, meals and entertainment, and automobile expenses. The IRS disallowed all deductions, and the Tax Court agreed.

Rent Expense

RS Tyson paid $24,000 in rent expense to the Tysons for use of their home in carrying on the Shaklee distributorship. The Tysons reported rental income on their Schedule E. The amount of rent was based on the number of hours per month RS Tyson would use the Tyson's home, times an amount per hour charged by local hotels for meeting space.

The Tax Court disregards the rent agreement because it was not an arm’s-length agreement, it lacked economic substance, and the monthly rental amount was little more than a guess.

Employee Benefit Expense

RS Tyson deducted $8,919 for employee benefit expenses, e.g. health insurance, paid on behalf of Mr. & Mrs. Tyson. Unfortunately, there was no proof that Mr. & Mrs. Tyson were employees of RS Tyson. During 2003, the Company did not pay any wages to either Mr. or Mrs. Tyson, there were no employee agreements, and RS Tyson reported no officer compensation on its tax return. Accordingly, the deduction for employee benefit expenses was denied.

Other Expenses

The Tax Court denied almost all of RS Tyson’s laundry, travel, meals and entertainment, and auto expenses because there were no adequate records substantiating the amounts or the business purpose.

Constructive Dividends

Because RS Tyson’s expenses were disallowed, and the expenses were paid to or on behalf of Mr. and Mrs. Tyson, the payments are considered constructive dividends to the Tysons.

Generally, where a shareholder diverts corporate funds to his own use, those funds constitute constructive dividends to him and are ordinary income to the extent of the corporation’s earnings and profits. Where a corporation provides an economic benefit to a shareholder with no expectation of reimbursement, the benefit is a ‘constructive dividend’ and is taxable income.

Consequently, RS Tyson’s deductions are disallowed, and Mr. & Mrs. Tyson have dividend income.

Analysis

The Tax Court makes note that the Tysons did not call their tax preparer as a witness at trial. Accordingly, the Court can infer the preparer’s testimony would have been unfavorable. Pro se taxpayers, and attorneys, should be aware of this inference in proceedings before the Tax Court.

The transactions entered into between RS Tyson and their shareholders make very little sense. The Tysons would be much better off simply taking a home office deduction rather than concocting a rental agreement. In the case of the disregarded rental agreement, RS Tyson has income, via disallowed expenses, taxed at corporate rates, and the Tysons have dividend income taxed at prevailing dividend tax rates. Because the rental agreement is disallowed, the Tysons end up paying two taxes: the first is the corporate tax paid by RS Tyson, the second is the dividend tax paid on the constructive dividends.

The real problem here is that RS Tyson is a C-corporation. As such, RS Tyson pays taxes on its income at corporate tax rates. Then, when RS Tyson pays dividends, Mr. & Mrs. Tyson have dividend income taxed at the then prevailing dividend tax rates. This is referred to as double-taxation associated with C-corporations, which is why very few small businesses operate as C-corporations. In fact, most large businesses do not operate as C-corporations.

My advice to the Tysons would be to convert their C-corporation to an S-corporation. This would avoid the dividend tax, and allow them to take tax-free distributions. Of course, they would have to start paying themselves a reasonable salary and they would be taxed on the S-corporation’s net income each year. But this is a more sensible way to run their businesses.

The Lohrke Test - When Can a Shareholder Deduct Payments Made on Behalf of His/Her Corporation

Canterbury Holdings, LLC v. Comm'r, T.C. Memo 2009-175 (T.C. 2009).

Before discussing this case, I want to point out the apparent cowboy motif in the opinion's opening paragraph. For example, the words or phrases: mounted a takeover, ride turned rough, pony up, and saddle are used to describe the crux of the case. Judge Holmes's clerk is either from the midwest or just using some creativity in the only place where allowed in a court opinion.

Background

The events that follow occurred between 1999 and 2005.

Canterbury Holdings is a U.S. limited liability company with five members: three individuals, a trust, and a retirement plan. The individual members included an investment banker, a New Zealand business man, and Kenneth Kopp, founder of The North Face. Canterbury bought under-performing sports-apparel brands intending to make them profitable. One such brand was the Canterbury brand (hereafter "Brand"), a famous New Zealand rand that built its name focusing on rugby.

The Brand was owned by LWR Industries, Ltd. (LWR), a New Zealand publicly traded company. Approximately two-thirds of the outstanding shares were owned by Brierly Investments, Ltd. (BIL), and the remaining one-third traded on the New Zealand stock exchange, NZX. Canterbury's plan to purchase the Brand included a tender offer for the LWR shares traded on NZX and an option agreement with BIL for the remaining outstanding shares.

Canterbury feared the New Zealand public would not be receptive to a U.S. company owning one of its biggest and oldest brands. To address this concern, they formed a New Zealand shell company, Canterbury Holdings, Ltd. (Canterbury NZ), to purchase and hold LWR's stock. Canterbury NZ was capitalized by Canterbury's partners with NZ$10,000,000. NZ$ stands for New Zealand Dollars, and at the time of the tender offer the exchange rate was .5294 NZ$ for 1.00 US$. In 1999, the tender offer was successfully completed. LWR was subsequently delisted from the NZX, and BIL and Canterbury NZ executed an option agreement for the remaining shares.

Canterbury's three partners where in no position to manage and run LWR, consequently Canterbury NZ signed a management agreement with BIL to collectively manager LWR. The agreement provided that LWR would pay both BIL and Canterbury NZ for managing its operations. The Canterbury partners took up positions in Canterbury NZ and received a salary for their services.

In late 2000, LWR stopped paying BIL as provided in the agreement. Canterbury disputed the amount owed BIL, asserting BIL was not living up to its side of the agreement. BIL accepted NZ$ 4,010,000 as payment in full for its management services, and reduced the option agreement price from NZ$ 22,700,000 down to NZ$ 6,250,000. The option agreement was paid in cash and notes collateralized by purchased LWR securities. Canterbury, NOT Canterbury NZ, paid the NZ$ 4,010,000 to BIL, and Canterbury, NOT Canterbury NZ, paid the interest on the note.

Canterbury deducted both the management fees and the interest expense on its 2000 and 2001 partnership tax returns. The IRS denied both deductions and assessed section 6662 accuracy and underpayment penalties.

The Lohrke Test

As a general rule, shareholders cannot deduct expenses paid on behalf of a corporation. Instead, these amounts are considered capital expenditures under Regulation 1.263(a)-2(f).

