The Tax Law Report

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.

Valuing Conservation Easements & Playing Golf

For anyone doing work related to the valuation industry, this is an interesting opinion that is worth reading in its entirety.

SUMMARY

In the early '90s, Mr. Drummond (not the father of Kimberly, Willis and Arnold), purchased 251 acres from the Resolution Trust Company for $1,050,000. The land is located on the Gulf of Mexico in Alabama. Soon after the purchase, he conveyed his interest in the property to an LLC he created (D&E Investments, LLC). With the property, D&E developed a residential resort community called Kiva Dunes, complete with golf course, swimming pools, etc. The golf course, Kiva Dunes Golf Course, was conveyed to Kiva Dunes LLC (also formed by Mr. Drummond).

At issue for the Tax Court is the value of a conservation easement donated by Kiva Dunes to the North American Land Trust. It is not clear from the opinion, but it seems the easement was placed on property adjacent to the golf course. Kiva Dunes LLC claimed a $30,588,235 charitable deduction for the easement on its 2002 tax return. The IRS's expert valued the easement at $10,018,000 while Kiva's expert valued the easement at $31,938,985.

The general rule is that charitable contributions of partial interests in property are not deductible. An easement, by definition, is a partial interest in property. But there is an exception for qualified conservation contributions under section 170(f)(3)(B)(iii). Section 170(h) defines "qualified conservation contribution for purposes of (f)(3)(B)(iii). Initially, the IRS challenged whether the contribution here even qualified, but later conceded this point.

The value of a charitable contribution deduction of property is its fair market value at the date of the donation. Regulation 1.170A-1(c) defines fair market value as: the price at which property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.

The Tax Court points out that, in the case of real property, the "highest and best use" is considered fair market value. And in the case of easements, the common approach is the "before and after" method; that is, the value of the property before the easement minus the value of the property after the easement equals the value of the easement.

These cases generally come down to a battle of experts. The value of property is a question of fact. The Tax Court being the trier-of-fact, is free to pick one expert over the other, or to reject both.

The experts agreed that the highest and best use of the easement would have been a residential subdivision.In assessing the "before value," the Tax Court looked at three key variables the two experts disagreed on. First, how many lots could be sold on the easement if it were a residential subdivsion, the average selling price of each lot, and how fast the lots would be sold. Kiva Dunes's expert offered very impressive analysis on the issue, and the Tax Court accepted their expert's opinion without change - $31,938,985. This figured assumed 370 lots could be sold at an average selling price of $170,000 over a ten-year period (multiplying 370 by $170,000 equals $62.9 million, thus the ten-year period cuts the value in half).

The experts used different methods for the "after value" analysis. Kiva's expert used the market approach (comparable sales). The IRS's expert used an income approach; he capitalized the earnings of the golf course. The problem for the IRS's expert was that the income stream he capitalized was incorrect.

Here again, Kiva's expert held the day. He presented five comparable sales of similar pieces of property in Alabama, and then made adjustments to each comparable sale based on seven variables. Some of the variables included, market conditions, location, and size. The Tax Court increased Kiva's "after value" for improvements made to the golf course by Kiva and enhancements. After adjustments, the Tax Court concluded the "after value" plus enhancements equaled $3,282,981.

Subtracting the after value ($3,282,981) from the before value ($31,938,985), the value of the easement equals $28,656,004.

Download KIVADUNES.TCM.WPD

ANALYSIS

First, the IRS picked the wrong caddy to play golf with. Their expert had very little experience in the state of Alabama, and made critical errors applying valuation methodology. Kiva obviously had a little more at stake, and no doubt went after a more qualified appraiser.

Second, let's put the value of this deduction in perspective; at a marginal tax rate of 28%, U.S. taxpayer's paid approximately $8 million for the easement. Two questions arise: should we buy it, and did we overpay?

The second question is probably easier to answer than the first. Kiva Dunes is still selling home lots and the average price appears to be north of $170,000. Given the real-estate bust, the ten-year sellout assumption is most likely at risk. Like everyone else over the past five years, we probably over paid for real estate. Hurrican Katrina hit Baldwin County very hard in 2005, but I won't try to factor this into the analysis.

Should we buy conservation easements in the first place? This requires an entire post by iteslf. But, it's a question worth considering, particularly now when we need to increase tax revenue. Perhaps a suspension until the country can get further out of debt would be prudent.

