The Tax Law Report

Ordinary and Necessary Business Expenses

Fuhrman v. Commissioner, T.C. Memo. 2011-236 (2011)

INTRODUCTION

IRC section 162(a) states the basic rule for deducting business expenses from gross income.  The section states that in order to deduct business expenses from a taxpayer's gross income, those expenses must be "ordinary and necessary."  As this opinion implicitly points out, the definitions of the terms ordinary and necessary are the result of case law and not something defined in the code.

An expense is ordinary if it is customary or usual within a particular trade, business, or industry or relates to a transaction 'of common or frequent occurrence in the type of business involved.'  Deputy v. du Pont, 308 U.S. 488, 495 (1940).

An expense is necessary if it is appropriate and helpful for the development of the business.  Commissioner v. Heininger, 320 U.S. 467, 475 (1943).

On top of these definitions, the tax court overlays an additional requirement: reasonableness.

The Court of Appeals for the Sixth Circuit, to which any appeal of this case would lie, has held that for expenses to be deductible as ordinary and necessary, they must be reasonable, because 'the element of reasonableness is inherent in the phrase 'ordinary and necessary.'  Commissioner v. Lincoln Elec. Co., 176 F.2d 815, 817 (6th Cir. 1949).

FACTS

The facts in this case are fairly straightforward.  The taxpayers owned, among others, a corporation called Top Line Express, Inc. and a limited liability company called Grasshopper Leasing, L.L.C.  Top Line Express is trucking company.  Grasshopper is truck leasing company.  Grasshoper often would lease trucks to Top Line Trucking.

During the tax years 2004 and 2005, Grasshopper paid Top Line approximately $210,000 for management and administrative services.  Because Grasshopper is a passthrough entity, its income and expenses passthrough to its members and are reported on the member's individual income tax return.  In this case, the taxpayers reported the $210,000 management and administrative services as deductions on their individual income tax return.

The IRS disallowed these deductions, arguing the expenses did not meet the section 162(a) rule, i.e. they were not ordinary and necessary business expenses of Grasshopper.

HOLDING

After stating the general rule of law discussed above, the tax court held for the IRS.  In its analysis, the court found dispositive the following facts:

[P]etitioners have failed to demonstrate how the management fees in question were determined.  They have no contemporaneous documentation. . . . There was no written contract for the management fees.  We question whether these amounts were determined at arm's length, since petitions was the sole owner of both Grasshopper Leasing and Top Line Express. (7).

According to petitioner's testimony . . . over half the hours allegedly worked by Top Line employees on behalf of Grasshopper consisted of services in the categories of sales management, safety, and driver relations.  Petitioners have not convinced us that it was necessary for Grasshopper to incur expenses for such services . . . since Grasshopper had no customers other than Top Line and other related entities.  Moreover, . . . Grasshopper had [no] need to recruit, train, test, track, or dispatch truck drivers, since it employed no drivers.  In addition, we are not convinced that [the] consulting services that petitioner allegedly provided to Grasshopper were performed in his capacity as an employee of Top Line rather than in his individual capacity as sole owner of Grasshopper.  Indeed, because Grasshopper had no other owners and no employees, it is not apparent with whom at Grasshopper petitioner might have consulted, other than himself. (10).

COMMENTS

Hopefully it becomes clear to the reader the scam that the taxpayer in this case was trying to pull off.  It should become equally clear how the tax court saw right through it.

The taxpayer thought he could create business deductions in a passthrough entity by having his LLC pay "management expenses" to his corporation.  This creates taxable income for the corporation and expense for the LLC.  The LLC is a passthrough entity, thus the expense flows through to his individual income tax return, where he can use those expenses to offset other income such as wages and interest income.  The revenue is of course taxable income inside his corporation, but probably taxed at lower corporate rates, and most likely offset by significant expenses in his trucking business.

Notwithstanding the fact that the IRS caught the taxpayer, it makes no sense to me why the taxpayer tried to shift income from a passthrough entity into a corporate entity.  Shareholders of the corporate entity pay two levels of tax: the corporate level tax, and the dividend tax.  Now that the taxpayer has created taxable income in his corporate entity, he will pay dividend tax when he, as the sole shareholder, receives the income.