But section 162(a) allows a deduction for ordinary and necessary trade or business expenses incurred or paid during the taxable year in carrying on any trade or business. "[A]ndthere is nothing in the Code that bars a shareholder from deducting payments from his corporation's expenses, if those expenses are also ordinary and necessary to his own trade or business." Lohrke v. Comm'r, 48 T.C. 679, 688-89 (1967).

The Lohrke test requires, 

that a shareholder who wants a deduction for paying his corporation's expenses must show two things: (1) that his purpose was to protect or promote his own business, and (2) that the expenses paid were ordinary and necessary to that business. Lohrke at 688.

The Tax Court finds here that,

during the years at issue, Canterbury itself had no actual business apart from stitching a deal for, then managing LWR...[There] was no existing operating business, credit standing, or a preexisting reputation to maintain. Its desire to build a future reputation is simply not enough for us to grant its current deductions as "protecting and promoting its trade or business"...[A] more direction connection with an existing business is needed to sustain a deduction in this area.

Canterbury also argues that Canterbury NZ was merely a nominee that should be disregarded. This argument is rejected because Canterbury NZ served a useful business purpose, namely it provided a local presence in New Zealand.

Notes

At the end of the opinion, the Tax Court points out, "[T]he Code and caselaw simply do not allow Canterbury to ignore its organizational choices when convenient for tax purposes. Further, "[W]hile a taxpayer is free organize his affairs for as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice."

Taxpayer's Attorney Abuses Discovery - IRS Awarded Attorney Fees

Powell v. Comm'r, T.C. Memo. 2009-174 (T.C. 2009).

I blogged previously about section 6673(a)(1) penalties assessed against taxpayers (here). But this is the first case I have seen - albeit I have only been blogging for two months - where the Court assessed section 6673(a)(2) costs against a taxpayer's attorney for "unreasonably and vexatiously" delaying proceedings before the Court. 

Taxpayer’s Belligerence 

The taxpayer, Mr. Powell, conducted research of the Internal Revenue Code, case law, etc., which led him to the conclusion that he was not required to file a tax return or pay taxes. This false conclusion resulted in his failure to file tax returns from 1999 through 2002 and his failure to pay some $434,796 in outstanding liabilities.

In October 2005, the IRS sent Mr. Powell a Notice of Intent to Levy and Notice of Your Right to a Hearing. Mr. Powell, however, persisted in his ways even after reading the IRS's publication, "The Truth About Frivolous Tax Arguments." In response to Mr. Powell's belligerence, the IRS sent him a Notice of Determination Concerning Collection Action(s) Under Section 6320 and/or 6330, dated August 11, 2006, sustaining the levy and warning him of potential 6673 sanctions. In September 2006, Mr. Powell filed a petition with Tax Court challenging the levy notice.

Almost a year later, the IRS filed its first Motion for Summary Judgment. The Court denied the IRS’s motion stating, “satisfaction of the requirements of section 6330 [Notice and Opportunity for Hearing Before Levy] should be demonstrated at trial rather than in a summary adjudication,” (as we will see, this comes back to haunt the IRS.) In November 2008, the IRS filed its second Motion for Summary Judgment and a Motion to Impose a Penalty Under section 6673.

In the interim, Mr. Powell retained the services of an attorney, Mr. Barringer, to represent him in the proceedings before the Tax Court. Mr. Barringer responded the IRS’s second motion for summary judgment by seeking more time for discovery and requesting the Court deny the IRS’s motion until Mr. Powell receives satisfactory answers to his questions regarding the meaning of “taxpayer” and “individual” under the Internal Revenue Code.

Attorney’s Defense

The Court grants the IRS's second motion for summary judgment. In addition, the Court set an April 20, 2009 hearing for Mr. Barringer to Show Cause why he should not be required to pay attorney’s fees under section 6673(a)(2). In its Order to Show Cause, the Court points out that Mr. Barringer employed the discovery process to delay trial.

Petitioner’s argument [i.e. Mr. Barringer] that respondent’s motions [i.e. IRS] should be denied because they are premature until petitioner secures responses to his various inquiries is patently for the purpose of delay. Petitioner’s interrogatories [interrogatories are written questionnaires] indirectly assert stale tax defiance arguments about terms such as “taxpayer”, “person”, “non-resident alien”, “income”, and other non-meritorious arguments about delegated authority.

On May 20, 2009, Mr. Barringer filed his Response and Objection stating he did not cause delay of the proceedings, but that “his conduct…was consistent with the demands of his [client].” And further, “[his client] sought to know exactly how all the provisions of the I.R.C. apply to him.”

Time and Costs Awarded: Abuse of Discovery Process and Second Motion for Summary Judgment

The Court rejects the IRS’s request for time and costs for the second motion for summary judgment because it was a choice by the IRS to file the first motion, which the Court warned against. Accordingly, Mr. Barringer – though not completely blameless – is not required to pay time and costs for the IRS’s attorneys in the second motion for summary judgment.

Mr. Barringer protests the abuse of discovery charge, stating that he was simply representing his client based on his client’s directive, and that it would have been futile to try and convince his client, Mr. Powell, otherwise.

Mr. Barringer’s reasoning is rejected by the Court because section 3.1 of the Model Rules of Professional Conduct, incorporated into proceedings before the Tax Court by Rule 201(a) of the Tax Court Rules of Procedure, prevent an attorney from “defending a proceeding…unless there is a basis in law and fact for doing so that is not frivolous, which includes a good faith argument for an extension, modification or reversal of existing law.” Under these Model Rules, Mr. Barringer was prohibited from defending Mr. Powell's frivolous claims. Consequently, the Court grants the IRS’s motion for time and costs for abuse of the discovery process, and awards the IRS $4,725 under section 6673(a)(2).

Analysis

In the middle of its opinion, the Court references section 3.1 of the Model Rules of Professional Conduct and states, “[I]n the absence of any acknowledgement of current law, there is no indication of a good-faith attempt to change it.” Mr. Barringer, or any other attorney, no doubt should represent his client zeolously. But all attorneys are bound by the Model Rules of Professionl Conduct. These rules are incorporated into proceedings before the Tax Court by rule 201(a) of the Tax Court Rules of Procedure. Here, neither the taxpayer nor his counsel had any interest in putting forth a good faith argument for “extension, modification, or reversal of existing law.”

The Court's decision here imposes section 6673 costs because the attorney abused the discovery process by advancing Mr. Powell's position. The implication of this particular decision is that an attorney is effectively barred, by both the Model Rules and section 6673, from even representing a taxpayer whose only grounds for challenging his or her tax liability are frivolous.

