The Tax Law Report

Divorce Decree not Controlling for Innocent Spouse Relief

Acoba v. Commissioner, T.C. Summ. Op. 2010-64 (2010)

The Tax Court held that a divorce decree allocating existing tax liabilities equally between spouses is not controlling for innocent spouse relief claims.

Petitioner and Mr. Acoba divorced on June 13, 2002. As part of the judgment of divorce, petitioner and Mr. Acoba each agreed to pay “50% of Internal Revenue Service debt for back taxes, interest, and penalties”. (3).

Petitioner argues that she should be liable for only 50 percent of the liabilities for the years at issue as provided in the divorce decree. (7).

Section 6013(d)(3) provides that if a joint return is filed, the tax is computed on the taxpayers’ aggregate income and liability for the resulting tax is joint and several. See also sec. 1.6013-4(b), Income Tax Regs. But the Internal Revenue Service (IRS) may relieve a taxpayer from joint and several liability under section 6015 in certain circumstances.  (5).

To obtain relief from joint and several liability, a spouse must qualify under section 6015(b), or, if eligible, may allocate liability under section 6015(c). In addition, if relief is not available under section 6015(b) or (c), a spouse may seek equitable relief under section 6015(f). (5).

This case does not involve a deficiency or an understatement of tax and, therefore, relief under section 6015(b) and (c) is not available to petitioner. (5).

Rev. Proc. 2003-61, sec. 4.01, 2003-2 C.B. at 297, sets forth seven threshold conditions that must be satisfied before the Commissioner will consider a request for equitable relief under section 6015(f). (7).

[A]fter weighing all the factors, the Court concludes that petitioner’s intimate involvement in the financial matters of the marriage and her knowledge of the protracted financial decline of the marriage should have put her on notice that filing a joint Federal income tax return was, for her, a poor choice. (13-14).

Unfortunately for Ms. Acoba, as the tax court points out, her divorce agreement does not defeat her "joint and several" liability for unpaid taxes.  This means the IRS can pursue either of them for 100% of the tax liability, regardless of their private agreement to share the burden equally.  If Ms. Acoba pays the entire amount, either voluntarily or involuntarily via IRS levy, the divorce decree will serve as her means for getting reimbursed by her husband.  Of course, if he has no money, she is going to have a hard time collecting.  She effectively becomes an unsecured creditor of her ex-husband, not a good place to be.

Taxpayer Discarded Day Planner, Mileage Deduction Denied

Menzies v. Commissioner, T.C. Summ. Op. 2009-196 (2009).

Question for the Tax Court

May Mr. Menzies deduct unreimbursed employer expenses for business use of his personal vehicle even though he discarded the day planner that he recorded his mileage in?

Background

Mr. Menzies held two jobs during 2005 interspersed with two periods of unemployment.  (2).  During the first half of 2005, he worked as a fire restoration field technician. (2).  During the second half of 2005, he worked as a field operations supervisor for a security company. (2).  Both jobs required Mr. Menzies to use his personal vehicle to travel during the day to various jobsites. (3).

The taxpayer deducted $18,649 in unreimbursed employee business expenses on schedule A of his 2005 tax return. (4).  The expenses consisted of $12,249 for business use of his personal vehicle, $400 for travel, and $6,000 for other miscellaneous unreimbursed employee business expenses. (4).

The IRS disallowed the taxpayer's entire deduction for lack of substantiation. (5).

Law for Unreimbursed Employee Business Expenses

Section 162(a) allows a deduction for ordinary and necessary expenses incurred during the taxable year in carrying on a trade or business. (6).  Generally, the performance of services as an employee constitutes a trade or business.  Primuth v. Commissioner, 54 T.C. 374, 377 (1970). (6).  For such expenses to be deductible, the taxpayer must not have received reimbursement and must not have the right to obtain reimbursement from his employer.  See Orvis v. Commissioner, 788 F.2d 1406, 1408 (9th Cir. 1986), affg. T.C. Memo. 1984-533. (6).

If a taxpayer establishes than an expense is deductible but is unable to substantiate the precise amount, the Court may estimate the amount, bearing heavily against the taxpayer whose inexactitude is of his own making.  Cohan v. Commissioner, 39 F.2d 540, 543-44 (2d Cir. 1930) (the Cohan rule or simply Cohan). (6).

Section 274(d), however, supersedes the Cohan rule with regard to certain expense.  Section 274(d) requires stricter substantiation for . . . travel, meals, and listed property such as personal automobiles. (7).

Answer from the Tax Court: no record, no deduction

[Here], the taxpayer calculated the amount of the deduction ($12,249) by multiplying the business mileage by the standard mileage rates in effect during 2005. (8).  Each workday, the taxpayer recorded the mileage from his first worksite to the last worksite of the day in a "day planner". (8).  He noted all the sites he visited during the day; however, he did not record the mileage between sites. (8).

Mr. Menzies testified that he discarded his day planner in 2007, sometime after filing his 2006 return and receiving his refund, because he felt the documentation was no longer necessary. (8).  He was therefore unable to produce any records to substantiate the business mileage, and, further, he did not attempt to reconstruct a record of his business mileage. (8).

The Court believes Mr. Menzies incurred unreimbursed vehicle expense related to his work . . . during 2005.  However, the Court may not estimate vehicle expenses under Cohan.  Therefore, we must sustain the IRS's determination. (9).

NOTE:  The Court also sustained the IRS's determination with respect to the $400 in travel expenses, but did allow 50% of Mr. Menzies' $6,000 in other miscellaneous unreimbursed items; subject to the 2% floor of course.  I think they felt sorry for him!

Blog Comments

Ouch! This was a very harsh lesson for the taxpayer.  Taxpayer's should keep records supporting the amounts on their tax returns for at least three years.  The IRS makes this very clear on page 91 of the Form 1040 instructions.  Of course, I am sure taxpayers thoroughly read the Form 1040 instructions before preparing their tax returns, all 174 pages!

Having read several tax court opinions over the last six months, it has become very apparent that the IRS's "go to" argument against taxpayers is lack of substantiation for their deductions.  Given the importance of record keeping, the three-year guidance should be front and center on the instructions to every tax form, not buried 91 pages into a 174 page document.

Moreover, Mr. Menzies claimed his unreimbursed employee business expenses on Form 2106-EZ.  The instructions for this form do not even mention the three-year record keeping requirement, only that records must be kept.  As applied here, Mr. Menzies did keep records, he just did not keep them long enough.

Charitable Contributions, Detrimental Reliance, and Notice of Deficiency

Ragassa v. Commissioner, T.C. Summ. Op. 2009-166 (2009).

This case was recently featured on TaxProf Blog because of the Tax Court's novel application of the Cohen rule to Mr. Raggassa's charitable contribution deductions.

Questions for the Tax Court

1. Does lack of substantiation preclude deductions for charitable contributions?
2. Is a preliminary notice from the IRS, for example a 30-day letter, required before the IRS can assess a valid deficiency?
3. Is the IRS bound by the communications of its representatives, even if the taxpayer relies on those communications to their detriment?

Background

Mr. Regassa claimed the following deductions on his 2005 Tax Return. (4).  The IRS disallowed a large portion because Mr. Regassa could not substantiate the deductions taken.

 

Mr. Regassa claims that he did not receive any preliminary notices, such as the so-called 30-day letter, that the IRS normally sends to taxpayers.  Therefore, depriving him of an opportunity to discuss the adjustments with the IRS before they determined his deficiency. (5).

He also claims that the IRS representative, Mr. Theodore, misled him during a conversation when Mr. Theodore said, the IRS was "all set" with respect to the adjustments.  Mr. Regassa interpreted Mr. Theodore's comments to mean he did not owe anything to the IRS.  Consequently, Mr. Regassa nearly missed the deadline to file a petition with the Tax Court upon discovering he still owed $1,575. (7-8).

Holding

The Tax Court answered "No" to question 2

Preliminary notices and administrative meetings may be courteous and may allow taxpayers to resolver early misconceptions by the Commissioner, but section 6212(a) (setting forth the requirements for issuing a notice of deficiency) or any other section does not require them. (6-7).  As long as the notice of deficiency reveals on its face that the Commissioner has made a determination for a particular year, in a particular amount, and after reviewing the information specific to the particular taxpayer, then barring unusual facts or circumstances not present here, the notice of deficiency is valid. (6).

The Tax Court answered "No" to question 3

[T]he Commissioner is empowered to retroactively correct mistakes of law, even where a taxpayer has relied to his detriment on the Commissioner's mistake.

The Tax Court answered "No" to question 1 (but see Blog Comments at the end of this post)

For each charitable contribution of money less than $250 made before 2006 the pertinent regulation requires that the taxpayer substantiate the contribution with a canceled check, a receipt, or other reliable evidence showing the name of the donee, the date of the contribution, and the amount of the contribution.

[P]recedents exist to all a Cohan estimate for charitable contributions, especially where we find the taxpayer was candid, forthright, and credible.  Stockwell v. Commissioner, T.C. Memo. 2007-149 (stating unconditionally that "We may estimate cash charitable contributions under the Cohan rule").

Mr. Regassa provided no substantiation of his charitable contributions.  However, the IRS's blanket disallowance goes too far.  Mr. Regassa's religious commitment appears genuine.  In summary, for charitable contributions, using our best judgment on the entire record before us, and under Cohan bearing heavily against Mr. Regassa's own inexactitude, we find it credible that at least once a month throughout 2005 Mr. Regassa attended and mad a cash contribution of at least $25 to a qualified Ethiopian Orthodox Church in Washington, D.C.

Blog Comments

While this decision might seem to give taxpayers a break, please take note the Tax Court recognizes Mr. Regassa's charitable deductions pertained to years before 2006.  Why is this important? Because the Pension Protection Act of 2006 added paragraph (f)(17) to section 107 of the Internal Revenue Code.  That paragraph reads as follows:

No deduction shall be allowed under subsection (a) for any contribution of a cash, check, or other monetary gift unless the donor maintains as a record of such contribution a bank record or a written communication from the donee showing the name of the donee organization, the date of the contribution, and the amount of the contribution.

This new provision provides no wiggle room and will mostly likely preclude taxpayers from arguing the Cohen rule in the future, at least with respect to charitable contributions.  The Tax Court should have pointed this out, or at least addressed it.

As a final note, the Tax Court also disallowed the insurance, auto and truck, and cost of goods sold deductions.  Mr. Regassa was apparently unaware of how his tax preparer had calculated these amounts.  And, gambling losses are only deductible to the extent of gambling winnings.