It would be interesting to know if the IRS will let the taxpayer unwind this transaction.  The worst case scenario for the taxpayer would be for the IRS to not only disallow the deduction (which is what occurred here) but also require Top Line to pay tax on the income...after all, there is no requirement that revenue be "ordinary and necessary" before it is subject to tax!

Finally, the best part of the opinion is when the tax court took note that Grasshopper had no employees, let alone truck drivers, so why did Grasshopper need to pay for driver safety.  If you are going to set up a scam, at least make sure it passes the "hold your nose" test.

 

Nonreceipt of K-1 Not Reasonable Cause; Accuracy-Related Penalty Assessed

Ziegeler v. Commissioner, T.C. Summ. Op. 2010-65 (2010).

The taxpayers received income, and distributions, from a partnership but never received a K-1.  Because they did not receive the K-1, they did not report the income on their 2005 tax return.  The Tax Court holds that nonreceipt of the K-1 is not a defense to the 20% accuracy-related penalty; the taxpayers have an obligation to make a good faith attempt to obtain the K-1.

This case follows a general theme from the past few days; pass-through entities can be traps for the unwary.  For comparison with the holding in this case, see Jones v. Commissioner (posted here), where the taxpayers also did not receive a K-1, and they made no reasonable attempt to obtain one.  Consequently, the Tax Court assessed an accuracy-related penalty.

It also came out at trial that the taxpayers provided their CPA a K-1 from the partnership in 2004 with a small amount of income. (3 fn.4).  Although under no obligation under the tax code, as a matter of best practice, practitioners should make an inquiry when information provided in year 1 is missing or incomplete in year 2.  Suppose, for example, in year 1 the taxpayer provided a W-2 from XYZ, Inc., but in year 2 the taxpayer did not provide a W-2 from XYZ.  A practitioner should ask whether the taxpayer changed jobs, or if the W-2 is missing.

This point is even more important when you know the taxpayer has a p'ship interest.  The taxpayer should receive a K-1 every year until she disposes of the interest, which is itself a taxable event that has significant implications.  As applied to the Ziegelers, I do not know whether their CPA made such an inquiry, but if she had, it might have saved the Ziegelers significant time and money.  Moreover, the new AICPA Statement on Standards for Tax Services, effective Jan. 1, 2010, state that practitioners should make use of prior year returns to "avoid the omission of items" on the current year return.  Tax Executive Committee, Statement on Standards for Tax Services 17 (2009).

Respondent determined a $25,123 deficiency in petitioners’ 2005 Federal income tax and a $5,025 accuracy-related penalty under section 6662(a). Petitioners concede liability for the $25,123 deficiency. The issue remaining for decision is whether petitioners are liable for the section 6662(a) accuracy-related penalty. (2).

 

Randi Bach (Ms. Bach), a certified public accountant (C.P.A.), prepared petitioners’ 2005 Federal income tax return.

Petitioner did not provide Ms. Bach with a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., from HealthFirst or any additional information that would have enabled her to calculate his income from HealthFirst. (3).

In order to prevail on this issue, the taxpayer must prove by a preponderance of the evidence that the taxpayer meets each requirement of the following three-prong test: (1) The adviser was a competent professional who had sufficient expertise to justify reliance; (2) the taxpayer provided all necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Neonatology Associates, P.A. v. Commissioner, supra at 98-99. The ultimate responsibility for a correct return lies with the taxpayer, who must furnish the necessary information to the agent who prepares the return.  ASAT, Inc. v. Commissioner, 108 T.C. 147, 176 (1997). (6).

Petitioners have failed to meet their burden of proving that they acted with reasonable cause and in good faith. Though petitioners never received a Schedule K-1, they never requested one, nor did they make any attempt to calculate and report the income from HealthFirst. (7).

Petitioners’ contention that nonreceipt of a Schedule K-1 constitutes reasonable cause is mistaken. See Deas v. Commissioner, T.C. Memo. 2000-204 (nonreceipt of Schedule K-1 did not constitute reasonable cause where taxpayer failed to report partnership income). (7).

 

Also, the fact that a C.P.A. prepared petitioners’ tax return does not establish good faith reliance on an independent, competent professional in this case. Petitioners did not provide Ms. Bach with necessary and accurate information for her to correctly determine petitioner’s income. (7)

Ms. Bach credibly testified that had petitioner informed her of the income from HealthFirst, she would have reported it. Ms. Bach was not required to perform an audit of petitioner’s books and records. (8).