Foreign Earned Income Exclusion and Tax Home

Musshafen v. Comm'r, T.C. Summary Opinion 2009-115 (T.C. 2009).

Form 2555, Foreign Earned Income Exclusion, is no doubt one of the more difficult forms taxpayers, and their tax preparers, may encounter. While the Court's opinion here is subject to section 7463(b) - meaning it may not be treated as precedent for any other case - it is still a good explanation of section 911, the foreign earned income exclusion. 

An exclusion is different from a deduction, but in most instances it functions just the same. 

The taxpayer, Mr. Musshafen, works for Parker Drilling Management Services, Inc., an oil drilling company located in Houston, Texas. Oklahoma is his home, but he works on a rig in Kuwait. He works 35-days-on and 35-days-off. While on duty, he works 12-hour days and is on call 24 hours per day. During his off-duty days, he returns home to his family in Oklahoma. After consulting with his CPA, Mr. Musshafen excluded a portion of his PDMS wages from his 2004 and 2005 tax return under the foreign earned income exclusion. The IRS disallowed the exclusion and assessed section 6662(a) accuracy penalties. 

The Foreign Earned Income Exclusion 

Section 911(a) excludes from gross income the foreign earned income and the housing cost of a qualified individual. Section 911(d) defines a qualified individual as, an individual whose tax home is in a foreign country and, who is either (1) a U.S. citizen who establishes he/she is a bona fide resident of a foreign country for an entire year (the bona fide residence test), or (2) a U.S. citizen who is present in a foreign country for at least 330 days during a 12 consecutive month period (the physical presence test). Under section 911(d):

The term “tax home” means, with respect to any individual, such individual’s home for purposes of section 162 (a)(2) (relating to traveling expenses while away from home). An individual shall not be treated as having a tax home in a foreign country for any period for which his abode is within the United States.

Confused yet? In simpler terms, tax home can have two different meanings under 911(d). Its first definition is the same as that for deducting travel expenses - principal place of business. BUT, if a person has an abode in the U.S., her abode is the tax home, not the foreign country. The Tax Court defines abode as, "the location where [a person] has a strong economic, family, and personal ties." This means "residence, domicile or place of dwelling." 

Tax Court Holds Mr. Musshafen's Tax Home is Oklahoma

The Tax Court cites several cases that analyzed the same issue (taxpayer works on an oil rig) and finds that Mr. Musshafen's tax home is Oklahoma. Because Mr. Musshafen returned to Oklahoma during his 35-day off schedule, he spent about 182.5 days per year in Oklahoma. Moreover, his family lived in Oklahoma, he had an Oklahoma driver's license, and he never really left the jobsite to mingle with Kuwaiti citizens. 

On balance, his "economic, family, and personal ties" were with Oklahoma. Therefore, he did not meet the tax home test and was not entitled to the foreign earned income exclusion. 

Analysis 

Here is an excerpt from Form 2555's instructions for 2008:

Your tax home is our regular or principal place of business, employment, or post of duty, regardless of where you maintain your family residence. If you do not have a regular or principal place of business because of the nature of your trade or business, our tax home is your regular place of abode (the place where you regularly live). 

You are not considered to have a tax home in a foreign country for any period during which your abode is in the United States. However, if you are temporarily present in the United States, or you maintain a dwelling in the United States (whether or not that dwelling is used by your spouse and dependents), it does not necessarily mean that your abode is in the United States during that time.

What should become instantly apparent - if you are still reading - is that the Form's instructions are so vague they are misleading. That is probably why the instructions contain an example that mirrors Mr. Musshafen's facts, and conclude a taxpayer with his circumstances does not pass the tax home test. 

Fortunately for Mr. Musshafen, the Tax Court realized how confusing the law is, and abated the section 6662(a) penalties. The IRS should do us all a favor and re-write the instructions for Form 2555.

Jurisdiction and Affected Items

Meruelo v. Comm’r, 132 T.C. No. 18 (T.C. 2009).

Mr. Meruelo owns a partnership interest in Intervest Financial, LLC via Meruelo Capital Management, LLC (a single-member limited liability company) (hereafter “MCM”). Mr. Meruelo’s portion of Intervest’s 1999 loss was $4,538,844; the losses stemmed from foreign currency transactions. On his 1999 tax return, he claimed the entire loss as a deduction. The return was filed in October 2000. The IRS has not: audited Intervest’s 1999 partnership tax return, notified Intervest of a pending audit of its 1999 partnership tax return, issued a final partnership administrative adjustment (FPAA) to Intervest for 1999.

On October 10, 2003, just before the three-year statute of limitations expired, the IRS issued a Notice-of-Deficiency (NOD) to the Meruelo’s. The NOD indicated that the IRS disallowed their Intervest loss because of sections 465 and 704(d). Section 465 limits losses to amounts at-risk. Section 704(d) limits partnership losses to a partner’s basis. But these sections are not at issue here.

The Meruelos motion the Court to dismiss this case for lack of jurisdiction on two grounds. First, they argue that the NOD is invalid because the deficiency is related to an affected item of Intervest. As such, the IRS is required to either issue a notice of FPAA or accept Intervest’s 1999 as filed, neither of which had been done. Second, the Meruelos argue in the alternative that the items in the NOD are not in fact affected items.

Limited Jurisdiction and Affected Item

The Tax Court “is a court of limited jurisdiction. Whether [the Court] has jurisdiction over the subject matter of a dispute is an issue that either party may raise at any time. Here… jurisdiction rests on finding that the NOD issues to [the Meruelos] was valid and that [their] petition to this Court was timely.”

Fortunately, the Court defines “affected item” before moving on to its analysis. There is no sense paraphrasing the Court here.

The term “partnership items” includes any item of income, gain, loss, deduction, or credit that the Secretary has determined is more appropriately determined at the partnership level than at the partner level. See sec. 6231(a)(3); sec. 301.6231(a)(3)-1(a), Proced. & Admin. Regs. The term does not include an “affected item”, defined by statute as any item to the extent the item is affected by a partnership item. See sec. 6231(a)(5); Adkison v. Commissioner, 129 T.C. 97, 102 (2007).

Affected items are of two types. The first type is a computational adjustment made to a partner’s tax liability to reflect adjustments to partnership items. See sec. 6231(a)(6). When partnership-level proceedings are complete, the Commissioner may assess computational adjustments against a partner without issuing a notice of deficiency. See secs. 6225(a), 6230(a)(1); N.C.F. Energy Partners v. Commissioner, 89 T.C. 741, 743-744 (1987).