The Effect of Life Insurance Tax-Free Build-Up on the U.S. Treasury Coffers

Barr v. Commissioner, T.C. Memo. 2009-250 (2009).

This blog post is about the taxation of cash value life insurance policies upon termination.  For a good explanation of the insurance terminology used in this opinion click here.

Question for the Tax Court

Does surrender of a whole life insurance policy with a cash value greater than the net investment in the policy create ordinary income or capital gain? (2, 4).

Facts

In 1980, Harvey Barr, took out a whole life insurance policy on the life of his mother, Lillian Barr. (3).  The face amount of the policy was $200,000 and the annual premiums were $8,929.  (3).  For the first 8 or 9 years, Lillian paid the premiums indirectly by gifting the amount to Harvey. (3).  At the end of that time, "the policy borrowed against itself to pay the premiums; i.e. premiums were automatically paid from dividend accumulations and loans against the cash value of the policy." (4).

By 2005, the cash value of the policy was $361,353, the total indebtedness was $354,399, and the net investment in the policy was $225,390.  (4).  Mr. Barr "surrendered the policy effective December 20, 2005." (5) (the net investment in the policy approximately equals Mr. Barr's cumulative premium payments, e.g. $8,929 x 25 = $223,225).

The insurance co. mailed Mr. Barr a check for $11,648.33.  Then the insurance co. issued Mr. Barr a 1099-R from the insurance company "showing a gross distribution and taxable amount of $135,963.44 for 2005." (6)   He did not include this amount on his 2005 individual income tax return. (6).  The $135,963 is calculated by subtracting the net investment in the policy from the cash value of the policy.(wait! how come I am taxed on $135k but only got cash of $11k?)

Does the Taxpayer have Income?

Before determining whether the taxpayer's gain is ordinary or capital, the tax court first determines whether the taxpayer realized a gain at all. (6-7). 

Section 72(e)(5)(A) states that "[a]ny amount received upon the surrender of a life insurance contract which is not received as an annuity is specifically included in gross income to the extent that it . . . exceeds the investment in the contract." (6).

[Here], the total cash value, $361,353.58 . . . was withheld to repay the outstanding policy loan balance.  The satisfaction of the loan had the effect of a pro tanto [i.e. partial] payment of the policy proceeds to Mr. Barr and constituted income to him at that time.  Thus, Mr. Barr constructively received the policy's cash value of $361,353.58.  Mr. Barr's net investment at the time he surrendered the policy was $225,390.14  Accordingly, . . . he is taxable under section 72(e) on the [difference], $135,963.44

And if so, is it Ordinary or Capital Gain?

To recognize a capital gain or loss, Mr. Barr must have engaged in a "sale or exchange" of a capital asset.  Sec. 1222(1)-(4).  Generally, the lapse, cancellation, surrender, or termination of a contract does not equate to a sale or exchange. (8).  [Our cases hold that] the surrender of an insurance policy is not a "sale or exchange" of a capital asset and thus do not result in capital gain. (8).

Accordingly, we find the resultant gain is ordinary income . . . (9).

Blog Comments

The Effect of Tax Free Build-up on the U.S. Treasury Coffers

Mr. Barr paid cash to insurance co. for nine years in the form of premiums.  He then took a loan, albeit from insurance co., and used the proceeds of the loan to continue paying cash premiums to insurance co. from approximately 1989 to 2005.  When all is said and done, he has paid insurance co. approximately $225,390.

Next, insurance co. invests the premiums received from Mr. Barr and generates an investment return of $135,963 (called the "inside build-up").  Neither the insurance co. nor Mr. Barr pays taxes on this investment return while the insurance contract is in effect.  Quite a coup, but legal!  It is similar to a qualified retirement plan where the investment gains build-up tax free.

Mr. Barr, however, had a problem.  He owed the insurance co. $354,399 for the loans he took out to pay the policy premiums.  Where does he get the money from to pay this loan?  The cash value of the contract.

At the time he cashed out the policy, the insurance co. applied the cash value against Mr. Barr' outstanding debts.  As the court points out, this constituted "constructive receipt" of the policy's cash value.  It is as if the insurance co. paid Mr. Barr $361,353 and Mr. Barr then used that money to pay off his debt.  Because Mr. Barr's contract cost, i.e. net investment, was $225,390, he is only taxed on the difference between the cash value and his cost.  see Section 72(e).

Is it fair that Mr. Barr is credited with having received $135,963 but only $11,648.33 in cash was actually paid to him?  Indeed it is.  Had Mr. Barr paid the premiums with his own cash, instead of borrowing against the policy, he would have received $135,963 in cash when he surrendered the policy.  But because he borrowed money from the insurance co., he had to pay it back.  He could have forked over $354,399 to the insurance co. out of his own pocket, but presumably he did not have the money.  Therefore, he used the cash value of the life insurance contract to pay of his debt.

In effect, Mr. Barr held a life insurance policy for the better part of 20 years without having to pay single penny towards premiums.  It is now time to pay the piper.  Of course, Mr. Barr still has a great deal.  His tax bill is only $39,608 plus an accuracy penalty of $7,922 for a total of $47,530.  If you recall, his yearly premiums were $8,929.  He held the insurance contract from 1980 to 2005, or 25 years.  Dividing the $47,530 by 25 = $1,901.  Effectively, his cost of the life insurance contract is reduced significantly. 

Who pays the difference between the $1,901 and the $8,929?  You and me of course!  Without the tax-free inside build-up, the cash value of Mr. Barr's insurance contract would have been reduced significantly.  Most likely, there would not be enough cash value to cover the policy loans, therefore Mr. Barr would have to pay this himself.  Instead, "We The People" help Mr. Barr pay for the life insurance contract on his Mother.

I think it's a bad deal for We The People, especially where the purpose was to pay for "the anticipated estate tax liability [on his Mom's estate]." (3).  So why doesn't Congress fix this?  Answer first this question:  who stands to get hurt the most if Congress starts taxing the inside build-up?  Insurance Companies.  Answer second this question:  do insurance companies lobby congress?  Need I say more?

Settlement of Disputed Debt Does Not Result in Cancellation of Debt Income

McCormick v. Commissioner, T.C. Memo. 2009-239 (2009).

Background

According to bank records, the taxpayers owed $8,042.10 to CitiFinancial and $2,875 to Chase. (2-3).  However, they disputed amounts owed. (2-3).  CitiFinancial agreed to settle the debt for $7,500 and Chase agreed to settle the debt for $1,000.  (2-3).  Both banks issued 1099-C's to the taxpayer for the difference between the settlement amount and the original amount of the debt. (2).  The IRS asserts that the taxpayers should recognize cancellation of debt (COD) income for this difference.  (1).

Cancellation of Debt Income (3)

Section 61(a)(12) includes in the general definition of gross income "income from discharge of indebtedness".  When the amount of a debt is disputed, "a subsequent settlement of the dispute would be treated as the  amount of the debt cognizable for tax purposes."  Zarin v. Commissioner, 916 F.2d 110, 115 (3d Cir. 1990) (holding that unenforceable debt is also disputed as to amount, and its settlement does not give rise to cancellation of indebtedness income).  There must be evidence of a dispute; a settlement standing alone does not prove that a good-faith dispute existed.

Evidence of Bona Fide Dispute Existed

Here, the taxpayers provided "evidence [that] supports a conclusion that a bona fide dispute existed regarding . . . the debt . . . ." (4).  The amount of the taxpayer's debt "that was definite and liquidated" was $7,549.66 and $1,000 for CitiFinancial and Chase respectively.  (5). Therefore, the taxpayer does not have cancellation of indebtedness income from Chase.  (5).  But they do have $49.66 of cancellation of indebtedness income from CitiFinancial.  (5).

Blog Comments

This case represents a caveat to COD income section of the tax code.  But, the dispute must bona fide, and the taxpayer must provide evidence of the dispute.  The Zarin case is on of the primary authorities on this topic.  In Zarin, a New Jersey casino allowed the taxpayer to run up a huge gambling debt, despite a State law that required the casino to limit the amount of credit extended to a single player.  Because the debt was not enforceable by the casino, the taxpayer and the casino settled their $3.5 million debt for $500,000.  The Third Circuit held that because the debt was unenforceable it was not liquidated.  It concluded the liquidated debt, and the amount of debt relevant for section 61(a)(12), was the $500,000.

This caveat may not help many taxpayers in these trying times because the debts being settled are normally not disputed debts.  But in the rare case that disputed debts are settled for less than the disputed amount, tax professionals should consider whether this disputed debt exception is helpful to clients.

Taxpayer's Reliance on "Internet Sources" Not Reasonable Cause, Accuracy-Related Penalty Assessed

Woodard v. Commissioner, T.C. Summary Opinion 2009-150 (T.C. 2009).

Question for the Tax Court

Does Mr. Woodard's reliance on unknown internet resources constitute reasonable cause for purposes of avoiding the accuracy-related penalty under section 6662(a)?

Background

Mr. Woodard received $100,000 from his IRA and deposited that amount into his personal checking account in 2004. (3).  In February 2005, Mr. Woodard wired funds to Amanda M. Mahn pursuant to demand notes and statutory mortgage documents . . . [naming] Ms. Mahn as debtor and Hunter Financial, LLC as lender. (3).  Mr. Woodard established Hunter Financial, LLC (Hunter) almost six months later in September 2005. (4).

The IRS determined that Mr. Woodard failed to include in income the $100,000 in distributions from his IRA and issued a notice of deficiency as well as assessed an accuracy-related penalty pursuant to section 6662(a). (2).

Mr. Woodard concedes the distributions are taxable but challenges the section 6662(a) accuracy-related penalty. (5).

In a separate action the Minnesota Court of Appeals voided the mortgage that granted Hunter a property interest because Hunter was not registered until September 2005, therefore it could not have taken delivery [of the mortgage] in February 2005. (5).

Requirements Under Section 6662

Section 6662(a) and (b)(1) and (2) imposes a penalty equal to 20 percent of any underpayment of tax that is attributable to negligence or disregard of rules or regulations or to a substantial understatement of income tax. (6). The term “negligence” includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws. (6). The term “disregard” includes any careless, reckless, or intentional disregard. (6).  An understatement of income tax is “substantial” if it exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000. (6).

Section 6664 provides a defense to the penalty if a taxpayer establishes that there was reasonable cause for the underpayment and that he acted in good faith.  (7). The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the pertinent facts and circumstances.  (7). 

Generally, the most important factor is the extent of the taxpayer’s effort to assess the proper tax liability, including reliance on the advice of a tax return preparer. (7).  An honest misunderstanding of fact or law that is reasonable considering the taxpayer’s education, experience, and knowledge may indicate reasonable cause and good faith. (7).