Opinion - Certifying Tax Preparers

There was quite a bit of discussion last week (and it seems to be continuing this week) regarding the IRS's interest in certifying tax preparers. The Tax Update Blog contains a healthy discussion between several tax pros on the topic. For what it's worth, here is my ten cents (keep the change).

In short, I like the idea. And the reason is simple; Title 26 of the U.S. Code is statutory law, and complex or not, applying any law requires a minimum amount of education, understanding, and experience. The only way to test education, understanding, and experience is through some sort of certification process.

But passing a test once is no guarantee of future competence, particularly with respect to the Internal Revenue Code. There must also be continuing education requirements to ensure a basic exposure to each year's changes. A certification process will, hopefully, require some sort of continuing education to maintain certification.

The last thing I think a certification process will increase is integrity. To deduct or not deduct, at times, is two-parts law and one-part ethics. A preparer will, at one point in her career, need to tell the taxpayer, "no, it's not deductible, and I do not care if your brother joe is taking the deduction." Through certification, the preparer now has something to lose for playing audit roulette - a license to earn a living. People act differently when they have something to lose.

One of the counter-arguments include increased cost to taxpayers. That is a real possibility. But my counter to this argument is that a more knowledgeable tax preparer should complete a return faster than one who is less knowledgeable. This phenomena plays out in my office ever year. Staff accountants almost always take longer to prepare a return, that's why we bill them at a lower rate - so the client doesn't get hosed.

Currently, CPA's and Enrolled Agents are the only tax-related certifications I know of. Each has passed an exam that has a significant focus on tax - the special enrollment exam is certainly the more rigorous tax exam of the two. It may come as a surprise, but lawyers are not always part of this group. In my opinion the bar exam does not test enough tax. Further, most law students take only federal income tax; largely an introductory course of income tax case law as it applies to individuals.

Tax lawyers, however, are a special class. Most go on to receive further education solely in tax law. And after a few year's of experience they are certainly qualified. For purposes of certification, however, it may not matter. Most people do not go to a lawyer to get their tax return prepared.

Finally, though already a CPA, I would be happy to take any exam or fulfill any certification requirement that the IRS introduces. I have never suffered from more education.

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.

Download PUGH2.TCM.WPD

Download Pugh-2003

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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Tax-Practitioner-Client Privilege

Countryside v. Comm'r, 132 T.C. No. 17, (T.C. 2009).

This is is a tax procedure case. The IRS filed a motion to compel production of documents (Rule 37 of the Federal Rules of Civil Procedure and Rule 72 of the Tax Court Rules of Practice and Procedure). The partnership asserted that the documents were privileged under section 7525(a).

The section 7525(a) privilege protects tax advice between a taxpayer and a federally authorized tax practitioner (FATP). The section states that this is the same privilege that would exist between a taxpayer and an attorney.

A Federally Authorized Tax Practitioner is defined as "any individual who is authorized under Federal law to practice before the Internal Revenue Service if such practice is subject to Federal regulation under section 330 of title 31, United States Code." Clear as mud. Generally, an attorney, a cpa, and an enrolled agent are allowed to practice before the IRS, but I will need to confirm if this generality applies here.

"Tax Advice means advice given by an individual with respect to a matter which is within the scope of the individual’s authority to practice described in subparagraph (A)." -- subparagraph (A) refers to the paragraph that defines a Federally Authorized Tax Practitioner. Clearer than mud.

There are two important exceptions to this privilege under section 7525(b). The first exception is that the privilege does not apply in criminal proceedings. This makes sense because if you are facing criminal charges you need an attorney not a Federally Authorized Tax Practitioner (though the two can be the same). The second exception is that the privilege does not apply to written communication promoting tax shelters.

It is this second exception that the IRS tries to assert in the present case. The Tax Court focused on two items in denying the IRS's motion. First, the requirement that the communication be written, and second that the communication promote tax shelters.

The IRS argued that notes, written down by the taxpayer, of an oral conversation between the FATP and the taxpayer constituted written communication. The Tax Court rejected this argument for two reasons. First, the communication was not in writing but was oral. Second, the taxpayer did not share his notes with anyone.