The second type of affected item requires a partner-level determination; it is an adjustment to a partner’s tax liability (other than to reflect a penalty, addition to tax, or additional amount relating to an adjustment to a partnership item) to reflect the proper treatment of a partnership item that is dependent upon factual determinations to be made at the partner level. See sec. 6230(a)(2)(A)(i); Domulewicz v. Commissioner, supra at 22-24.

 

The normal deficiency procedures apply to affected items that require partner-level determinations (other than penalties, additions to tax, and additional amounts that relate to adjustments to partnership items). See sec. 6230(a)(2)(A)(i). These procedures require the timely issuance of an NOD as a precondition to the Commissioner’s assessment of a deficiency or accuracy-related penalty related to affected items. A valid NOD requires that any partnership-level proceeding involving the related partnership be complete. See sec. 6225(a); GAF Corp. v. Commissioner, supra at 528; Maxwell v. Commissioner, supra at 788.

When an FPAA is issued to the partnership and a partnership-level proceeding as to the FPAA is properly brought in this Court, the partnership-level proceeding is complete when our decision becomes final. See sec. 6225(a)(2). When the Commissioner opts not to begin a partnership-level proceeding or issue an FPAA within the normal period of limitations, the partnership-level proceeding is considered complete when the Commissioner accepts the partnership’s return as filed. See Roberts v. Commissioner, 94 T.C. 853, 860-861 (1990). Whether the Commissioner has accepted a partnership return as filed is a question of fact that turns in part on a finding of whether the Commissioner opted to allow the normal period of limitations to expire without beginning a partnership-level proceeding. See id.

Tax Court’s Analysis

The Tax Court dismisses the Meruelo’s motion. In addressing their first argument, the Court points out that the IRS concedes it may no longer adjust Intervest’s partnership items because the normal statute of limitations has expired. Accordingly, the restriction to complete partnership-level proceedings under section 6225(a) prior to issuing an NOD is lifted. As such, the NOD is valid.

The Meruelos argued in the alternative that their items were not affected items. Of course they were. A partner’s basis and amounts at risk are necessarily partner-level determinations; the second type of affected items. Therefore, their alternative argument also fails.

Notes

The Court takes note that while the NOD was issued to MCM, Mr. Mereulo placed no weight on this fact in his argument; he attacked only the IRS’s proceedings, or lack thereof, with Intervest. I am not sure what, if any, difference this would make.

Lastly, Mr. Mereulo’s alternative argument is just silly (silly is a term of art in Tax Law). Perhaps they did not understand “affected items.”

Unreimbursed Employee Business Expenses

Foriest v. Comm’r, T.C. Summary Opinion 2009-110 (T.C. 2009).

Mr. Foriest is a firefighter and an alleged farmer (during 2003 he was also the owner of a lawn care business). The IRS disallowed, among other things, his unreimbursed employee business expense deductions (except the union dues), and his farming loss deductions on his 2003 and 2004 tax returns.

Unreimbursed Employee Business Expenses

In total, Mr. Foriest claimed a $4,024 deduction for unreimbursed employee business expenses on Form 2106, Employee Business Expenses. This amount included:

1. $2,040 in contributions to a common meal fund for meals consumed at the firehouse.
2. $1,514 in 2003 and $1,580 in 2004 for uniform cleaning and maintenance.
3. $260 for incidental business expenses for both 2003 and 2004.
4. $210 for union dues in 2003, and $510 for union dues in 2004

Section 162(a) allows a deduction for trade or business expenses that are ordinary and necessary. Section 6001 requires taxpayers to keep records that substantiate expenses were paid or incurred during the year they take the deduction. Section 262(a), however, disallows personal living expenses. Here, Mr. Foriest failed to adequately substantiate his incidental business expenses because he provided no documentation supporting the $260. Neither could Mr. Foriest provide documentation supporting more than $260 in union dues. Consequently, the Court reduced his deductions to an amount he could substantiate.

Meal Expenses are generally not deductible unless incurred while traveling on business away from home. see section 262(a). The Court points out, however, that where a firefighter is required as a condition of employment to contribute to a common meal fund, then those contributions qualify as deductible ordinary and necessary business expenses. But, if a firefighter voluntarily contributes, then the contribution is considered a non-deductible personal expense. Here, Mr. Foriest voluntarily contributed to the common meal fund, consequently his meal expenses are non-deductible personal expenses.

Uniforms are deductible if (1) required as condition of employment and (2) not adaptable for everyday use. While the Tax Court agrees that Mr. Foriest is required to wear a uniform as a condition of employment, he did not provide any documentation to substantiate his claimed expenses. Consequently, the Court reduces his uniform expense deductions to $500 for both 2003 and 2004.

Farming Losses

Finally, the Foriests reported a $24,116 net loss on Schedule F, Profit or Loss from Farming. The IRS disallows all their farming deductions because their farming activity did not rise to the level of a trade or business. As such, their deductions are limited by section 183, the hobby loss rules. One quote from the Tax Court says it all:

Keeping petitioner’s observation in mind [“nobody farms as a hobby”], as we view the matter, living on a family farm and the purchase of two cows, without more, does not a farmer make.

Frivolous Arguments and Labor Theory

Samples v. Comm’r, T.C. Memo. 2009-167 (T.C. 2009).

Mr. Samples asserts the income tax is an indirect excise tax improperly imposed upon the labor of a natural person. That is, he believes wages received in exchange for labor become property, and it is therefore improper to impose an income tax on his property.

Mr. Samples’s theory is rejected by the Tax Court. His argument is frivolous for several reasons but mostly because “gross income means all income from whatever source derived.” 26 U.S.C. sections 61(a) and 61(a)(1).