Mr. Woodard's Argument

Mr. Woodard explained that he thought he had a self-directed IRA and that he intended to reinvest the $100,000 in private mortgages. He searched the Internet for information about self-directed IRAs, and he followed advice he found on line. He deposited the $100,000 into his personal checking account and wired the funds from that account to Ms. Mahn as mortgagor. (8).

The Court's Analysis

Good-faith reliance on advice from an independent, competent professional as to the tax treatment of an item may meet the reasonable cause requirement. (9).  A taxpayer must act with ordinary business care and prudence to claim reasonable cause. (9).

Mr. Woodard claims that he relied on information found on unspecified Web sites written by unidentified individuals or organizations. (9).  From the record, it is not clear that he questioned the provenance or accuracy of the information he found through the Google search engine. (10).  Mr. Woodard has not provided the Court with any information about the sources of the information he found on the Internet. (9).  Without knowing the sources of the information, it is impossible for the Court to determine that those sources were competent to provide tax advice. (10).

Accordingly, we cannot conclude that Mr. Woodard exercised ordinary business care and prudence in selecting and relying upon the information he found on line. (10).

Blog Comments

The court's recitation of the facts was poorly written.  On the other hand their statement of the law and their analysis was well done.

This case is interesting because the court does not actually say Mr. Woodard could not meet his burden by using an internet source, rather Mr. Woodard did not provide the internet source he relied on therefore they could not continue their analysis.  Had he done that, the court presumably would need to visit the internet source and determine if the advice on the website met the "independent, competent professional" requirement.

Given the proliferation of tax advice on the internet in the form of newspaper articles, magazine articles, finance website, blogs, etc., I believe this is an area of concern for taxpayers.  My advice is to not use websites or blogs for tax advice, but if you do, this case should make clear that the taxpayer should document where the advice came from and inquire about the writer's competence to give advice. 

Additionally, most websites and blogs (like mine) have disclaimers regarding the use of information to avoid penalties imposed by the IRS.  I am not sure how this would effect the analysis for the taxpayer, but it probably would not be helpful to the taxpayer's argument.

Finally, the tax court footnotes on the last page of the opinion that credible information is on the internet; "such as, for example, the Internal Revenue Code and the income tax regulations."  Good Luck With That!

Courier Allowed Deduction for 234 Miles Per Day (i.e. 58,250 per year)

Freeman v. Commissioner, T.C. Memo. 2009-213 (T.C. 2009)

Question for the Tax Court

[Is] Mr. Freemen entitled to a deduction under section 162 for his mileage between his personal residence and job locations . . . .(3).

Background

During the tax years 1999 and 2000, Mr. Freeman . . . was a courier for Parts Distribution Xpress, Inc. (PDX), and auto parts delivery company. (4).  During the years at issue, Mr. Freeman was an independent contractor with respect to PDX. (7).

Mr. Freeman's job as a courier involved picking up auto parts at PDX's warehouse in Baltimore, Maryland, and delivering those parts to 15 or more of PDX's customers on a route that went through several cities in Maryland and Delaware. (4)

Mr. Freeman made these deliveries for PDX 5 days each week, 50 weeks each year, during the tax years at issue.  He used is own vehicles to make these deliveries and was not reimbursed by PDX for his mileage. (4-5). 

During tax years 1999 and 2000, Mr. Freeman's delivery route took the form of a loop through Delaware and Maryland, with 15 or more stops at automobile dealers and repair shops. (5).

Mr. Freeman apparently drover more than 148 miles to make his individual stops; but as we explain below, he did not substantiate the greater number of miles he actually drove on this route. (6).

Mr. Freeman kept a daily log of [his] delivery route . . . by recording daily his vehicles' odometer readings and his stops in a spiral-bound logbook. (8).  On November 13, 2004, Mr. Freeman's house . . . was destroyed by an accidental fire. (8).  Mr. Freeman credibly testified . . . that the logbook was destroyed along with his house in the 2004 fire. (8).

Mr. Freeman claimed deductions for 193,000 business miles on his Schedule C for 1999, and 129,000 business miles for 2000. (10).  [T]he IRS disallowed Mr. Freeman's claimed deductions for car and truck expenses . . . . (10).

Rule for Deducting Travel Expenses

In general, the cost of daily commuting to and from work is a nondeductible personal expense.  See Commissioner v. Flowers, 326 U.S. 465, 473-474 (1946); sec. 1.162-2(e), Income Tax Regs.  However, 'certain types of business-related travel have been found to be deductible', including 'local travel incurred while performing a job . . . and travel between jobs or job locations. (11).

In Lopkoff v. Commissioner, T.C. Memo. 1982-701, we observed that '[i]f traveling between two businesses is an allowable section 162(a) deduction, traveling within a business is most assuredly so.' (12).  A '[delivery] business is the travel itself.'  Id. (12).Therefore, any transportation expenses incurred in delivery business is travel within a business, and 'is most assuredly' deductible. Id. (12).

Miles are Deductible...

We find that Mr. Freemen is entitled to a deduction for his mileage, except for the mileage added by his commute to and from his residence. (3).  It is clear that [the] mileage [from Mr. Freemans' delivery route] arose from travel between two job locations . . . and travel within a business, and is deductible under either rationale if substantiated. (14).

Therefore, Mr. Freeman is entitled to deduct--if substantiated--the costs of 234 miles per workday, which represents (i) the 148 miles . . . on his delivery route; and (ii) the 86 miles between his last stop and PDX's warehouse.  The additional 24 miles . . . from his last stop to home and back [to the warehouse] constitute nondeductible commuting that arose from his personal choice to live off his route. . . . (16).

...If Substantiated

[S]ection 274(d) imposes stringent substantiation requirements for claimed deductions relating to the use of 'listed property', which is defined under section 280F(d)(4)(A)(i) to include passenger automobiles. (17) (see here for requirements).

'It is well established that the Tax Court may permit a taxpayer to substantiate deductions through secondary evidence where the underlying documents have been unintentionally lost or destroyed.' (18)

[T]he regulations under [section 274] allow a taxpayer to 'substantiate a deduction by reasonable reconstruction of his expenditures or use' when records are lost through circumstances beyond the taxpayer's control, including a fire. Sec. 1.274-5T(c)(5), Temporary Income Tax Regs. (19).

Having observed Mr. Freeman's appearance and demeanor at trial, we find him to be credible with respect to the route he drove . . . [and] that Mr. Freeman at one time possessed adequate documentation . . . to establish the required elements under section 274(d). (19).

Therefore, we hold that Mr. Freeman is entitled to deductions under section 162 for 234 miles for each of his 250 workdays (i.e. 58,250 miles) in both 1999 and 2000 using the applicable standard mileage rates. (22).

Comments

You have to wonder why the IRS put Mr. Freeman through the wringer.  Especially since it was 'clear' to the tax court his miles were deductible if substantiated. (14).

The more interesting issue here is whether Mr. Freeman was truly an independent contractor rather than an employee, particularly in light of the recent news that FedEx is challenging the IRS on this very issue (here).  If FedEx loses, all those drivers's unreimbursed mileage expenses (assuming that is the case) will go from fully deductible for independent contractors, like Mr. Freeman, to partially deductible subject to the 2% of adjusted gross income limitation. See IRS Publication 463. In other words, the Treasury has a lot of money on the table here besides employment taxes. 

Costs of Prostitutes and Pornographic Magazines Not Medical Expenses

Generally I do not 'jump' to post Tax Court opinions.  In fact, if you rely on my blog for tax news you may be the last one to know.  But I could not hold this opinion for days on end.

Halby v. Commissioner, T.C. Memo. 2009-204 (T.C. 2009).

Question for the Tax Court

The issue for decision is whether the taxpayer is entitled to deduct amounts paid to prostitutes and for medical texts and pornographic materials. (6).

Background

The taxpayer has been an attorney for 40 years and specialized in tax law. (10). During 2004 and 2005 taxpayer frequented prostitutes in New York. (2).  [He] did not visit these prostitutes as part of a course of therapy prescribed by his doctor. (2).  [Although] he did keep track of these visits in a journal.  The journal included the date, the name of the 'service provider', and the amount. (2).

For 2004, the taxpayer claimed medical expense deductions of $76,314 on his Schedule A. (3).  Included in this amount was $65,934 for prostitutes; and $2,368 for medical books, magazines, videos, and pornographic material. (3).

For 2005, the taxpayer claimed medical expense deductions on his Schedule A of $49,023. (3).  Included in this amount was $42,152 for prostitutes; and $5,005 for books, magazines, videos, and pornographic materials. (4).

The IRS disallowed the deductions for the cots of prostitutes and the costs of the books (3-4).

Medical Expense Deductions

Section 213(a) permits a deduction for a taxpayer's medical and dental expenses that were paid and not compensated for by insurance, to the extent the expenses exceed 7.5 percent of the taxpayer's adjusted gross income. (5).  Section 213(d)(1) provides in pertinent part that the term "medical care" means amounts paid "for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body." (5).  Section 1.213-1(e)(1)(ii), Income Tax Regs., provides that amounts expended for illegal operations or treatments are not deductible and that deductions allowed under section 213 will be confined strictly to expenses incurred primarily for the prevention or alleviation of a physical or mental defect or illness. (5).

Taxpayer's Arguments

The taxpayer points to book and magazine articles about the positive health effects of sex therapy and argues that we should allow him a deduction despite the illegality of his conduct or the fact that taxpayer's doctor did not prescribe this treatment. (6).

Holding

We agree with the Commissioner that the taxpayer is not entitled to deduct the amounts at issue.  Patronizing a prostitute is illegal in the State of New York. (7).  The taxpayer's payments to various prostitutes were personal expenses not prescribed by a doctor and not intended to treat a medical condition. (7).  [L]ikewise . . . amounts paid for books and magazines on sex therapy and pornography . . . were not for the treatment of a medical condition but were instead personal items.

Comments

I am going to leave this one alone.  In all seriousness, this is a sad case for the taxpayer either way you look at it.  Here is an article that appears to be the same William Halby as in this case.

Spousal Relief Under Section 6015

Sykes v. Commissioner, T.C. Memo. 2009-197

This opinion (and post) is quite long, but it's worth reading if you really want to understand spousal relief.

Questions for the Tax Court

Is Ms. Sykes [petitioner] entitled to relief under section 6015(b), (c), or (f). (10).

Spousal Relief From Joint and Several Tax Liability

Under section 6013(d)(3), a husband and wife filing a joint return are jointly and severally liable for all tax for the taxable year, including interest and penalties. (14).