 

 

 

Disproportionate Distributions in an S-Corp; Innocent Spouse Relief

Jones v. Commissioner, T.C. Memo. 2010-112 (2010).

The issues for decision are: (1) Whether petitioner’s former husband’s distributive share of the income of two pass-through entities is includable in their joint income for the year at issue . . . .

 

Mr. Jones is a 45-percent shareholder of Hadley & Pech, Inc. (Hadley & Pech), an aviation management company that is an S corporation, and a 50-percent owner of Archipelago Aviation, LLC (Archipelago), a limited liability company that charters aircraft and is taxed as a partnership. Roger Sutton (Mr. Sutton), who was a friend of Mr. Jones’, owns the remaining 55 percent of Hadley & Pech and 50 percent of Archipelago.  (3).

 

For 2005 Hadley & Pech and Archipelago had $101,927 and $212,298 of ordinary net business income, respectively. Mr. Jones’ shares of that income, as Mr. Sutton eventually reported to the Internal Revenue Service (IRS) on the Schedules K-1, were $45,867 and $106,149, respectively. Hadley & Pech’s cash distributions for 2005 consisted of $115,000 to Mr. Sutton and $10,000 to Mr. Jones, while Archipelago did not make any distributions for 2005.  (4).

 

Although Mr. Jones received only a $10,000 cash distribution from Hadley & Pech in 2005, as a shareholder he was required to recognize his 45-percent share of the S corporation’s income even though it was not distributed. (7).

 

Archipelago reported ordinary net business income of $212,298 on its partnership return but did not make distribution to Mr. Sutton or Mr. Jones during 2005.  As a 50-percent partner, Mr. Jones is required to recognize and report $106,149, his share of the partnership income even though it was not distributed to the partners. (9).

This is an unfortunate, but correct, outcome for Mr. & Mrs. Jones.  Pass-through entities, such as partnerships and S-corporations, are double-edge swords for the unwary.  On the one hand, distributions of cash from the entity are generally not taxed.  But on the other hand, the partner's/shareholder's share of net income is taxable, EVEN IF NO DISTRIBUTIONS WERE MADE.

There were two more decisions for the court to decide: innocent spouse relief, and accuracy-related penalty.  Ms. Jones won the first and lost the second.

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.

Education Expense as Trade or Business Deductions: Part Two

Shah v. Commissioner, T.C. Summ. Op. 2010-6 (2010).

Question for the Tax Court

May a taxpayer deduct education expenses as trade or business expenses when the education expenses directly related to the taxpayer's existing trade or business, but were part of a program of study that led to a new trade or business?

Background

During the years at issue, 2005 and 2006, Mr. Shah was an undergraduate student at New York University (NYU), where he majored in film and television studies. (3).  To meet his graduation requirements he was required to complete both the core courses of his major and elective courses from other fields of study. (3).  A substantial number of the elective courses . . . were in computer science, web design, and multimedia. (3).

While attending high school in Chicago, IL, Mr. Shah began performing information technology services for clients of his Dad's business. (3).  Part of the work involved working on websites for these clients. (4).  He earned between $5,000 and $10,000 during 2003 and 2004 providing these services. (3).

After graduating from NYU, he began working in the entertainment industry . . . creating multimedia content for his employer's website. (4).

On his 2005 and 2006 tax return, Mr. Shah deducted the costs of the classes he took at NYU that related to his trade or business as a website designer while in high school. (8).

When are Education Expenses Deductible as a Trade or Business Expense?

The Tax Court does not recite the applicable regulations in their opinion, but they are helpful for the analysis so I have provided them below.

Regulation 1.162-5(a) states in part:  [e]xpenditures made by an individual for education . . . are deductible as ordinary and necessary business expenses (even though the education may lead to a degree ) if the education -

(1) Maintains or improves skills required by the individual  in his employment or other trade or business, or

(2) Meets the express requirements of applicable law or regulations, imposed as a condition to the retention by the individual of an established employment relationship, status, or rate of compensation.