The Court also grants the Service’s motion for a $5,000 section 6673(a) fine. The best part of the opinion is the following 32-year-old quote from Hatfield v. Comm’r, 68 T.C. 895, 899 (1977):

In recent times, this Court has been faced with numerous cases, such as this one, which have been commenced without any legal justification but solely for the purpose of protesting the Federal tax laws. This Court has before it a large number of cases which deserve careful consideration as speedily as possible, and cases of this sort needlessly disrupt our consideration of those genuine controversies. * * *

Many citizens may dislike paying their fair share of taxes; everyone feels that he or she needs the money more than the Government. On the other hand, as Justice Oliver Wendell Holmes so eloquently stated: “Taxes are what we pay for civilized society.” Compania de Tabacos v. Collector, 275 U.S. 87, 100 (1927). The greatness of our nation is in no small part due to the willingness of our citizens to honestly and fairly participate in our tax collection system which depends upon self-assessment. Any citizen may resort to the courts whenever he or she in good faith and with a colorable claim desires to challenge the Commissioner’s determination; but that does not mean that a citizen may resort to the courts merely to vent his or her anger and attempt symbolically throw a wrench at the system. ***

Analysis

Mr. Samples’s argument sounds like a very twisted application of John Locke’s Theory of Labor. Locke theorized that when a person “mixes his labor with” the land, their labor becomes part of the land, and thus imparts land ownership to the laborer. But, as pointed out by the Tax Court, whether a person receives money or property in exchange for his labor, he has received income.

Defense of Marriage Act

I blogged yesterday (here), that the Tax Court denied same-sex couples the married filing jointly status on their 2004 and 2005 tax returns. At the end of the post, I suggested that Mr. Merrill is probably filing MFJ with his partner Mr. Boyle now, since they were legally married in 2008.

I would like to make clear, however, that the IRS rejects same-sex marriages recognized by State law in Publication 17. Though in its opinion the Tax Court cited case law that marital status is determined by the taxpayer's State of domicile, the Defense of Marriage Act (DOMA) nullifies those cases for same-sex couples. DOMA, passed in 1996, states:

In determining the meaning of any Act of Congress, or of any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States, the word “marriage” means only a legal union between one man and one woman as husband and wife, and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife.

This phrase was codified in Title 1, Section 7 of the United States Code.

Tax Court Denies Domestic Partners MFJ Status

Merrill v. Comm’r, T.C. Memo. 2009-166 (T.C. 2009).

Mr. Merrill (yes he’s related to a Merrill Lynch founder) did not file tax returns for 2004 or 2005. When the IRS prepared the returns on his behalf they used the single filing status. Mr. Merrill asserts that he should be afforded the married filing jointly (MFJ) status because he is in a long-term domestic partnership with Mr. Boyle, his partner of 18 years.

During the years at issue, Mr. Merrill and Mr. Boyle lived in North Carolina. North Carolina did not then – and does not today – recognize same-sex marriages. In 2008, Mr. Merrill and Mr. Boyle moved to California and were legally married.

The issue for the Court is whether a long-term domestic partnership qualifies for the married filing jointly status.

Section 7703(a)(1) states that an individual’s marital status shall be determined at the end of the tax year. “Whether a taxpayer is married for Federal income tax purposes is determined by reference to the laws of the State of the taxpayer’s marital domicile.” Further, “where a taxpayer did not file a return and a substitute for return was prepared using single filing states, the taxpayer may claim married filing joint status only by subsequently filing a return.”

The Tax Court upholds the single filing status because Mr. Merrill did not file a return claiming the MFJ status after the IRS prepared his return using the single filing status. The Court points out that Mr. Merrill admitted he was not legally married under the laws of any state during 2004 or 2005, but it does not appear this was the basis for their decision.

Next, Mr. Merrill argues that the Tax Code discriminates against same-sex couples in violation of their constitutional rights. The Court does not address this argument but rather cites case law, which has consistently denied these types of constitutional claims brought by not only same-sex couples, but married and single persons alike.

Mr. Merrill also challenges the constitutionality of the Defense of Marriage Act (DOMA). The Court does not address the constitutionality of DOMA because that question is irrelevant to Mr. Merrill’s filing status.

The California Quandary

The Court seems to suggest that had Mr. Merrill and Mr. Boyle been married under the laws of their State of domicile they would be afforded the MFJ status. As stated, the couple was legally married in 2008 under the laws of California. Since that time, however, California has overturned their same-sex marriage laws (here). Presumably, Mr. Merrill’s marriage was preserved by the Calif. Supreme Court’s ruling since it was already in existence prior to the passing of Proposition 8. I would expect, therefore, that Mr. Merrill and Mr. Boyle are now filing tax returns under the MFJ status.

Other blogs referencing this case:

TaxProf

TaxGirl

Pensions and Divorce Agreements

Strand v. Comm’r, T.C. Summary Opinion 2009-103 (T.C. 2009).

Pursuant to a Property Settlement Agreement entered into in 1980, 75% of Mr. Strand’s military retirement pension payments were payable to Mrs. Strand.

In 2004 and 2005, Mrs. Strand received $12,621 and $12,952 respectively. The Defense Finance and Accounting Services (DFAS) issued Mrs. Strand a 1099-R, but she did not report the amounts on her tax returns. The IRS issued a notice of deficiency for each year. Mrs. Strand filed a petition disputing the deficiencies.

Generally, amounts received from pension accounts are taxable under section 61(a)(11). Mrs. Strand makes three arguments against including the the payments in gross income. The third argument will not be addressed in this post.

The first argument is that 2004 and 2005 is the first time since 1986 – when the payments started – that she has been required to include the amounts in gross income. The Tax Court rejects the first argument because “each tax year stands on its own and must be separately considered.” Further, “It is well settled…that the Commissioner cannot be estopped from correcting a mistake of law, even where a taxpayer may have relied to his detriment on that mistake.”

Second, she argues that the payments are divisions of property thus excludable from income under section 1041. Section 1041 states that no gain or loss shall be recognized on a transfer of property between spouses under a divorce agreement. For example, if H and W agree, as part of their divorce, that W gets 100% of H’s stock in General Electric, then under section 1041 W does not have to recognize gain on receipt of GE stock. W does, however, have a capital gain when she sells the stock. Her gain will be equal to the sale price less H’s basis. Sec. 1041(b). H’s basis in the GE stock is generally what he paid for it. Sec. 1012.

The Tax Court first points out that section 1041 is inapplicable because the property settlement occurred prior to section 1041’s enactment. Relying on prior case law, however, the Court holds that when Mrs. Strand received an interest in her ex-husband’s military retirement account she recognized no gain or loss. But, a pension is “simply a right to receive a future income stream from the retiree’s employer.” Since neither she nor her ex-husband had basis in that “income stream”, the payments from the account are taxable.

Qualified Domestic Relations Orders

It is worth pointing out that the pension payments, like the ones here, are also taxable today to Mrs. Strand under section 72 and section 402(a).

Mrs. Strand is considered an “alternate payee” under section 402(e)(1). An alternate payee is a spouse or former spouse who receives retirement distributions under a qualified domestic relations order (“QDRO”). As such, she is treated as “the distributee of any distribution payment made.” Under section 402(a), amounts distributed to a distributee are taxable to the distributee under section 72.