Section 6015 relieves a spouse of joint and several liability in three situations:  (1) if the spouse did not know or have reason to know of the deficiency when the return was signed, and satisfies other conditions; (2) if a divorced or separated spouse seeks to limit individual liability to the portion of the deficiency attributable to him or her; and (3) in the case of a deficiency or of a tax shown on a return but not paid, if it is inequitable to hold the spouse liable for the tax.  See sec. 6015(b), (c), and (f), respectively.  The last provision, found in section 6015(f), only applies if relief is not available to the taxpayer under the other two provisions. (14-15).

Tax Court's Section 6015(b) Analysis

Under section 6015(b), the first situation above, A spouse has reason to know of the understatement if a "reasonably prudent taxpayer in her position at the time she signed the return could be expected to know that the return contained the . . . understatement." Price v. Commissioner, 887 F.2d 959, 965 (9th Cir. 1989). (16).

Factors to consider in analyzing whether a spouse had reason to know of the understatement include: (1) the spouse's level of education; (2) the spouse's involvement in the family's business and financial affairs; (3) the presence of expenditures that appear lavish or unusual when compared to the family's past levels of income, standard of living, and spending patterns; and (4) the culpable spouse's evasiveness and deceit concerning the couple's finances. Price v. Commissioner, 965. (17).

[Here], Ms. Sykes held two bachelor degrees, kept all the records for her husband's law practice in 2003, was the sole party responsible for reviewing the documents to be presented to the tax return preparer for the tax year 2003. (17).  Her husband was not deceptive about financial matters, and in fact frequently discussed with her . . . business and family financial matters. (17).  She either knew or should have known, as the manager of the law practice that business expenses were being twice deducted and that excessive deductions for advance client costs were being claimed. (18).  Thus, because she knew or should have known of the understatement of tax, she does not qualify for relief under section 6015(b).

Tax Court's Section 6015(c) Analysis

[U]nder section 6015(c)(3)(C), apportionment of liability does not apply if the Commissioner "demonstrates that an individual making an election under this subsection had actual knowledge, at the time such individual signed the return, of any item giving rise to a deficiency (or portion thereof) which is not allocable to such individual . . . ".  This Court has defined actual knowledge as "an actual and clear awareness (as oppose to a reason to know) of the existence of an item which gives rise to the deficiency (or portion thereof)".  Cheshire v. Commissioner, 115 T.C. 183, 195 (2000). (20).

And, consistent with Cheshire, such actual knowledge does not include knowledge of the tax laws or knowledge of the legal consequences of the operative facts. (21).

It is clear to the Court that Ms. Sykes had actual knowledge of all items giving rise to the deficiency in joint tax.  She was solely responsible for keeping the finances of the law practice; had actual knowledge of the year the Cadillac Escalade was purchased and placed in service; helped prepare the 2003 income tax return by reviewing items with the preparer and reviewing and gathering all financial documents . . . . (22).

Tax Court's Section 6015(f) Analysis

Section 6015(f) relief is available if, taking into account all of the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or deficiency, and if relief is not available under section 6015(b) or (c). (22).

Rev. Proc. 2003-61 states the requesting spouse must satisfy all of the following threshold conditions to be eligible for relief under section 6015(f) . . . Ms. Sykes satisfies these threshold requirement for equitable relief. (24.)  However, the I.R.S. argues that as described under the revenue procedure, she is not entitled to relief under section 6015(f) because petitioner had knowledge of the items giving rise to the deficiency; had knowledge or reason to know that intervenor would not or could not pay the tax liability shown on the return; and if held liable for the payment of the tax she would not suffer an economic hardship. (24).

[T]he Court determines that petitioner is not entitled to relief under section 6015(f). (26).  [Ms. Sykes] knew at the time she signed the 2003 tax return that [her husband] owed a separate in come tax liability for tax year 2001 in excess of $50,000. (25).  This liability was not satisfied until after the 2003 return was filed, and the money used to [pay] the debt was provided by [her husband's] family.  This information supports the conclusion that Ms. Sykes knew that . . . [her husband] could not pay the tax liabilities shown on the return. (25).

Comments

Three strikes and your out.  Ms. Sykes failed the test for relief under (b), (c), and (f).  It goes to show that spousal relief is not a "get out of tax owed" free card.  It is truly for those occasions where it would be inequitable to hold the truly 'unknowing' spouse 'jointly and severally' liable for the tax of his or her deadbeat spouse.

Fees Paid to Settle Credit Card Debt Not Deductible

Melvin v. Commissioner, T.C. Memo. 2009-199 (T.C. 2009).

Question for the Tax Court

Whether taxpayers had $8,768 of discharge of indebtedness income arising from [the settlement of credit card debt] and whether they may deduct the $2,126 fee they paid to the agency that negotiated that settlement. (1-2).

Background

The taxpayers had $13,084 in credit card debt with Chase Manhattan Bank. (2).  Arbitronix, Inc.  negotiated a settlement with Chase on behalf of the taxpayer, whereby Chase agreed to accept $4,579 in full satisfaction of petitioner's balance. (2).  Arbitronix charged the taxpayer a fee of 25 percent on the $8,505 savings, or $2,126. (3).  The taxpayer conceded at trial that they had $8,768 of cancellation of debt (COD) income. (3).  The court did not address the discrepancy between the $8,505 savings and the 1099-C that stated $8,768 as the amount of debt canceled. (3 fn. 3).

Quick anecdote if I may.  Let's assume the taxpayer is in the 15% marginal tax bracket and also pays 5% state income tax for a combined tax rate of 20%.  Their federal and state income tax on the COD income would be $8,768 x 20% = $1,754.  Adding this tax bill to the $2,126 fee, the taxpayers $8,505 savings is reduced by $3,880 for a total real savings of $4,625, approximately 53% of the $8,505.

Taxpayer's Arguments

The taxpayers argued that 'this is a case of disputed debt or contested liability.'  [And] that the settlement is the 'amount of debt to be recognized for tax purposes' and that the 'excess of the original (disputed) debt over * * * [the settlement] should be disregarded for both accounting and tax purposes.'

The taxpayers also argue that the fee paid to Arbitronix is deductible, not under section 162 or 212, but rather 'part and parcel of the 'income' assessed through I.R.C. sec. 61(a)(12) is the reduction . . . of the amount . . . that does not provide a benefit.'

Commissioner's Arguments

The taxpayer is wrong.

Tax Court's Opinion

[We find] that the taxpayers have failed to introduced credible evidence that they disputed the debt. (6).  The Arbitronix invoice describes the debt forgiven as 'savings' and the letter from Chase confirming the settlement states that if Chase did not receive the $4,579 payment before a certain date, then the 'offer' would no longer be 'valid.' (6).  Neither the invoice nor the letter in any way indicates the debt was disputed. (7). 

The taxpayers suggest that they received no monetary benefit from the cancellation of debt. . . . We cannot agree with petitioners.  Section 61(a)(12) manifestly does not provide for any kind of deduction. (8).

Comments

Nothing real earth shattering about this opinion here.  Although, the taxpayer's argument to reduce their COD income by the fee paid was interesting.  Without doing a lot of research in this area, they probably would have gotten further with a section 212 argument, but still lost.  Here is the analysis for the Tax Court in case they face the question in the future. . . free of charge.

Section 212 states, "there shall be allowed a deduction for all ordinary and necessary expenses paid or incurred during the taxable year -- for the production or collection of income."  Here, the taxpayers paid an expense that did in fact produce taxable income.  The regulations under 1.212-1 do not make a specific exception for the type of fees paid by the taxpayer in this case.

In contrast, section 262 disallows deductions for all expenses that are for personal, living, or family expenses.  I think the fee paid to Arbitronix could easily be classified as a personal expense.

Going back the regulations under section 1.212-1(e) we find that "a deduction under section 212 is subject to the restrictions and limitations in part XI (section 261 and following). . . relating to items not deductible.  [Further] section 212 does not allow the deduction of expenses which are disallowed by any of the provisions of Subtitle A of the Code, even though such expenses may be paid or incurred for one of the purposes specified in section 212."

In other words, section 262 trumps section 212 via the regulations in section 1.212-1(e).  An amount that is otherwise deductible under section 212, will not be deductible if specifically excluded by section 262, or other code provision under Subtitle A of the Code.  Confusing enough!  Who needs tax reform when I can charge $250 per hour to figure this stuff out, and worse yet I enjoy it!

Collection Due Process Hearings

Willock v. Comm'r, T.C. Memo. 2009-178 (T.C. 2009) (parenthetical references are to the page number of the opinion).

The Willocks challenge the IRS's use of a lien to collect $191,724 in unpaid taxes and penalties related to their 2001 tax return. (2).  The Tax Court sustains the lien because the Willocks "offered no collection alternatives or other defenses to the lien." (6).

Chronology of Events

This opinion moves pretty fast; and fortunately so because it is not all that exciting. A chronology of events leading up to this opinion is helpful here:

December 7, 2005 - IRS mails a Notice of Deficiency to the taxpayers. (2).

April 11, 2006 - IRS assesses the tax, penalty, and interest because the taxpayer did not respond to the NOD within the requisite 90-day period. (2).

January 23, 2007 - IRS files Notice of Federal Tax Lien. (3).

January 30, 2007 - IRS mails taxpayer the Notice of Federal Tax Lien and Your Right to a Hearing Under IRC 6320 (Letter 3172). (3).

February 26, 2007 - Taxpayer requests a collection due process hearing (CDP). (3).

July 23, 2007 - IRS schedule telephone CDP hearing for August 14, 2007. (3).

August 14, 2007 - at the hearing, "[taxpayers] did not present any reason why the filing of the Federal  tax lien should not remain in place, nor did [taxpayers] present any collection alternatives during the hearing." (3).

August 23, 2007 - IRS mails taxpayers a Notice of Determination. (4).

October 1, 2007 - Taxpayers file petition with the Tax Court. (4).

October 7, 2008 - Tax Court holds hearing to discuss taxpayer's motion for summary judgment. (4).

June 18, 2009 - Tax Court denies taxpayer's motion for summary judgment. (4).

Tax Court's Decision

At the telephone CDP hearing, the Willocks disputed the amount of tax owed, that is, they disputed the underlying tax liability assessed by the IRS. (3). But, "[b]ecause the petitioners had a prior opportunity to dispute the underlying tax liability for 2001, they would not be permitted to do so during the CDP hearing." (3). In other words, the Willocks had an opportunity to dispute the amount of the liability and they let it pass. Consequently, at the CDP hearing they could only dispute the IRS's collection methods. As the Court points out, in the absence of any relevant arguments from the taxpayers, a lien is a lawful method of enforcing collection of an outstanding tax liability. (6).