Exceptions to the General Rule

Regulation 1.162-5(b)(2) states in part:  The first category of nondeductible educational expenses . . . are expenditures made by an individual for education which is required . . . to meet the minimum educational requirements for qualification in his employment or other trade or business.

Regulation 1.162-5(b)(3) states in part:  The second category of nondeductible education expenses . . . are expenditures made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business.

Argument Made by Taxpayer

Petitioner maintains that he deducted only tuition and book costs for those classes related to his computer work.  (7).  Specifically, petitioner posits that since he was employed in Web design and multimedia while in high school, classes he took at NYU related to those fields should be considered to be qualifying work-related education that improved skills and not a program of study that qualifies him for a new trade or business. (8).

Tax Court's Holding

While his computer and Web design courses may have improved his skills, they also helped qualify petitioner for a new trade or business. (8).  These courses were necessary for him to earn his bachelor's degree since he could not have graduate from NYU without those credits. (8).  Therefore, these courses were part of a course of study that will lead to qualifying petitioner in a new trade or business. (8).  As we stated in Warren v. Commissioner, supra:  "what is important under the regulations is that the degree 'will lead' petitioner to qualify for a new trade or business. (8) citations omitted.  Consequently, we hold that petitioner may not deduct his tuition and book expenses for 2005 and 2006. (8).

Blog Comments

The Court reached the right conclusion, but for the wrong reason.

The Court concludes that Mr. Shah's bachelor's degree qualifies him for a new trade or business different from his web design trade or business, but they don't say what that new trade or business is.  In reaching this conclusion, the Court places emphasis on the fact that Mr. Shah could not graduate NYU without the credits in website design and multimedia classes.  I suppose the inference we are meant to draw from this point is that education leading to a bachelor's degree in XYZ implicitly qualifies the taxpayer for a new trade or business.

However, this ignores the first sentence in the regulation that allows a deduction for education expenses "even though the education may lead to a degree."  Based on the first sentence of the regulations, it would seem irrelevant then that the credits in web design and multimedia classes were required to graduate from NYU.  In fact, if this were the standard, almost every type of secondary education expense would be nondeductible as trade or business expenses.

The Court should have placed their emphasis on the type of bachelor's degree Mr. Shah was pursuing, "film and television studies."  The Court then could reasonably hold that "film and television studies" qualified Mr. Shah for a trade or business different from web design, namely "film and television."  Mr. Shah points out, however, that he only deducted the courses that specifically related to his web design trade or business.  But the Tax Court correctly responds that the regulations exclude education expenses that are "part of a program of study that qualifies him for a new trade or business."  Mr. Shah's web design classes were "part of a program of study".

Separately, the Court might have focused on the first category of nondeductible education expenses, those that "meet the minimum requirements of his employment or other trade or business."  Presumably, Mr. Shah's bachelor's degree "meets the minimum requirements of . . . [an] other trade or business."

Education Expenses: Is Your MBA Deductible?

Singleton-Clarke v. Commissioner, T.C. Summ. Op. 2009-182 (2009).

This is a long post because the decision will have some widespread implications, even though it is a tax court summary opinion, which is by definition of no precedential value.

Question for the Tax Court

Is a registered nurse working in an administrative role in the healthcare industry entitled to deduct the costs of an MBA with a focus in healthcare management, or does the MBA qualify her for a new trade or business, thus not deductible?

Background

Petitioner, Ms. Singleton-Clarke, is a registered nurse (RN) with 24 years experience.  From 2004 to 2007 she worked for Civista Medical Center.  (3).  Her job title was quality improvement coordinator and her responsibilities were to coordinate the quality improvement and risk management activities for the hospital. (3).  The minimum education and experience requirements were 'a Bachelor of Science degree in Nursing or equivalent education and experience' . . . and 'current licensed as a RN . . . .' (4).

From 2007 to 2008 she worked for Children's National Medical Center in Washington, D.C.  (4).  Her job requirements stated:  'Bachelor's in Nursing; Master's in Public Health preferred.  Two years quality improvement experience in a hospital setting . . . . ' (4).

In late 2008, she began working at St. Mary's Hospital.  Her title is performance management coordinator, and . . . her duties focus on coordinating, planning, and implementing the Hospital's performance improvement activities.  The job qualifications are:  RN license required.  B.S. Health Care Administration required--Masters preferred.