Passive Activity Losses and LLC Interests

Garnett v. Comm’r., 132 T.C. No. 19 (T.C. 2009)

This is considered by many a very important decision by the Tax Court and was addressed several days ago in the Wall Street Journal (here). I was not very fond of WSJ's explanation. I invite you to compare and contrast this analysis with what the article stated.

The Garnett’s Entity Holdings

The Court decides here ‘what the law actually says,’ and not ‘did the taxpayer comply with the law,’ the facts, therefore, are somewhat irrelevant. A brief explanation, however, to set the background is helpful.

The taxpayers, the Garnetts, owned interests in several partnerships. GFF stands for Garnett Family Farms. Through their various GFF, LLC entities, the taxpayers owned interests in 6 LLPs, 1 LLC, and 2 entities considered Tenants-In-Common. They directly owned interests in 1 LLP and 1 LLC. A diagram is worth more than a thousand words here.

On their 2000 through 2002 tax returns, the Garnetts reported income and losses that flowed through to them from their interests in the LLPs and LLCs. The IRS asserts that the Garnetts hold their interests as “limited partners” and are therefore subject to the limitations imposed by section 469(h)(2).

Passive Activity Rules and Seven Material Participation Tests

Section 469(a) disallows losses associated with passive activities. A passive activity is defined – in sec. 469(c) – as a trade or business in which the taxpayer does not materially participate. Section 469(h)(1) states, taxpayers who are involved in an activity on a “regular, continuous, and substantial” basis are treated as materially participating. Section 469(h)(2) provides an exception for interest in limited partnerships. Under 469(h)(2) a taxpayer whose interest is held in a limited partnership is not treated as materially participating except as provided by the regulations.

The regulations, sec. 1.469-5T(a), set out seven ways in which a taxpayer can show material participation. In the case of 469(h)(2) limited partnership interests, however, only three of the seven can be used to determine material participation. Those three are (1), (5), and (6). Sec. 1.469-5T(e)(2). Consequently, it is more difficult to establish material participation if the taxpayer’s interest is considered a 469(h)(2) interest. The seven tests are as follows:

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

The really important test is (4). This is where most taxpayers can satisfy the material participation test. This test allows taxpayers to aggregate significant participation activities. A significant participation activity is a trade or business activity where the taxpayer participates for more than 100 hours during the year. By aggregating significant participation activities the 500 hour threshold for test (4) becomes much easier to reach.

Tax Court Holds an LLC/LLP Interest is not Covered by Section 469(h)(2)

The Tax Court points out that aside from one State, LLCs and LLPs were not even in existence at the time Congress passed 469(h)(2). It is therefore unlikely Congress contemplated these entity types when the legislation was drafted.

As justification for 469(h)(2) the legislative history takes particular note, that a limited partner necessarily voids his or her liability protection by materially participating in the partnership’s business. As a result, there is a presumption that the limited partner is passive. The legislative history also states the “Secretary would have regulatory authority to treat ‘substantially equivalent entities’ as limited partnerships for purposes of section 469(h)(2).”

The Tax Court contrasts the legal characteristics of limited partnerships with limited liability partnerships and limited liability corporations; one difference appears determinative. An LLC member or an LLP partner maintain their liability protection even though he or she materially participates in the partnership’s business. Thus, the presumption mentioned earlier seems misplaced when applied to LLC and LLP interests.

What Really Changes

In an earlier decision, Gregg v. United States, 186 F. Supp. 2d 1123 (D. Or. 2000), the Oregon District Court came to the same conclusion as the Tax Court. The difference being that decision was authority for taxpayers in the 9th Circuit, while the Tax Court’s decision here applies to all taxpayers.

My research in this area revealed that most secondary sources already indicated a lack of statutory support for the IRS’s position in this case. Consequently, I think most tax return preparers already used all seven tests to determine material participation for LLC members.

The Garnett’s case is just getting started. They still have to prove they materially participated in each of their eleven entities, although now it will be a little easier. In addition, as was before this case, they have to satisfy the at-risk rules of section 465 and the partnership basis rules of section 704 to deduct losses.

The Tax Court, at the request of the Service, ignored the indirect ownerships when interpreting 469(h)(2). Question for the readers – assuming there are any – which entity do the Garnett’s apply the material participation tests to? The GFF entities or the second tier?

Litigation Costs Awarded to Taxpayer

Fitzpatrick v. Comm'r, T.C. Summary Opinion 2009-102 (T.C. 2009).

I recently had a discussion with the Internal Revenue Service regarding a client’s account. The customer service representative kept saying to me, “the computer says…” At one point I wanted to say, “let me speak to the computer, because the human here is not helping.”

Mr. & Ms. Fitzpatrick felt the brunt of the Service’s bureaucracy, but at least in the end they received restitution. I have taken a few liberties with the facts here for comedic effect…but not many.

The Story of Bud and Sally

The problems started when the IRS’s computer (let’s call him Bud) sent a notice to the Fitzpatricks in March 2007 indicating they failed to report $22,581 in social security benefits on their 2005 tax return. Bud apparently received an SSA-1099 and matched the form to their 2005 return. When Bud identified a mismatch, he generated a deficiency notice.

The taxpayers responded to Bud with a letter stating they did not qualify for nor did they receive social security benefits during 2005. In response, Bud instructed them to get a letter from the Social Security Administration acknowledging the mistake. After contacting the SSA, Mr. Fitzpatrick learned he was due $196.00 in survivor’s benefits but that nothing had been paid in 2005. Naturally, SSA’s computer (let’s call her Sally – equal opportunity) failed to provide documentation, so Bud sent another deficiency notice in August 2007.

In November 2007, the taxpayers filed a petition with the Tax Court. Not long after, Bud assigned the case to an Appeals officer – finally a human! The Appeals officer’s records indicate several conversations with the Fitzpatricks and their representative, an Enrolled Agent. The AO’s records – really Bud’s records - indicate the difficulty the Fitzpatricks faced trying to contact and obtain a corrected SSA-1099 from Sally. There is no indication, however, that anyone from the Appeals office attempted to call a human where Sally works.

Attempts to contact Sally still failing, the AO processed the case for trial. In early July 2008, as part of the pre-trial activities, a paralegal (human) from the IRS hand-delivered a letter to the Boston SSA office to obtain certified records for trial. The SSA office responded; viola! Sally issues a corrected 1099.