Analysis

Section 6501(a) provides, as a general rule, that taxes must be assessed within three years after a return is filed. This is the basic statute of limitations provision in the Internal Revenue Code. There are exceptions to this general rule, one of which is in section 6501(c)(4)(A). This section states that if "both the Secretary and the taxpayer have consented in writing to its assessment after such time, the tax may be assessed at any time prior to the expiration of the period agreed upon." In other words, the taxpayer can extend the three-year statute of limitations imposed on the Internal Revenue Service.

A review off the above chronology shows that the three-year limitation had expired long before the IRS assessed the tax on April 11, 2006. As is usually the case, there is more here than meets the eye. In footnote no. 2, the Tax Court states that the taxpayers signed Form 872 prior the expiration of the three-year statute of limitations. (4). Form 872 is an agreement between the taxpayer and the IRS that adheres to the requirements under section 6501(c).

I did a search of the IRS website and could not find Form 872. This leads me to believe the IRS has transitioned to a different form. Form 921 appears to be its replacement.

Deducting Education Expenses as Trade or Business Expenses

Ortega v. Comm'r, T.C. Summary Opinion 2009-120 (T.C. 2009).

Ms. Ortega deducted $19,885 in education expenses associated with her doctoral degree in psychology on her 2004 tax return. She claimed the expenses were deductible as a trade or business expense because she was already a mental health practitioner. The IRS denied the deduction because the doctoral degree qualified her for a new trade or business, i.e. staff psychologist. The Tax Court agreed with the IRS.

Ms. Ortega's Career and Education History

Ms. Ortega earned her masters degree in psychology from the University of Nebraska in 1996. After several years of working as a Mental Health Practitioner for the State of Nebraska, she went back to the University of Nebraska to earn a doctorate in psychology. Upon earning her doctoral degree in psychology, she moved to New York and began work as a staff psychologist for the Federal Bureau of Prisons. New York required a doctoral degree to practice psychology, therefore Ms. Ortega could not practice as a staff psychologist without it. 

When are Education Expenses Deductible as Trade or Business Expenses?

The Tax Court succinctly states the law here:

Expenditures made by an individual for education are deductible as ordinary and necessary business expenses if the education maintains or improves skills required by the individual in her employment or other trade or business. Sec. 1.162-5(a), Income Tax Regs. However, the general rule under section 1.162-5(a) does not apply [and the expenses are not deductible] if the expenses fall within either of the two specified categories: (1) The expenses are incurred to meet the minimum education requirements for qualification in the taxpayer's trade or business; or (2) they qualify the taxpayer for a new trade or business. Sec. 1.162-5(b).

If the education in question qualifies the taxpayer to perform tasks and activities significantly different from those she could perform before the education, then the education is deemed to qualify the taxpayer for a new trade or business. Browne v. Commissioner, 73 T.C. 723, 726 (1980).

The mere capacity to engage in a new trade or business is sufficient to disqualify the expense for deduction. Weiszman v. Commissioner, 52 T.C. 1106, 1111 (1969).

Did Ms. Ortega's Doctoral Degree Qualify Her for a New Trade or Business?

Ms. Ortega asserts the doctoral degree did not qualify her for a new trade or business because she continued to work in the field of psychology before and after her education.

The Tax Court disagreed. State law controls the outcome here. In both Nebraska and New York, the only requirement for being a mental health practitioner was a masters degree in psychology, which Ms. Ortega already had. In contrast, both states required a doctoral degree in psychology to practice as staff psychologist. When Ms. Ortega left Nebraska and went to work in New York, she started practicing as a staff psychologist. Accordingly, "the doctorate . . . [q]ualified her to perform tasks and activities significantly different from those she could perform before the eduction." Therefore, her education expenses were not deductible as a trade or business expense.

Analysis

This is not a completely straightforward area of the law, but the decision here is correct. For example, though I already practice tax law as a CPA, my law degree will qualify me to be a lawyer. Therefore, even if I never intend to practice as a lawyer, my law degree expenses are not deductible.

Finally, even if Ms. Ortega was allowed to deduct the education expenses in question, the deduction would be limited by section 67. Section 67 imposes a two-percent floor on miscellaneous itemized deductions. That is, itemized deductions, other than those listed in section 67, are deductible "only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income." Sec. 67(a). Adjusted gross income is defined in section 62. Alternatively, you can look at page 1 of the Form 1040 to see how to calculate AGI.

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.

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.

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

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.

Download JillHager.SUM.WPD

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.

Download Humes.SUM.WPD

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.

Download Kovac5evich.TCM.WPD

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.

Download Manning.TCM.WPD

Taxpayer Loses...Again - Section 6673 Penalties Imposed

Mr. Florance appears to be making a name for himself in the halls of the U.S. Tax Court. He was the recipient of not one, but two decisions from the Tax Court yesterday.

The facts are almost identical in each case, the only real difference is the year at issue. In the first case Mr. Florance failed to file his tax return for 2003, and in the second case he failed to file for 2005. The IRS assessed a deficiency, to which Mr. Florance asserts he is not liable for because "he did not consent to becoming a taxpayer and therefore is not subject to the income tax laws of the United States." This might be my favorite frivolous argument yet.

In response to Mr. Florance's assertion, the IRS filed a motion to dismiss and asked the Court to impose section 6673 penalties. Section 6673 penalties are reserved for frivolous arguments and "proceedings instituted primarily for delay." The Tax Court can impose up to $25,000 in penalties.

The best part is at the motion to dismiss hearing for the 2003 tax return. Mr. Florance did not show up. The IRS wins right? Well, not here because the IRS asked the Court to dismiss its own motion. Turns out, the IRS found more of Mr. Florance's unreported income and they needed additional time to assess higher deficiencies.

After the factual background is presented, the Tax Court begins its discussion with:

"Mr. Florance is no stranger to this Court, In Florance v. Commissioner, T.C. Memo. 2005-60, affd. 174 Fed. Appx. 200 (5th Cir. 2006) and Florance v. Commissioner, T.C. Memo. 2005-61, affd. 174 Fed. Appx. 200 (5th Cir. 2006). Florance asserted similar tax defier arguments for the 1994 through 1997 tax years and was sanctioned by this Court under section 6673 in the respective amounts of $10,000 and $12,500. In this case he asks us to consider his frivolous arguments once again."

Mr. Florance loses. The Tax Court imposes a $15,000 section 6673 penalty for the 2003 tax year, and a $17,500 section 6673 penalty for the 2005 tax year.

Here is the opinion for the 2003 tax return

Download Florance2628307.TCM.WPD

Here is the opinion for the 2005 tax return

Download Florance736408.TCM.WPD

Nonstatutory Stock Options

Mr. Beane obviously did not hire a very good bean counter.

Mr. Beane was founder and chief-executive of AAVID Engineering. In 1992, Mr. Beane was granted 1,518,000 nonstatutory stock options. The stock options were scheduled to vest 25% per year over a four-year period. In 1996, AAVID went public. Between 1997 and 2000, Mr. Beane exercised all his options and sold the underlying stock.

A nonstatutory stock option (or nonqualified) is any option that does not meet the qualification criteria found in section 422. If a stock option meets the requirements of section 422 the employee is given preferential treatment pursuant to section 421. Generally, an employee must include in gross income compensation in cash and in-kind for services rendered. Under section 421, the employee will generally have income only after she has exercised the options and sold the underlying stock.

Nonstatutory stock options, on the other hand, result in gross income when the option is granted or upon exercise pursuant to section 83. In the latter instance (upon exercise), the difference between the fair market value of the stock and the price paid to exercise the options is treated as compensation in the year of exercise. Depending on the fair market value of the stock, this can result in a huge tax bill to the employee without a lot of money to pay it with (although, the employee could immediately sell the stock or take a loan against the stock to pay the tax bill).

When Mr. Beane exercised his stock options he made a myriad of errors in reporting his gain. For each of the three years Mr. Beane exercised the options, he reported the gain three different ways.

1. In 1997 he reported income from exercised options as ordinary income.
2. In 1998 he reported the income as trade or business income. He also reported the income subject to self-employment taxes.
3. In 1999, he reported income for exercised options as self-employment income.

The IRS issued Mr. Beane a notice of deficiency for his 1998 tax return because he not only reported his gain incorrectly but he also reported less than 100% of it. His total gain on exercised options in 1998 was $21,886,688. But he only reported $13,511,014. Moreover, he reported this amount as trade or business income and paid self-employment taxes.

In 1999, Mr. Beane’s gain from exercised options was $4,938,543, but this time he reports $10,139,696. Again, he reported it as self-employment income and paid self-employment taxes.

The resources spent here trying to unwind Mr. Beane’s 1998 and 1999 tax returns appear to frustrate the Tax Court. And for good reason. The case here is a fairly simple. AAVID should have included the gain on Mr. Beane’s annual W2 as compensation. This would subject the gain to backup withholding and employment taxes. This is all spelled out rather clearly in IRS’s publication 525. Instead, Mr. Beane underreports one year, overreports the next, and pays self-employment taxes to boot.

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Negligence Penalties & Reasonable Reliance

There is more to this opinion than just the regular run-of-the-mill taxpayer penalty. I encourage you to read on.

SUMMARY

In the early 80’s, Mr. Pack, at the advice of his CPA, invested $25k in a limited partnership called Platte Leasing Associates. A $25k investment in 1981 equates to about a $60k investment today (per the calculator on The Federal Reserve Bank of Minn.'s website). Prior to Mr. Pack’s investment, he was informed via several documents that Platte was taking significant tax risks, and would most likely be challenged by the IRS. Within those documents was a section that stated Platte’s general partners were involved in other partnerships that were currently under IRS audit. As a result of those audits, the partnerships deductions were disallowed.

In 1983, Platte passed-through ordinary losses and interest expense, which Mr. Pack reported on his 1983 tax return. Similarly, in 1985, Platted passed-through ordinary income and interest expense, which Mr. Pack reported on his 1985 tax return.

In the early 90’s, the IRS adjusted Platte’s 1983 & 1985 tax returns. In 2006, the Tax Court upheld those adjustments. Shortly thereafter, the IRS sent Mr. Pack a notice of deficiency relating to his 1983 and 1985 tax returns.

The issue for the Tax Court is whether penalties imposed by section 6653(a) and 6661(a) apply to Mr. Pack. Don’t go looking for section 6661(a); it is not part of the current tax code, it was repealed in 1989. Section 6653(a) – under the 1954 tax code - imposes a 5% penalty for underpayments “due to negligence or intentional disregard of rules or regulations.” Section 6653(a)(2) imposes an additional tax “equal to 50 percent of the interest payable under section 6601.” This means, that whatever interest penalty the Pack’s have to pay because of underpayment, increase it by 50%.