In rejecting the promotion requirement, the Tax Court referred to legislative history for guidance on the word "promotion." Specifically referring to a House Conference Report that stated , "[T]he Conferees do not understand the promotion of tax shelters be part of the routine relationship between a tax practitioner and a client." Here, the FATP had a "longstanding" relationship with the taxpayer that existed prior to the transactions at issue. The Tax Court dedicates an entire page to describing their relationship. Among other things, the Tax Court describes their fee arrangement, the length of their relationship, the scope of the services provided, and the FATP's source of knowledge.

As mentioned, the 7525(b) test has two parts; for all practical purposes the IRS lost after the Court determined the communication was not written - the Court even says so on page 8. It is interesting, therefore, that the Tax Court devotes 50% of the opinion (the last seven pages) to discussing the second part of the test. Given the relationship between the FATP and the taxpayer (all on record), perhaps this was a good opportunity for the Court to emphasize factors to consider in determining whether someone is "promoting a tax shelter."

As a final note, like the attorney-client privilege, the privilege here can be waived. There is an ongoing case in the First Circuit, United States v. Textron, Inc., 560 F.3d 513, 2009 U.S. App. LEXIS 10679 (1st Cir. 2009), that will have important implications. I will post an update when the case is over.

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.

Download R2ice.SUM.WPD

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.

Download Blackmon.SUM.WPD

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.

Family Limited Partnership, QTIP, and Inter Vivos Transfers

The facts in this case are very convoluted. I will try to simplify and briefly explain the facts that are relevant to the Tax Court's decision.

Mrs. Miller died in May 2003 - the value of her estate is the issue in this case. Mr. Miller (Mrs. Miller's husband) became an avid investor after retiring as an architect. He used technical analysis, e.g. charts, to make investment decisions and developed his own investment philosophy. Prior to his death in 2000, Mr. Miller established two trusts; a revocable trust and a qualified terminable interest trust or QTIP trust. At the time of his death, his revocable trust held $7.6 million in securities and constituted 99.6% of his total estate. Virgil G., one of Mr. Miller's four children, became the executor of Mr. Miller's estate (he is also the executor of Mrs. Miller's estate). Virgil G. funded the QTIP trust with $1 million worth of assets and took a marital deduction for the full amount on Mr. Miller's estate tax return pursuant to section 2056(b)(7).

Two years after Mr. Miller's death, Mrs. Miller and Virgil G. formed the Miller Family Limited Partnership. The purpose of the MFLP was to centralize the management of the family's securities. Mr. Miller trained Virgil G. in his investment philosophy. Virgil G. was charged with managing the MFLP assets using his father's investment philosophy. In so doing, Virgil G. was paid a management fee and worked 40 hours per week managing the investments.

The MFLP distributed 1,000 units. 920 to Mrs. Miller and 20 units to each of the four children which included Virgil G. In April 2002 Mrs. Miller funded the MFLP with two transfers. The first transfer was for $2.7 million in securities. The second transfer was $1.2 million in securities.

The last transfer from Mrs. Miller to the MFLP occurred in May 2003, several weeks prior to Mrs. Miller's death. Mrs. Miller transferred all her remaining assets to the MFLP; in total about $1.2 million.

In total Mrs. Miller transferred about $5.1 million to the MFLP over a period of two years. At her death, she still had the funds from the QTIP which had dwindled to about $.5 million. This at least gets us close to the $7.6 million that the family started with when Mr. Miller died. But I can't totally account for the $7.6 million.

On Mrs. Miller's estate tax return, Virgil G. valued Mrs. Miller's 920 units at fair market value and took a 35% marketability discount. The discount for marketability reflects the illiquid nature inherent in units of limited partnership. For example, if you own stock in a publicly traded company, you can sell that stock and receive cash in three business days. You cannot do the same with units in a limited partnership. It could take weeks at best and probably months to sell your units and receive cash. This time difference reduces the units' value.

The IRS argues three points. First, the fair market value of the QTIP trust should be included in Mrs. Miller's estate since it was excluded under Mr. Miller's estate using the marital deduction. Second, both the April 2002 and the May 2003 transfers should be disregarded, and the full fair market value should be included in Mrs. Miller's estate without discounts, because the transfers were not pursuant to a bona fide sale for adequate and full consideration. If this is the case, then the full fair market value of the transfers will be included in Mrs. Miller's gross estate pursuant to section 2036(a). The purpose of this section, as the Tax Court points out, is to prevent escape from the estate tax by making transfers while a person is living that would normally not take place until that person died. The IRS did not argue in the alternative and challenge the 35% discount, which I think was a mistake.