Issue for the Tax Court

In total, the Fitzpatricks spent $3,982 in court fees trying to resolve the error started by Sally and compounded by Bud. The issue for the Tax Court is whether the Fitzpatricks are due litigation costs under section 7430.

Sections 7430(a) and (b) allow reimbursement for reasonable administrative costs and reasonable litigation costs to the prevailing party, unless the prevailing party either unreasonably protracted the proceeding or has not exhausted available administrative remedies.

The IRS concedes all the requirements here except that the Fitzpatricks are a prevailing party as that term is defined in section 7430(c). A prevailing party means, a party that has “substantially prevailed” with respect to either an amount in controversy or a significant issue. section 7430(c)(4)(A)(i)(I), (II). If, however, the IRS substantially justifies their position, then no party is considered the “prevailing party.” section 7430(c)(4)(B).

The Court points out that Tax Payer Bill of Rights 2 shifted the burden under 7430(c)(4) from the taxpayer to the IRS. Thus, the IRS must produce evidence their position was substantially justified. The IRS need only show they “acted reasonably on all facts and circumstances and the legal precedents relating to the case…” to substantially justify their position. In addition, under section 6201(d):

In any court proceeding where a taxpayer asserts a reasonable dispute with respect to income reported on a third-party information return and fully cooperates with the IRS, ‘the Secretary shall have the burden of producing reasonable and probative information concerning such deficiency in addition to such information return.’(emphasis added).

The IRS argues they acted reasonably by relying on the third-party information reported by the SSA. The Fitzpatricks argue that once the IRS was informed in mid-2007 that the SSA-1099 was erroneous it was not reasonable to litigate the case without first meeting their burden under 6201(d).

The Court agrees with the Fitzpatricks. The IRS did not meet their burden under 6201(d) until July 2008 (remember the human paralegal), three months after the Court issued a notice of trial. “Thus, on this record, it is clear that between the filing of the petition in November 2007, and the paralegal’s inquiry in July 2008, respondent did not conduct any independent investigation despite petitioners’ continuing challenge to the accuracy of the Form SSA-1099.”

The IRS makes several policy argument in response to the Court’s holding. Among others, they suggest that the decision will require them to validate all third-party information returns prior to issuing a notice of deficiency. They also argue the administrative burden would be both “unreasonable and overwhelming.”

The Court rejects both arguments by pointing out that section 6201(d) “does not apply to prelitigation actions.” “The issue here is whether respondent was reasonable in adopting and maintaining the administrative position as his litigation position, in view of the affirmative duty imposed by section 6201(d)…”

Unfortunately, or fortunately depending on your view, this case no precedential weight and it may not be appealed, because it is subject to the provisions of section 7463(b).

Vehicle Expenses & Substantiation Requirements

The Tax Court provides a thorough explanation of the section 274(d) substantiation requirements for vehicle expenses otherwise deductible under section 162(a).

The taxpayer is self-employed in the promotions and marketing business. She regularly travels to client sites changing out displays and advertising signs. She did not file a tax return for 2003, as a result the IRS prepared one for her pursuant to section 6020(b).

The are two issues for the Tax Court. First, is the taxpayer allowed a mileage deduction for vehicle expenses. Second, is she liable for penalties under 6651(a)(1) and (2), and 6654(a).

Section 162(a) allows a deduction for ordinary and necessary expenses incurred or paid in carrying on a trade or business. Section 274(d) disallows all travel expenses, including vehicle expenses, otherwise allowed under section 162(a), unless the taxpayer substantiates the expenses with adequate records. The taxpayer's records must include the amount, time and place, business purpose of the expense, and business relationship between the taxpayer and the person entertained, etc.

Acceptable forms of records include "an account book, a diary, a log, a statement of expense, a trip sheet, or a similar record and documentary evidence that in combination are sufficient to establish each element of expenditure or use." see Temp. Reg. 1.274-5T(c)(2)(i). Records should be made at or near the time of the actual expenditure or use. As elapsed time increases, the record's credibility decreases. see Temp. Reg. 1.274-5T(c)(2)(ii).

Here, the taxpayer testified that she kept a mileage booklet but unfortunately she could not find it for trial. She also provided a mileage trip list for 2003, but she stated at trial that she prepared the list in 2007 - after the IRS sent her the notice of deficiency at issue in the case. She also produced several different reports showing client names and the dates she serviced their accounts.

The Court holds for the Service because the taxpayer’s records were not made "at or near the time" she incurred the vehicle expense. Thus she did not meet the substantiation requirements. As such, she is not allowed a mileage deduction. There is nothing in the opinion regarding actual vehicle expenses.

The IRS also assessed penalties for failure to file her 2003 tax return, failure to pay the tax shown on the return, and failure to pay estimated taxes. The Tax Court (in fact the same Judge) dealt with this identical topic here. As was the case with Ms. Humes, the IRS did not produce evidence of the taxpayer's 2002 return, thus the Court abated the 6654(a) failure to pay estimated tax penalties. The failure to file and failure to pay penalties under 6651(a) were sustained.

This opinion is subject to section 7463 and may not be used as precedent for any other case.

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Penalties And Reasonable Cause

This opinion is subject to section 7463(b), which means the opinion may not be treated as precedent for any other case (even though this information is in the opinion, I will provide this disclosure going forward if applicable). This, however, does not diminish its usefulness. Private letter rulings, for example, may not be used as precedent either under section 6110(k)(3), however, many practitioners use them as guidance in analyzing particular fact and law scenarios.

Summary

There are three penalty sections at play in this case: 6651(a)(1), 6651(a)(2), and 6654(a). The taxpayer concedes she is liable for a deficiency for her 2003 and 2004 tax returns. But she contests penalties imposed under 6651(a)(1) & (2), and 6654(a).

Section 6651(a)(1) imposes a penalty for failure to file a tax return. Section 6651(a)(2) imposes a penalty for failure to pay tax shown on a tax return. And Section 6654(a) imposes a penalty for failure to pay estimated income tax. To overcome a section 6651(a) penalty the taxpayer must show the failure was due to reasonable cause and not due to willful neglect – see language in same section.

To overcome a section 6654(a) penalty, in addition to reasonable cause, the taxpayer must either be disabled, or 62 and retired – see section 6654(e)(3)(B) . For the section 6654(a) penalty there is also a provision under 6654(e)(3)(A) that gives the Secretary discretion to waive the penalty because of casualty or disaster, and under circumstances which would be against equity and good conscience.