Here, the Tax Court has to determine if the Pack’s acted negligently. The Tax Court points out that in the Ninth Circuit (where this appeal would lie), “[in] cases involving a deduction for loss that results from an investment [a determination as to negligence] depends on both the legitimacy of the underlying investment, and due care in claiming the deduction."

Mr. Pack attempts to show reasonable reliance on his CPA to avoid the negligence penalty. He relies on a three-prong test set out by the Third Circuit in Neonatology Associates, P.A. v. Comissioner, 299 F.3d 221, (3d Cir. 2002). The three prongs are:

(1) The adviser was a competent professional who had sufficient expertise to justify reliance,
(2) the taxpayer provided necessary and accurate information to the adviser, and
(3) the taxpayer actually relied in good faith on the adviser's judgment.

As to the first prong, The Tax Court cites the CPA’s lack of investment experience to show Mr. Pack’s reliance was unjustified. The second prong was not an issue. The Tax Court also agrees with the IRS’s on the third prong; Mr. Pack knew of his CPA's conflict of interest. Lastly, the documents that accompanied the Platte investment contained several warnings regarding the tax risks that should have resounded loudly in Mr. Pack’s head.

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ANALYSIS

Mr. Pack loses because the document he received in connection with the Platte investment was a clear warning, and he ignored it.

At first glance, the Tax Court’s application of Neonatology’s first prong appears incorrect. Based on the context of the Third Circuit's opinion, the first prong refers to the professional’s expertise as a tax adviser not as an investment adviser. In Neonatology, the taxpayer received tax advice from their insurance agent, “rather than from a competent, independent tax professional.” Neonatology, 299 F.3d at 234. Here, the IRS attacked the CPA’s expertise as an investment adviser and said nothing of his expertise as a tax adviser.

But as stated above, the standard for negligence here is defined by the Ninth Circuit. The Ninth Circuit requires a showing that the underlying investment was legitimate to avoid the negligence penalty. This has the impact of turning Neonatoloty's three-prong test into a six-prong test. Now, Mr. Pack has to show he acted reasonably not only with respect to taking the deduction, but also with respect to investing in Platte in the first place. Since Mr. Pack did not seek independent investment advice he fails the test.

My only policy argument against the Ninth Circuit's negligence test is that it is different than the test used in the Fifth Circuit. The Tax Court cites the Ninth Circuit's opinion in Saks v. Commissioner, 82 F.3d 918 (9th Cir. 1996). The Saks Court rejects the Fifth Circuit's opinion in Chamberlain v. Commissioner, 66 F.3d 729, (5th Cir. 1995). In Chamberlain, the issue of negligence is based solely on whether the taxpayer acted negligently in claiming the loss.

While I think the Fifth Circuit is the better approach, it seems wholly unfair that taxpayers in the ninth circuit should be subjected to a more stringent negligence test than taxpayers in the fifth circuit.

The Rules of Evidence

This post will not be about substantive tax law but rather the Federal Rules of Evidence (it just so happens that I am taking Evidence now, so my ulterior motive is studying for the final exam).

SUMMARY

Mr. Lawson failed to file tax returns for all years at issue. The IRS assessed deficiencies based on a reconstruction of his income. Before addressing the substantive tax issues, the Tax Court made an evidentiary ruling on an exhibit the IRS wanted admitted into evidence. In the end, Mr. Lawson loses.

While the Tax Court has its own rules of procedure, they generally follow The Federal Rules of Evidence pursuant to section 7453 of the Internal Revenue Code. Here, the rules of evidence play an important role in the IRS's case because without evidence they cannot prove Mr. Lawson earned income. As was the famous line, "if the glove doesn't fit, you must acquit," so this case goes, "if the income is not mine, i don't pay a dime."

At issue is an exhibit that the IRS wanted admitted into evidence. The exhibit is a deposition Mr. Lawson gave during a prior lawsuit. The IRS needed the deposition to prove Mr. Lawson owned income-producing assets during 2004 and 2005. In fact, the deposition directly contradicts Mr. Lawson's testimony given at the tax trial.

In this case, there are three hurdles the IRS must jump to get the exhibit admitted into evidence: relevance, hearsay, and authentication. They jump each hurdle with ease.

The threshold for relevance is pretty low. Evidence that has "any tendency to make the existence of any fact that is of consequence . . . more probable or less probable than it would be without the evidence" is relevant. Fed. R. Evid. 401. The deposition is relevant because it will help the IRS prove that Mr. Lawson earned income in 2004 and 2005.

Secondly, the IRS must establish that the deposition is either not hearsay, or if it is, then show a hearsay exception applies. I will do my best to explain, but this topic can get complicated real quick.

Why would the deposition be hearsay? Because it is an out-of-court statement offered to prove the truth of the matter asserted. Fed. R. Evid. 801. First, the deposition is a statement made out of court, that is, outside the matter currently before the Tax Court. Second, the deposition asserts Mr. Lawson does in fact own income-producing assets (truth of the matter asserted).

The Tax Court holds the exhibit gets admitted under either of two exclusions provided by Rule 801 - this means the deposition is not hearsay. The first exclusion is called a prior inconsistent statement. Mr. Lawson's deposition (the prior statement), made under oath, is inconsistent with his current testimony, also made under oath, at the tax trial. Hence, a prior inconsistent statement.

The second exclusion is a party admission. The party admission exclusion is exactly what it sounds like, and it's easier to use than the prior inconsistent statement. A party admission does not need to be made under oath.

Finally, Because the IRS wants the deposition entered into evidence, and not just someone's recollection of the deposition, it must be "authenticated." That is, the Court must be sure that the exhibit offered is in fact what it purports to be. Without authentication, we would have no assurance that the IRS is providing the real deposition. But as in the case of relevance, the threshold for authentication is low.

Rule 901(b) provides ten illustrations of how to authenticate a document. The IRS relies on 901(b)(1) and 901(b)(4). Rule 901(b)(1) authenticates based on testimony of a witness with knowledge. At trial the IRS called its revenue agent to testify that he received the deposition from Mr. Lawson's attorney - the attorney actually took the deposition. I would argue that the revenue agent does not have the requisite knowledge to authenticate because he received the deposition second hand (this is the point in class where my Prof. goes, "overruled").

Rule 901(b)(4) authenticates based on the document's contents, distinctive characteristics, and the circumstances. The Tax Court relies on this illustration for proper authentication. The exhibit appeared to be a deposition, both in form and content, Mr. Lawson admits being deposed in a prior law suit, and of course the revenue agent testified to receiving it from Mr. Lawson's attorney.

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ANALYSIS

So, just how important are the rules of evidence in a tax case? Just ask Washington, DC's infamous council member Marion Barry. The U.S. Attorney's office recently filed suit to revoke Mr. Barry's probation for failure to file tax returns. The suit was dismissed because the U.S. Attorney did not call any witnesses. It is awfully hard to present evidence during trial without any witnesses - probably impossible.

Allocation of Settlement Agreement

The Hellesens were both attorneys for State Farm. In 1995, they filed a lawsuit against State Farm alleging, among other things, sexual harassment, discrimination, and wrongful discharge. During the lawsuit against State Farm, Mr. Hellesen stated he suffered chest pains, stomach problems, weight loss, etc., all related to being sexually harassed.

In 1997, the lawsuit was settled and the Hellesen's received a check from State Farm for $273,500. They did not file their 1997 tax return until 2000, nor did they report the proceeds from the settlement.

The Hellesens tried to exclude the settlement proceeds from gross income pursuant to section 104(a)(2). This section excludes from gross income damages received because of physical injury or sickness. The section's flush language excludes emotional distress from the definition of physical injury/sickenss.

While the settlement agreement with State Farm mentioned physical injury and sickness, it did not specifically allocate damages. Furthermore, the Hellesens's complaint did not allege physical injury or sickness. These two points were fatal to their 104(a)(2) exclusion argument.

I previously suggested that excluding emotional distress from the definition of physical injury and sickness was an archaic notion given the advances in physchiatric science over the last ten years. While a policy change could take quite a long time, an intermediate solution might be to use those advances in science to prove physical injury in these types of lawsuits. The Court does not come out and say it, but the implication is that if damages are specifically allocated to physical injury or sickness then the taxpayer might have a chance.

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Real Estate Held For Sale To Customers?

This is a pretty dry post (and reads more like a tax law exam), but it's a common issue for taxpayer's that sell real estate.

Mr. & Mrs. Rice bought 14.4 acres for $300,000 in Austin, Texas. Their initial intent was to keep the entire 14.4 acres and build their dream home. Ultimately, they decided to subdivide the property into ten lots. They spent considerable effort subdividing the land, including rezoning, water and sewage, etc.

Afterward they built themselves a 12,000 square foot house (4,000 of which was for garage and porches) on the most desirable lot, and commenced selling the remaining lots. The first lot was sold in 2000 to friends. In 2002 they posted a wooden sign advertising lots for sale. the The next sale did not occur until 2004, at which time the Rice's sold three lots. Two of the lots were sold at a loss to relatives, and one was sold at a gain to friends. The remaining lots were sold in 2005, 2007, and 2008 to friends and acquaintances.

The issue for the Tax Court was whether the gain(loss) from the lots sold in 2004 should be ordinary or capital. When this issue arises the taxpayer usually argues for capital treatment if there is a gain and ordinary if their is a loss. The reason is that capital gains are taxed at lower rates than ordinary gains. Alternatively, capital losses are limited, while ordinary losses can be used to offset other earned income. Here, the Rice's have both a gain and a loss, but they were arguing for ordinary treatment (probably because their losses exceed their gains).

To receive ordinary treatment, taxpayer's must "hold the property primarily for sale to customers in the ordinary course of business." If, however, the taxpayer holds the property for investment, then gains(losses) from sales receive capital treatment.

The law in this area is well settled, though the application of facts to the law is anybody's guess. The governing section is 1221, but the courts have developed a seven factor test to determine whether the taxpayer held the property primarily for sale . . . quoted straight from the 5th Circuit in U.S. v. Winthrop:

1. The nature and purpose of the acquisition of the property and duration of ownership
2. The extent and nature of the taxpayer's efforts to sell the property
3. The number, extent, continuity and substantiality of the sales
4. The extent of the subdividing, developing, and advertising to increase sales
5. The use of a business office for the sale of the property
6. The character and degree of supervision or control exercised by the taxpayer over any representative selling the property
7. The time and effort the taxpayer habitually devoted to the sale.