Petitioner began taking courses at the University of Phoenix in March 2005, graduating in April 2008 with an MBA/HCM.  (5).  The MBA/HCM provides students 'with the business management skills needed to manage successfully in today's health care delivery systems.'  The program features courses in 'health care organizations, health care finance, quality and database management, health care infrastructure, and health care strategic management.'

Ms. Singleton-Clarke paid the entire cost of the program and none of her employers had a reimbursement policy for the MBA/HCM program.  Ms. Singleton-Clarke deducted $14,787 in unreimbursed employee business expenses for education expenses.  The IRS disallowed the entire amount.

When Are Education Expenses Deductible?

Section 1.162-5, Income Tax Regs., Expenses for Education (the regulation), interpreting section 162, Trade or Business Expenses, governs whether a taxpayer may deduct education expenses.  The regulation provides that a taxpayer may deduct education expenses as ordinary and necessary business expenses

if the education--

(1) Maintains or improves skills required by the individual in his employment or other trade or business, or

(2) Meets the express requirements of the individual's employer, or the requirements of applicable law or regulations, imposed as a condition to the retention by the individual of an established employment relationship, status, or rate of compensation.

Sec. 1.162-5(a)(1) and (2), Income Tax Regs.

Conversely, the regulation provides that if the education qualifies the individual for a new trade or business, then the education expenses are not deductible because the education is a personal expense or constitutes an accumulation of personal capital. Sec. 1.162-5(b)(3), Income Tax Regs.

Whether the education qualifies the taxpayer for a new trade or business is an objective inquiry analyzing the tasks and activities the taxpayer was able to perform before the education in comparison to those the taxpayer was qualified to perform afterward. (citations omitted). In other words, the relevant standard is whether the education objectively qualifies the taxpayer for a new trade or business. (citations omitted).  Accordingly, the taxpayer's subjective intent in undertaking the education is not relevant, and likewise it is not material whether the taxpayer does in fact become employed in a new trade or business. (citations omitted).

IRS's First Contention:  The MBA/HCM was a prerequisite to the St. Mary's job

The IRS contends that without receiving the MBA/HCM in April 2008 petitioner would not have obtained her final job, the one she started in September 2008 at St. Mary's, because the St. Mary's job description . . . required at least a bachelor of science in health care administration, which petitioner had not previously earned.

Tax Court's Answer: No.

We believe that St. Mary's would have gladly hired petitioner . . . even without the MBA/HCM.  All three positions, [prior to her St. Mary's position], required an RN license or a bachelor's in nursing, with clinical or risk management experience; credential the petitioner possessed. (10).

[W]e find that the MBA/HCM may have been a helpful addition to her qualifications, but was not an essential prerequisite for petitioner to secure the position at St. Mary's. 

IRS's Second Contention:  The MBA qualifies petitioner for a new trade or business

The IRS contends that the MBA/HCM does qualify petitioner for a new trade or business, because in respondent's words, under the regulation 'the tasks and activities she was qualified for before she obtained the degree are different than those which she is qualified to perform afterwards'.

Tax Court's Answer:  The MBA does not qualify petitioner for a new trade or business

An MBA degree is different from a degree that serves as foundational qualifications to attain a professional license.  For instance, this Court had denied deductions for law school expenses, because a law degree qualifies a taxpayer for the new trade or business of being a lawyer. (11).

An MBA is a more general course of study that does not lead to a professional license or certification. (11).

This Court has had differing outcomes when deciding whether a taxpayer may deduct education expenses related to pursuing an MBA, depending on the facts and circumstances of each case. (12).

Analyzing petitioner's situation, her facts and circumstances far more closely resemble the cases that allowed a deduction for pursuing an MBA.  Petitioner worked for 1 year as a quality control coordinator and had more than 20 years of directly related work experience, gaining vast clinical and managerial knowledge in acute and subacute health care settings, before beginning the University of Phoenix MBA/HCM program. (15).

[T]he MBA/HCM may have improved petitioner's preexisting skill set, but objectively, she was already performing the tasks and activities of her trade or business before commencing the MBA. (16).