The taxpayer, Ms. Humes, was experiencing emotional problems during the years at issue. The only evidence offered by Ms. Humes at trial regarding her illness was her own testimony. She testified that she stopped working in August 2004, was hospitalized the same month, and was one year in arrears on her mortgage payments. Her house was foreclosed on in 2005. The Tax Court acknowledges that there are circumstances in which a taxpayer's illness may constitute reasonable cause for all three penalties imposed here.

Section 6654(a) Penalties

The Tax Court disposes of the 2003 section 6654(a) penalty without any reference to Ms. Humes’s illness. Under 6654(c) & (d), estimated tax payments equal to 25% of the “required annual payment” are due in four equal installments. The required annual payment is the lesser of 90% of the current year’s tax, or 100% of the prior year’s tax. The 100% prior year tax clause does not apply in cases where the tax return was not filed in the prior year.

The IRS did not introduce any evidence that Ms. Humes failed to file her 2002 tax return. If she did file it, they did not introduce evidence of the 2002 tax shown on the return. Without any indication as to Ms. Humes’s 2002 tax return, the Court must apply the formula as written without exception. Consequently, under the 6654(d) formula Ms. Humes’s required annual payment for 2003 is $0.00 (100% of the prior year = $0.00; which is always going to be less than 90% of the current year’s tax). Either the IRS was not prepared for trial, or they did not understand the law.

Since the IRS was auditing both 2003 and 2004, there was ample evidence on the record that Ms. Humes was liable for 2004 estimated tax payments. Using the 6654(d) formula for the 2004 tax year, the 100% clause applies to the 2003 tax return admitted at trial. The Court, nonetheless, agrees with Ms. Humes that her illness met the definition of a disability under 6654(e)(3)(B)(i)(II) and abates the failure to pay estimated tax penalty.

Section 6651(a)(1) and (2) Penalties

The Tax Court sustains both penalties for 2004, but finds Ms. Humes established reasonable cause for 2003 and abates the penalties for that year.

2003 Penalties

In April 2004, Ms. Humes filed for an extension, thus the 2003 tax return’s due date was August 15, 2004. She testified at trial that her illness prevented her from working after August 2004 and that she was hospitalized in the same month. The Tax Court agrees this is enough to show reasonable cause under 6651(a)(1) for failure to file a tax return. Ms. Humes also testified that she was not able to manage her finances in 2004, she was one year in arrears on her mortgage payments, and the mortgage was foreclosed in 2005. The Court agrees here as well, Ms. Humes established reasonable cause for failure to pay the tax shown on her 2003 return.

2004 Penalties

Ms. Humes loses here because she failed to introduce evidence of her illness in 2005 and its impact on her ability to file her 2004 tax return and pay the tax shown on the return. In contrast to April 2004 where Ms. Humes at least filed for an extension, there is nothing in the opinion regarding her efforts to comply with the 2004 filing requirement in April 2005. She also provided no evidence regarding her ability to pay the tax shown on her 2004 tax return. Such evidence could include her income, assets, and liabilities in 2005.

Analysis

It seems the Tax Court was more than willing to help Ms. Humes, but they were not going to make her case for her. Producing evidence at trial is critical. In this case both sides lost an issue simply because they failed to produce evidence.

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Collection Due Process Hearings

This case is important because the IRS is issuing levies left and right these days. This opinion is a good discussion of section 6330, notice and opportunity for hearing before levy.

How does a seemingly simply issue turn into an almost fifteen year dispute with the IRS? Ask the Kovaceviches. The issue is seemingly simple. The Kovaceviches say that the IRS did not properly apply five checks to their outstanding tax liability from 1992. Twenty-eight pages later the Tax Court says the IRS did apply the payments properly. In the interest of full-disclosure, there is a lot of the opinion I am leaving out.

The 1992 dispute started when the IRS determined Mr. Kovacevich was an employee of his law firm and not an independent contractor. Mr. K. challenged the determination in tax court and lost. As a result, his law firm owed back employment taxes. Mr. K’s business deductions as an independent contractor were disallowed, as well as his personal deduction for ½ self-employment tax paid. The law firm’s employment tax liability was settled by the self-employment taxes paid by Mr. K. The payments were credited to his firm’s liability pursuant to section 3402(d).

In April 2005, the Service sent Mr. K a notice of intent to levy for amounts still owed from 1992. Between the 1992 and today, the following events transpired:

1. 1999 – IRS deficiency notice for 1992 tax year
2. 2003 – Tax Court upholding deficiency notice
3. 2006 – Ninth Circuit upholds Tax Court’s decision

In response to the levy notice, the K’s requested a collections due process (CDP) hearing and presented copies of four checks they claimed were not applied to the 1992 tax year. The appeals officer upheld the levy because she considered the K’s “misapplied check” argument a challenge to the underlying tax liability; a matter not within the scope of a levy hearing under 6330(c)(2)(B).

The IRS concedes the officer’s reading of 6330(c)(2)(B) an error. Nonetheless, the Tax Court lays out a fine analysis of section 6330(c) beginning on page 12. The language of (c)(2)(A) states, “a person may raise at the hearing any relevant issue relating to the unpaid tax or the proposed levy…” Since the K’s did not challenge the liability rather the unpaid amount, their check theory was within the scope of a hearing

Interestingly, because the appeals officer’s incorrect reading of 6330(c) is an “error of law . . . she necessarily abused her discretion, unless her error was harmless.” To show harmless error, the IRS asserts that the exclusion to 6330(c)(2)(A) under (c)(4) applies. Under 6330(c)(4) an issue “raised and considered at previous administrative or judicial proceeding” may not be raised again. Since one of the checks at issue was considered by the Tax Court at the 2003 deficiency trial it could not be properly considered at the CDP hearing.

To show harmless error for the remaining four checks, the IRS would need to show the checks were applied properly in the first place. Each check was considered in turn by the Tax Court. The Tax Court states, “a taxpayer who makes a voluntary payment may designate which liability he or she wishes to pay.” The Court then conducts an exhaustive analysis between the IRS’s records and the writings on each of Mr. K’s checks. Only one of Mr. K’s checks indicated the 1992 tax year. The other checks had writings that indicated other tax years and were properly applied accordingly.

The obvious problem with Mr. K’s argument – the Court points this out – is that if it is assumed for the sake of argument that the IRS erroneously applied his checks, he still owes money. The checks were in fact applied to one of the K’s tax liabilities. So shifting the checks from one tax year to another gets him nowhere. It suggests Mr. K’s motives for the fight were illogical from the start.

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Day Trading & Trade or Business Expenses

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.

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