Unfortunately for the Rice's their intent and efforts did not rise to the level of a business, thus there losses and gains are capital not ordinary. The Tax Court primarily considered their lack of effort to sell the lots coupled with the infrequency of sales.

Considering this was all going on during the real-estate boom, and in a thriving city like Austin, the Rice's did not have much of an argument. With the right amount of effort they probably could have sold all the lots in 18-24 months and made a substantial gain. Of course, then they would be arguing for capital gain treatment and the IRS would have argued they were in a business!

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Frivolous Arguments - Claim of Right

Some people have to learn the hard way. Mr. Pugh seems to be one of those people. Apparently a $10,000 penalty for his 2003 frivolous argument did not have the deterrent effect that the Tax Court hoped it would.

Back for more, Mr. Pugh reported $107,465 of wages on his 2004 tax return. He took a deduction for an equal amount on schedule A stating his wages were not taxable pursuant to section 1341 - Claim of Right (the same argument he made to the Tax Court in 2003). Section 1341 rarely comes into play these days. In short, it allows a taxpayer to take a deduction for income previously taxed which the taxpayer has to subsequently return.

For example, suppose in year 1 taxpayer A includes $25,000 in gross income because she thought she had an unrestricted right to the $25,000. Then in year 2 it turns out that taxpayer A did not have an unrestricted right to the entire $25,000, and is required to return $10,000. Under section 1341 she is allowed a $10,000 deduction in year 2 (there are other nuances but this makes the point).

Mr. Pugh of course did not return his 2004 wages (he did not return his 2003 wages either). Consequently he loses and the IRS's motion for summary judgment is granted.

Tax Court to Mr. Pugh: "in view of the fact that a $10,000 penalty was not a sufficient deterrent . . . we shall require petitioner to pay a penalty of $15,000."

The first case is the current decision. The second case is the decision from 2003.

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Hobby Loss Rules

Beasley v. Comm'r, T.C. Summary Opinion 2009-93 (T.C. 2009).

The Tax Court writes an excellent opinion on the profit motive requirement to avoid the loss limitations imposed by section 182.

The Beasley's are from Maryland - based on the facts, probably somewhere near the Chesapeake Bay. During 2003, Mr. Beasley started a charter fishing business, all the while working full-time as an HVAC project manager. Mr. Beasley deducted losses from his charter fishing service on a Schedule C: ($101,085), ($47,296), and ($33,769) respectively during the periods 2003 - 2005.

The IRS denied the loss deductions for his charter fishing service pursuant to section 183(a) and (b)(2). This section limits the amount that can be deducted when the activity is not engaged in for profit. Specifically, deductions cannot exceed the gross income from the activity. This rule is commonly referred to as the Hobby Loss Rule.

The Tax Court walks through the nine-factor test stated in the Regulations for determining whether an activity is engaged in for profit. After applying the facts to each factor the Court decides if the factor favors the IRS or Mr. Beasley. On balance Mr. Beasley loses. Here is a table of the nine-factors and the Court's decision.

As you can see, Mr. Beasley did not win a single factor. I thought the first three factors could have gone either way. Mr. Beasley was hard pressed to win the last six. My point here is not whether Mr. Beasley won but how the Tax Court went about making its decision.

The last thing I want to point out is how much depreciation Mr. Beasley deducted. In total, $105,288 in depreciation over the three-year period. Assuming a 28% marginal tax bracket, Mr. Beasley saves $29,481 in taxes. Compared to his total interest expense on the boat of $22,545 for the same three-year period, Mr. Beasley essentially gets his fishing boat paid for by the Treasury for three years. If Mr. Beasley never makes a taxable profit (because a profit is not his objective), then Treasury never gets its money back. In this context, the rule reflects good tax policy.

Compensatory Damages & Equal Protection

I am posting this decision because the Tax Court addresses one of my arguments in a prior post. Section 104(a)(2) excludes from gross income compensatory damages for physical injury or sickness. The flush language of 104(a) excludes emotional distress from the definition of physical injury or sickness.

Mr. Hennessey was an officer in the U.S. Air Force. In 1993, he was selected for involuntary separation by the U.S. Airforce's Reduction-In-Force Board. The Board was directed by the Secretary of the U.S. Air Force to consider factors such as gender and race, particularly females and minorities, in making their selections. The justification given was past "individual and societal attitudes, policies, and practices."

In 1998, Mr. Hennessey, among others, filed a class-action law suit alleging violation of their equal protection rights under the 5th amendment because the Board "improperly considered race and gender." The suit was settled and Mr. Hennessey received a $30,000 lump-sum payment.

Mr. Hennessey did not include the lump-sum payment on his 2004 tax return and of course the IRS quickly addressed Mr. Hennessey's apparant oversight. The IRS wins here because the payments were not for physical injury or physical sickness as required by section 104(a).

Among Mr. Hennessey's many arguments is the same equal protection argument I suggested in my previous post - namely, that their is no rational basis for treating physical injuries different than mental injuries. The Tax Court dismisses Mr. Hennessey's equal protection argument by citing a Sixth Circuit decision holding the statute constitutional. Young v. United States, 332 F.3d 893 (6th Cir. 2003). Mr. Hennessey, however, lives in Missouri which is in the Eight Circuit. I assume if an Eigth Circuit decision existed the Tax Court would have cited one. Maybe Mr. Hennessey will appeal this issue to the Eigth Circuit.

I will write a post soon analyzing the Young decision.

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Frivolous Arguments - The SSA-Trust

Mr. Lizalek was a regular wage earner like the rest of us. He received W-2's for wages earned, and 1099's for retirement distributions, etc. But instead of filing a Form 1040 he filed a Form 1041 - tax return for estates and trusts.

Mr. Lizalek made the argument that when he received his social security card from the Social Security Administration a property transfer occurred and a trust was created. A trust must have three things; a trustee, a beneficiary, and property. Mr. Lizalek said he was the trustee and the US Government was the beneficiary. He finally asserts that his wages are earnings of the trust and should be reported on the trust's tax return.

The Tax Court rejects Mr. Lizalek's "trust theory" outright as frivolous. The Court states that issuance of a social security card is not a transfer of property, thus no trust was created. As a result, all of Mr. Lizalek's wages are includable in his gross income.

Even if Mr. Lizalek had created a valid trust, he cannot assign his wages to a trust, or anyone else for that matter. Since 1930, this point is well established. Lucas v. Earl, 281 U.S. 111, 114-115 (1930).

As for each person's social security number, a trust fund does exist. After all, it is called the Social Security Trust Fund. The Social Security Trust Fund has a trustee (more than one in fact), and I assure you it is not Mr. Lizalek. There are also beneficiaries, and the U.S. Government is not one of them. The beneficiaries of the Social Security Trust Fund are those Americans currently receiving social security benefits.


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Qualifying Child; Commuting Expenses and Work Clothes

Not many opinions were released towards the end of the week. Therefore, I am writing about two summary opinions in this post.

In the first case, Mr. Rice lived in one house with his mother, girlfriend, his daughter, and his girlfriend's son. He claimed head-of-household filing status and took dependency exemptions for his daughter and his girlfriend's son. The IRS determined Mr. Rice should file single and denied both dependency exemptions.

Section  152(c) is controlling here. To claim someone has a dependent they must be a qualifying child; there is a four-part test for determining whether someone is a qualifying child; Support, Residence, Age, and Relationship. I tried to think of a catchy acronym like 'some roads are rough', but maybe it is easier to just remember the test as it is written.

After Mr. Rice produced a copy of his son's birth certificate proving he was the father, the IRS conceded head-of-household filing status and the dependency exemptions for his son. Mr. Rice, however, could not prove the relationship test with respect to his girlfriend's son. He also could not show he had adopted his girlfriend's son. Finally, he was not married to his girlfriend (that's called a wife), thus g's son was not Mr. Rice's step-son.

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The next opinion involved a construction worker who claimed deductions on his 2003 tax return for his work clothes (denim jeans, denim shirts, and boots), and his transportation expenses between his home and his work site.

Generally, clothing is a non-deductible personal expense. Revenue Ruling 70-474, however, states that clothing expense is deductible if required as a condition of employment and not adaptable for ordinary every day use. The IRS did not challenge Mr. Blackmon on this test, but rather denied his deduction because he could not substantiate the amount of his deduction (although, the Tax Court did mention this test in the footnotes). The Tax Court upheld the IRS's determination because Mr. Blackmon could not provide any records to substantiate the cost of his work clothes or boots.

Likewise, Mr. Blackmon could not substantiate his transportation expenses. But even if he could, his transportation expenses between his home and his job site are considered non-deductible commuting expenses. Revenue Ruling 99-7 provides three exceptions to this general rule: a deduction for transportation expenses is allowed (1) if the work location is temporary and the location is "outside the metropolitan area where the taxpayer lives and normally works," (2) if there are one or more regular work locations away from the residence, then daily transportation expenses are deductible between the taxpayer's residence and a temporary work location in the same trade or business, and (3) if the taxpayer's residence is their place of business. Temporary is generally defined as a realistic expectation that a work location will last less than one year.

Here, Mr. Blackmon worked at a plant in Darlington, NC and lived 71 miles away in Chadbourn, NC. He worked there for 7 years, and 11 1/2 months in 2003. The record is not clear, but it seems he was laid off a few times during that 7 year period, and worked at other jobs in different locations. Mr. Blackmon believed all his work locations were temporary because he might get laid off at a moment's notice. Unfortunately this is not the definition of temporary; if it were we could all deduct our commuting expenses since must of us are at-will employees.

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Both Mr. Rice and Mr. Blackmon were completely ignorant of the law. As a taxpayer, I wish there was a way to resolve these types of meritless petitions without the expense of a hearing and a written opinion.

Compensatory Damages and Emotional Distress

Mrs. Shelton was sexually harassed by her former employer. As a result of an EEOC class action case against her employer, Mrs. Shelton received $123,500 through a settlement. In exchange for the settlement, Mrs. Shelton signed a release that indicated the proceeds were for pain and suffering, mental anguish, etc.

Mrs. Shelton did not report the proceeds of the settlement on her 2004 tax return. She believed, based on discussions with the IRS, that the settlement proceeds were excludable under section 104(a)(2). This section excludes from gross income damages (other than punitive) received on account of physical injuries or physical sickness. The IRS assessed a deficiency because her damages were received for emotional distress and not physical injury. The Tax Court upheld the IRS's determination because section 104(a) also says that for purposes of 104(a)(2), emotional distress shall not be treated as a physical injury.