The Tax Court affirms the IRS's decision on the QTIP and the May 2003 transfer. The taxpayer wins on the April 2002 transfer. The QTIP issue is not worth analyzing in this post; the Tax Court does a very good job starting at the bottom of page 20. Plus it is rather obvious that if the QTIP funding was excluded from Mr. Miller's estate it was going to be included in Mrs. Miller's estate.

In addressing the IRS's first argument, the Tax Court explains that the bona fide sale test is satisfied when the transfer occurs for a non-tax business purpose and the tansferor receives a proportionate interest in the partnership after the transfer. The Tax Court analyzes the substance of the MFLP and determines there was a legitimate non-tax business purpose. It clarifies that the MFLP does not need to be a "business" it merely has to have a non-tax business purpose. The non-tax business purpose test was satisfied by both the MFLP agreement and Virgil G.'s efforts in the years subsequent to its formation. Lastly, Mrs. Miller received 920 units in the MFLP (92%) in exchange for the April 2002 transfer. As a result, section 2036(a) does not apply to the April 2002 transfer.

The May 2003 transfer did not meet the bona fide sale exception of 2036(a). It was logically inferred by the Tax Court that a transfer two weeks prior to Mrs. Miller's death was solely to exclude the amount from her gross estate. As a result, the transfer to MFLP was disregarded. Since the transferred assets are no longer considered part of the partnership, there is no marketability issue to consider, i.e. no discount.

Phew!

Download EstateMiller.TCM.WPD

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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Leasehold Improvements & Substitute For Rent

The IRS really went after Hopkins Partners in this case. The Tax Court rejects not one, not two, not three, but all seven of the IRS's arguments.

Hopkins leased a Sheraton Hotel from the City of Cleveland located at the airport. The City wanted Hopkins to make substantial improvements to the Sheraton otherwise the City was going to build a second hotel. The Sheraton was losing money and Hopkins could not obtain a commercial loan. Hopkins renegotiated the lease with the City and secured rent credits in exchange for eligible improvements. Excess rent credits were carried forward to subsequent years.

Hopkins deducted the eligible improvements against rent expense in the year rent credits were received. Once rent credits were received, Hopkins transferred title of the improvement to the City. When eligible improvements generated excess rent credits, Hopkins capitalized and depreciated the improvements. In subsequent years when the excess rent credits were used, Hopkins transferred title to the City, recognized a sale on the transfer, and calculated gain on the transfer including depreciation recapture.

The IRS argued:

1. the improvements were not substitutes for rent, 
2. the rent credits should be limited
   
3. the transfer of title was illusory,
   
4. the rent credit arrangement lacked economic substances,
   
5. use of the rent credit did not clearly reflect income,
   
6. use of the rent credit was an accounting method change, and finally
   
7. accounting method changes require adjustments under section 481(a).

A common theme throughout was the IRS's focus on the City's tax exempt status. Since the City pays no tax on rent received from Hopkins tax revenue is lost, and at the same time tax deductions are given. The Court considers this point. In the end, however, the lease controlled the transaction. More importantly, there were too many non-tax reasons for the rent credit arrangement. This favored Hopkins's position. Hopkins also kept very good records, obtained opinions from two accounting firms, and treated the transactions consistently throughout the entire period.

There is the potential for abuse when one party to a transaction is tax indifferent, as is the case here with the City. I think another common example is where a Not-for-profit has a for-profit subsidiary. Frequently, the transactions between the not-for-profit and the for-profit allow for deductions on one side and tax-exempt revenue on the other. Lease payments are a prime example. Hopefully the new Form 990 will disclose more of these transactions.

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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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Trade or Business Requirement & Depreciation

Mr. Doherty entered into a purchase agreement with Alpha Telecom to buy 20 pay telephones for $5,000 each. Under the terms of the agreement Alpha would find sites for the pay phones, install them, provide maintenance, and collect revenue. In exchange Alpha would receive 70% of the gross income from the pay phones. Mr. Doherty also entered into a similar arrangement with a different vendor. This time for the purchase of ATM machines.

In an unrelated civil suit brought by the SEC against Alpha, a federal district court determined that the Alpha's pay telephone program was an investment contract. Consequently, it was a security that required registration with the SEC.