Blog Comments

I think the Tax Court missed the mark here.  They do a wonderful job of articulating the law but then drop the ball when applying the facts to the law.  Its analysis regarding whether an MBA qualifies the taxpayer for a new trade or business is overly generous, and is almost certain to allow any taxpayer with even remote ties to any sort of existing trade or business a free ride on the Fisc's shoulders for an MBA. 

A walk through the regulations will help highlight my point.  The regulations lay out a test that has two prongs, both of which must be satisfied before education expenses are deductible. 

The first prong can be satisfied in one of two ways: either by showing that the MBA "improves existing skills required by the employer or trade or business" OR by showing that the MBA "is required condition of retaining the current job".  Here, Ms. Clarke's MBA was not a condition to her keeping her job, thus she had to show that the MBA improves the skills required by her current job, namely "coordinating, planning, and implementing the Hospital's performance improvement activities."  No big disagreement here, an MBA improves this required skill.

The second prong is always the more difficult prong for taxpayers to pass.  The second prong requires a showing that the MBA does not qualify you for a new trade or business.  It does not matter whether the taxpayer actually takes a job in a new trade or business, it only matters that the taxpayer is now qualified to do something different.  A key question is whether the taxpayer's current trade or business should be considered in determining if the education qualifies the taxpayer for a "new" trade or business.  Based on examples provided in the IRS regulations, I think the answer is yes.  How do you know if the taxpayer is qualified to do something "new" without comparing a "hypothetical new trade or business" to the "old trade or business"?

Here, Ms. Clarke's "old" trade or business is in the field of healthcare management.  Now that she has an MBA, is she qualified to leave healthcare management and go work in a different industry? This is where the Tax Court's analysis completely breaks down.  The Court considers an MBA, "a general course of study" that may or may not qualify the taxpayer for a new trade or business depending on the facts and circumstances.  It might be helpful to know that all MBA's from accredited institutions require 2/3 of the studies to be in various areas of accounting, marketing, operations management, etc.  The other 1/3 can focus in concentrations or other areas of study.  Ms. Clarke's MBA/HCM from the University of Phoenix is no different.  36-54 credit hours must be in required courses of study such as accounting, marketing, business law, management, economics, etc.  After which, 15 credits can be taken in areas of study/concentration such as Health Care Management.

I find it extremely unreasonable to conclude that this course of study does not qualify Ms. Clarke to leave the field of healthcare management and pursue any myriad of job opportunities in other industries with her new MBA.  I would conclude that she is absolutely qualified to "perform tasks and activities different" from those she was qualified to do before her MBA.  To conclude otherwise ignores the fact that 2/3 of her course of study were not relevant to her existing position.

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 and Facade Easements

Simmons v. Commissioner, T.C. Memo. 2009-208 (2009).

Question for the Tax Court

[W]hether petitioner, Simmons, is entitled to charitable contribution deductions with respect to facade conservation easements petitioner granted to L'Enfant Trust, Inc. (L'Enfant). (2).

Background

Simmons was a real estate agent . . . operating under the real estate brokerage firm of Coldwell Banker. (2).  She owned two improved properties in Washington, D.C. . . . Both were rowhouses subject to the Historic Landmark and Historic Preservation Act of 1978 during the years at issue. (3).  Simmons granted facade easements on both properties to L'Enfant, a 501(c)(3) nonprofit corporation. (3-4).  Each facade conservation easement was memorialized by a 'Conservation Easement Deed of Gift' (the deed). (4).  The deeds provided in effect that Simmons could not make any material changes to the respective facades in any way without L'Enfant's consent. (4).  The deeds also provided that should petitioner sell the subject properties, the easements would remain in force. (5).

Simmons hired appraisers to determine the values of the conservation easements. (5).  The appraiser valued the Logan Circle easement at $162,500, and the Vermont Avenue easement at $93,000. (5).  At trial . . . Simmons and the Commissioner introduced expert reports valuing the contributions. (7).

Commissioner's Three Arguments

[T]he easements granted to L'Enfant are not valid easements for purposes of section 170; that even if . . . the easements are valid, Simmon's appraisals are not qualified appraisals; [and] Simmon's has not met her burden of proof because her appraisals are not credible. (8).

Section 170 Rules for Conservation Easements

Section 170(h)(1) provides that a contribution of real property may constitute a qualified conservation contribution if the real property is a 'qualified real property interest,' the donee is a qualified organization, and the contribution is 'exclusively for conservation purposes.  All three requirements must be met for a donation to qualify as a qualified conservation contribution. (9).