The IRS also assessed a 20% underpayment penalty for negligence. The Tax Court rejected the IRS's assessment citing Mrs. Shelton's good faith attempt to understand and apply the tax law. The Tax Court found Mrs. Shelton's argument that her emotional distress manifested itself in physical ways reasonable. Nonetheless, the law clearly excludes emotional distress despite its obvious physical impacts.

The decision here is technically correct. Congress has chosen to exclude emotional distress from the myriad of physical injuries that can occur. What's more, Congress is probably free to exclude emotional distress from the category of physical injury despite the fact that modern science can prove Mrs. Shelton physically suffered from her employer's harassment.

Congress needs to change the law. Excluding emotional distress from the definition of physical injury is archaic, particularly in light of the Mental Health Parity and Addiction Equity Act of 2008. If Congress sees fit to require insurance companies to treat mental health benefits on par with other health benefits, then Congress should re-evaluate its rationale for excluding emotional distress from the definition of physical injury.

I might even go so far as to say that Congress is discriminating against a "class of people" - those with mental injuries. Thus, the carve out for emotional distress might be unconstitutional under the 5th amendment. Since people with mental injuries are neither a suspect class nor gender based, it would receive rational basis treatment. Under the rational basis test, Congress would need to assert a legitimate reason for excluding mental injury from the definition of physical injury. Given the strides modern science has made in the area of mental health, and given the MHPAE Act, I am not sure Congress could meet this very light burden.

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Spousal Relief & "Reason to Know"

The IRS denied Mrs. Villela-Wilcox relief under section 6015 because she "knew", or had "reason to know" of significant loss deductions taken on her and her husband's 1997 and 2000 joint tax returns. Mrs. Villela-Wilcox filed a petition in 2007 challenging the IRS's determination. At the time of this decision, the IRS had conceded Mrs. Villela-Wilcox was entitled to relief under 6015(c).

This case is interesting because Mr. Wilcox, petitioner's ex-husband, challenged the agreement between the IRS and Mrs. Villala-Wilcox (he can join the issue as an intervenor under rule 325 of the Tax Court Rules of Practice and Procedure). Mr. Wilcox re-asserts the IRS's original point; that she "knew" or had "reason to know" of the loss deductions taken on their 1997 and 2000 joint return. As such, Mr. Wilcox disputes Mrs.'s entitlement to any relief under section 6015.

The Tax Court agreed with Mr. Wilcox that the "evidence overwhelmingly would support a finding that Mrs. Villela-Wilcox had 'reason to know'." The Tax Court points out, however, that section 6015(c) requires "actual knowledge." Mr. Wilcox's evidence on balance, per the Tax Court, was not strong enough to overcome the agreement between the IRS and his ex-wife. Thus, the agreement stands.

It seems to me this case could have gone either way. This couple was separated in 2002 and were divorced in 2006. It means three years after their divorce they are still fighting! What is more, now that Mrs. Villela-Wilcox is entitled to relief, there needs to be an allocation under 6015(d). So, it is not over. Divorce is the gift that keeps on giving.

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Foreign Earned Income Exclusion

Mrs. Rogers (no relation to Buck Rogers or Fred "Mister" Rogers) is a U.S. citizen living in Taiwan. She is a flight attendant for United and works on round-trip flights between Hong Kong, Tokyo, San Francisco, and Chicago.

Because part of her income is "foreign earned income," and because her tax home is a foreign country, she is allowed to exclude part of her foreign earned income from gross income. section 911(a). Foreign earned income is defined in section 911(b)(1)(A) as amounts received in a foreign country. In this case, there was a dispute over the amount Mrs. Rogers claimed was "foreign earned income." Key to the decision here is that international waters is not a "foreign country." This means that while Mrs. Rogers was in-flight over international waters she was not receiving "foreign earned income."

Mrs. Rogers produced no evidence that could rebut the Service's calculation of flight time over international waters. Consequently, the Service's calculation was upheld.

The rationale behind the foreign earned income exclusion (and the foreign tax credit) is to provide relief to U.S. Citizens who are taxed by foreign countries on income that is also taxed by the U.S. As the opinion points out, the U.S. taxes its citizens on worldwide income (worldwide income most likely includes income earned in outer space as well -- wait! maybe Buck Rogers is relevant to this post after all!). Mrs. Rogers did not introduce evidence that she paid foreign tax on her income earned while over international waters. If this is the case, then she is probably being taxed twice (I am not familiar with Taiwan's tax laws).

In Mrs. Rogers's case, Congress might consider broadening the definition of foreign earned income to include, "income subject to tax of a foreign country." Under this broadened definition, Mrs. Rogers might be made whole.

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Travel Expenses & Tax Home

162(a)(2) allows a deduction for travel expenses away from home in the pursuit of a trade or business. A person's tax home for purposes of 162(a)(2) is their principal place of business (or employment). If it were otherwise, then commuting expenses would be deductible, but they are not.

Generally, a person's principal place of business or employment is obvious. Not so for Mr. and Mrs. Allen - see the table below. The first two columns show where the Allen's worked for the two-year period in question. The third column is where they lived, and the fourth column indicates when they started renting their residence in The Dalles.

Mrs. Allen really never had much of an argument. As the table shows, she always worked where she lived. The Tax Court held that when Mr. Allen started working in Pendleton it became his new "tax home." As a result, Mr. Allen could not deduct travel expenses from The Dalles to Pendleton. If Mr. Allen could establish that his work in Pendleton was temporary he might have had a chance, but on the facts here his work in Pendleton was not temporary.

You would think that this determination meant Mr. Allen could deduct travel from Pendleton back to The Dalles (Mr. Allen taught two nights per week in The Dalles while working full-time in Pendleton). But, the IRS argued Mr. Allen made a personal choice to stay in The Dalles overnight and could have driven back to his tax home in Pendleton after teaching. Pendleton is 125 miles from The Dalles.

Lastly, the Allen's tried to deduct travel expenses between their new rental home in Oregon City and their former residence in The Dalles (the Allen's were renting their former home in The Dalles). Generally, this type of travel expense is deductible. However, the Allen's were renting their The Dalles residence under the not-for-profit rules. see IRS Pub 527. This means that the Allen's could deduct expenses up to rental income, but all losses in excess of income are neither deductible nor carried forward

Unfortunately for Mr. Allen this is a harsh result. The record is not clear, but if Mr. Allen had left from his Pendleton employment and went straight to The Dalles to teach, then his travel expenses going  from one job to a second job should have been deductible. see Rev. Rul 99-7. Also under the same Revenue Ruling, Mr. Allen should have met the "going between the taxpayer's residence and a temporary work location outside the metropolitan area where the taxpayer lives and normally works" circumstance.

Finally, It is also interesting to note that the Tax Court allows a married couple to have two different tax homes. This is consistent with tax theory that the individual is the taxable unit.

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Dependency Exemption Deductions

I like this summary opinion because the Tax Court methodically lays out the rules for determining who is and who is not a dependent. The Court then meticulously applies the facts to the rules.

The issue here is pretty straightforward. Ms. Brockington claimed dependency exemption deductions for her son (age 19), daughter (age 21), and grand-daughter on her 2005 tax return.  The Court determined she could not claim any of them as dependents because they were not full-time students and (with the exception of the grand-daughter) they each earned more than the 2005 personal exemption, $3,200.

But, they did not earn much more. Ms. Brockington's daughter earned $3,512 and her son earned $7,365 during 2005. From a tax policy perspective, why not provide Ms. Brockington with a dependency exemption deduction? Without her support, three people would probably not be able to live indoors. Further, because she is denied the dependency exemptions, she also is denied head of household filing status and is taxed at the higher single filing status rates.

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Education Expenses & IRC Sec. 72(t)

Mrs. Benz (no her first name is not Mercedes), made an election to receive substantially equal periodic payments from her IRA in January 2002 pursuant to IRC 72(t)(2)(A)(iv). By making this election, Mrs. Benz avoids the 10% additional tax on early distributions from qualified retirement plans. Two years later, Mrs. Benz took two additional distributions to pay for her son's college education. On her 2004 tax return she indicated the two additional distributions were not subject to the 10% additional tax because of the exception found in 72(t)(2)(E) for education expenses.

The IRS argued that Mrs. Benz's distributions in 2004 for education expenses constituted a modification in the substantially equal payments under 72(t)(4). Assuming this is true, since the modification occurred prior to her turning 59 1/2 and prior to the five-year period beginning with the first distribution in 2002, she would be liable for the 10% additional tax including interest.

The Tax Court rejects the Services's argument. The Court cites the statute's plain language and its legislative history. Yet another lesson in statutory construction for the IRS.

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Spousal Relief & Statutory Interpretation

In this 12-3 opinion, the tax court invalidated regulation 1.6015-5(b)(1). This regulation was an interpretation of sec. 6015(f) of the I.R.C.

The taxpayer spouse was pursuing spousal relief from joint tax liability under sec. 6015(f) because the two-year limitation required for relief under 6015(c) had passed. The regulation interpreted 6015(f) to include a two-year limitation period even though no such limitation appears on the face of the statute.

The majority and dissent agree, the appropriate standard of review is Chevron deference (referring to the Supreme Court case that laid out a two-prong test for reviewing a regulation). The test is as follows:

(1) If Congress has directly spoken to the precise question at issue, we give effect to the unambiguously expressed intent of Congress. If the statute is ambiguous, then we continue to the second prong: (2) If the statute is ambiguous with respect to the specific issue, we determine whether the regulation is a permissible construction of the statute. 467 U.S. 837, 842-843.

Prong one is the tough hurdle here. The majority finds Congress's silence on the face of 6015(f) combined with Congress's explicit requirement of a two-year limitation in 6015(c) dispositive of prong one.

The dissent finds enough interstices in 6015(f) to make it ambiguous and continues the analysis under prong two. The dissent looked at legislative history to determine that the Commissioner acted "eminently reasonably" in interpreting 6015(f).

I find the dissent's analysis hard to accept. As I learned from my constitutional law professor, language is inherently interstitial (which means it is filled with gaps). But gaps alone do not make a phrase ambiguous. The IRS got this regulation wrong; adding a 2-year limit to 6015(f) when it already existed in 6015(c) makes 6015(f) surplusage.

A note for practitioners: Based on my own research, Lexis and Westlaw have the regulation updated with this case. CCH Tax Research Network and BNA do not (as of the date of this post).

Download Lantz.TC.WPD

Charitable Conservation Easements

Servitudes, appurtenant easements, servient and dominant estates, the Restatement of Property, and Bull Mountain. If I did not know any better, I would think this tax court memo was written by my property law professor.

The Tax Court provides a well thought-out analysis of the interaction between property law and real estate valuations. The good stuff starts on p. 28...

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