On his 2000 and 2001 Schedule C, Mr. Doherty reported income and took depreciation deductions of $162,124 for the pay telephones, and also claimed other business expenses . The IRS determined he was not entitled to depreciation deductions nor was he entitled to deductions for business expenses.

The Tax Court held that since the "benefits and burdens of owning" the payphones did not pass to Mr. Doherty, he was not entitled to take depreciation deductions. Further,transfer of nothing more than "bare legal title" is insufficient.

Secondly, the Tax Court held that Mr. Doherty was not in a trade or business since he "never had the benefits and burdens of owning the payphones . . . and did not conduct any business involving the pay phones."

Lastly, the Tax Court agreed with the IRS that the income received from the pay phones should be reported as other miscellaneous income on the Mr. Doherty's tax return.

The Tax Court came to the same conclusion in two other cases: TCM 2009-98 and TCM 2009-97.

I am pretty dissatisfied with the analysis in this decision. I will not address the benefits and burdens analysis, that would require more than one post. Although, I would like to know if Alpha took depreciation deductions for the pay telephones during 2000 and 2001.

 I will, however, take issue with the Court's trade or business analysis, and the determination to treat the income from the pay telephones as other miscellaneous income.

First, the Court's conclusion that Mr. Doherty was not in a trade or business is based on the premise that he did not obtain the benefits and burdens of ownership associated with the pay phones. The law, which the Court laid out, requires regular and continuous activity plus a profit motive. On the facts here, I find it hard to believe Mr. Doherty did not have a profit motive. Over the periods 2000 and 2001, Mr. Doherty received $164,260 in gross receipts from Alpha. Further, he ultimately invested $200,000 of his own money (there is no indication he took loans) to purchase 40 pay phones. These facts seem to favor a profit motive.

The regular and continuous requirement can be met through the use of an agent. On the facts here, it seems that Mr. Doherty's agreement with Alpha to perform all the required work would be no different than if Mr. Doherty had hired employees and agreed to pay them commissions.

I think the better argument for the Court would be to rely on the SEC's determination that the purchase agreement was a security. This makes Mr. Doherty an investor. It also eliminates the depreciation problem because you cannot depreciate the cost basis of a security.

Lastly, the IRS's request to treat the income as other miscellaneous income has no "because" after it. I am not sure why the IRS thinks this is miscellaneous income, particularly since the purchase agreement is a security that requires registration with the SEC. They seem to completely ignore this fact. If the purchse agreement is a security, then the income received is generally interest, dividends, or capital gains.

In the end, maybe the right decision by the Court, but the analysis is weak.

Download Doherty.TCM.WPD

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).

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Temporary Jobs & Travel Expenses

The facts in this case are pretty straightforward. Mr. Burley expected his temporary assignment to last less than one year. In actuality, the assignment lasted longer than one year. The Tax Court denied Mr. Burley's deductions for travel expenses because his assignment in actuality lasted longer than one year. This decision is in direct contradiction to Revenue Ruling 93-86 which provides in part:

"In Situation 3, C at first realistically expected that the work in CI-2would last only 9 months. However, due to changed circumstances occurring after 8 months, it was no longer realistic for C to expect that the employment in CI-2 would last for 1 year or less. Therefore, C's employment in CI-2 is temporary for 8 months, and indefinite for theremaining 7 months. Thus, C's travel expenses paid or incurred in CI-2during the first 8 months are deductible, but C's travel expenses paid or incurred thereafter are nondeductible."

The Tax Court relies on prior case law with no mention of the revenue ruling. I think they got it wrong here.

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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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Issue Preclusion

Excellent discussion by the Tax Court on issue preclusion (see link to case opinion below). Taxpayer plead guilty to criminal charges for, inter alia, failure to pay employment taxes. The taxpayer was collaterally estopped from denying responsibility for paying employment taxes in suit with the IRS. Nice job IRS lawyers!

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Introduction

The Tax Law Report provides opinion, analysis, and hopefully some humor, on Tax Policy and U.S. Tax Court Decisions (or any other tax topic of interest). The editor, G.Christopher Wright (Chris Wright), is a Certified Public Accountant, Certified Valuation Analyst, and currently attends the Catholic University Columbus School of Law. At present, Chris Wright provides tax, accounting, audit, and valuation services to both corporate and individual clients in the Washington D.C. metro area.

Comments, questions, analysis, and opinions from readers are welcome. Nothing on this website should be construed to constitute tax advice.