[A] 'qualified real property interest' means 'a restriction (granted in perpetuity) on the use which may be made of the real property.' . . . . See sec. 1.170A-14(g)(1), Income Tax Regs. (9).  [T]he term 'conservation purpose' means the preservation of an historically important land area or a certified historic structure. (9).

Commissioner's Arguments Against Valid Easement

[N]o conservation purpose described in section 170(h)(4) has been met because L'Enfant:  (1) can consent to changes in the facades, even if they are contrary to the conservation purposes of the easements and (2) has the right not to exercise any of its obligations under the easements. (10).

[T]he requirements of section 1.170A-14(g), Income Tax Regs., have not been met because the restrictions in the easements allow L'Enfant to consent to changes in the facades. (10).

The Contributions Here are Qualified Conservation Easements 

Although the grants do allow L'enafant to consent to changes to the properties, the grants require rehabilitative work or new construction on the facades to comply with the requirements of all applicable Federal, State, and local government laws and regulations.  (11).  Section 1.170A-14(d)(5), Income Tax Regs., specifically allows . . . future development [that] is subject to local, State, and Federal laws and regulations. (11).

Reporting Requirements for Charitable Contributions

Section 1.170A-13(c)(3)(i) and (ii), Income Tax Regs., contains the specific requirements that a "qualified appraisal" must meet.  (14).  In Bond v. Commissioner, 100 T.C. 32, 41 (1993) . . . This Court found the requirements to be directory rather than mandatory, and found the taxpayers to have substantially complied with the qualified appraisal requirements because substantially all of the information required had been provided . . . . (15).

Commissioner argues that the appraisals . . . are not qualified appraisals as defined in section 1.170A-13(c)(3), Income Tax Regs., because they:  (1) Fail to adequately describe the properties contributed; (2) fail to accurately identify the method of valuation used to determine the fair market value of the contributed easements or to adequately describe the specific basis for valuation;  (3) do not include a statement that the appraisals were prepared for income tax purposes; and (4) do not provide the dates of contributions. (17).

[Here], [t]he appraisals adequately describe the parcels of land owned by petitioner . . . . The appraisals also contain lengthy discussions of historic preservations easements in general.  (17).

Although the appraisals did not contain an explicit statement that they were prepared for income tax purposes, the appraisals did contain statements that the owner . . . was contemplating donating conservation easements to L'Enfant.  The appraisals also include discussion of IRS practice and cases of this Court concerning facade easements. (18).

Accordingly, petitioner has complied with the substantiation requirements of section 170. (18).

Valuation of Conservation Easements

The "before and after" approach has been used on numerous occasions to determine the fair market values of restrictive easements with respect to which charitable contribution deductions are claimed. (citations omitted). (18).  The "before" value of the property generally reflects the highest and best use of the property in its condition just before the donation of the easement. (19).

The Court does not define "after" value and its significance in the "before" and "after" approach.  The "after" value is the fair market value of the property including the easement.  Generally, the fair market value of a parcel of property will decrease "after" an easement is placed on the property.  Consequently, in the context of charitable contributions, the taxpayer's charitable contribution is the difference between the "before" value and the "after" value.  The larger the decrease in the value, the greater the charitable contribution.  In these instance, each side hires an expert appraiser.  Then the Court must decide which appraiser they believe.

The Court Accepts the Taxpayer's "Before" Value 

The difference in the "before" valuations . . . mainly stem from the taxpayer's expert putting a premium on the Logan Circle parcel's view.  Because the view from the Logan Circle parcel is of Logan Circle Park, the taxpayer's expert increased his valuation by $50,000. (21).

We find petitioner's "before" valuations to be reasonable and we adopt them. (21).

But Rejects the Taxpayer's "After" Value

The parties' disagreement concerns how the easements affect the fair market value of the properties.  The Taxpayer's appraisals apply a 13-percent decline in value to Logan Circle parcel and and 11-percent decline to the Vermont Avenue parcel. (21).  The IRS's expert reports did not find any change in the fair market value of either property as a result of the granting of the easements.  (21).

We agree with the taxpayer that the easements granted do affect the fair market value . . . . However, we do not agree with the amounts . . . claimed.  [W]e . . . find that the easements resulted in only a 5-percent reduction in the values of the subject properties.  (25).

This decrease stems from the heightened financial burdens of an eased facade and L'Enfant's affirmative enforcement of its easements.  (25).   [E]ven though the property was subject to local preservation laws before the granting of the easement, . . . it is important to note that granted easements to L'Enfant meant that the taxpayer would be subject to a higher level of enforcement than that provided by the District of Columbia.  (25).

[P]etitioner is entitled to charitable contribution deductions of $56,250 for 2003 and $42,250 for 2004. (27).

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.

Where do You Get Your Finance News From?

This post is far from the purpose of this blog, but I wanted to share an observation I made this morning that I thought readers might find interesting.

Citigroup reported its third quarter financial results yesterday evening.  Today, the New York Times, the WSJ, and Bloomberg reported the results.  The differences are striking.  Below, I provide the first two paragraphs of each story.  And so I pose the question, "where do you get your finance news from?"  Do you get it from the New York Times, The Wall Street Journal, Bloomberg, etc.? 

The difference between the $101 million profit from continuing operations (Bloomberg), mostly due to an $851 million gain (WSJ), that ultimately resulted in a net loss of 27 cents per share to common shareholders (NYT) is based on several accounting principles that the average American is not aware of...I even struggle to keep them all straight -- and I am a genius! ha ha.

So who is doing a better service to its readers?  Is the New York Times "exposing" a "lie" (I use that word facetiously) or are they really misleading the average reader? Conversely, are the WSJ and Bloomberg "hiding" something? Or is this just more of the same conservative/liberal spin on a story?  Do I really have to read three different news sources to get the full picture?

NEW YORK TIMES

CITIGROUP'S TROUBLES CONTINUE IN THIRD QUARTER

Published: October 15, 2009

After pulling off two consecutive quarterly profits, Citigroup posted a loss in the third quarter as spiraling consumer losses overwhelmed its strong trading results.

The banking giant said that it had a loss to stockholders of 27 cents a share or $3.2 billion, compared with a loss of $2.9 billion, or 61 cents a share, in the third quarter a year ago. The bank reported a profit from continuing operations of $101 million. (here for story).

BLOOMBERG

CITIGROUP HAS $101 MILLION PROFIT AS RESERVES GROW MORE SLOWLY

Oct. 15 (Bloomberg) -- Citigroup Inc., the lender 34 percent owned by the U.S. government, posted a $101 million profit, defying expectations for a loss, as the company slowed the pace of building reserves for future loan defaults.

The third-quarter profit compared with a loss of $2.82 billion a year earlier, the New York-based bank said today in a statement. On a per-share basis, the company had a loss of 27 cents because of a charge related to the exchange of government- and privately held preferred shares into common stock. Eighteen analysts surveyed by Bloomberg News estimated a loss of 29 cents.  (here for story).

WALL STREET JOURNAL

CITIGROUP SWINGS TO NARROW PROFIT ON EXCHANGE GAIN

Citigroup Inc. swung to a narrow profit in the third quarter on an $851 million gain from its securities-exchange efforts in the quarter that left the U.S. government owning a one-third stake in the company.

The bottom line wasn't as bad as analysts feared though the far-flung bank saw more credit losses and a build in loan loss reserve. (here for story).

Why Taxpayers Should Not Follow Tax Advice from a SkyMall Catalog

"Oh what a tangled web we weave, When first we practice to deceive."  Sir Walter Scott

Estate of Angle v. Commissioner, T.C. Memo. 2009-227 (T.C. 2009).

Ever been on an airplane?  If yes, then you are probably familiar with SkyMall, the mail-order catalog easily found in the pouch behind every airplane seat.  But I bet you never knew you could find tax advice in those catalogs did you?  Let me introduce Cloyd Angle and his son Tyler.

Cloyd was the founder and sole owner of Cal-Almond, Inc.  He started the Company in 1979, and by the mid-90's was one of the top four almond processors in the country. (2).  During the 1990's Cloyd transferred both ownership, approximately 51%, and management of the Company to his son Tyler. (2). 

Interested in selling his remaining 49% ownership interest for a hefty price tag, Cloyd came upon Morven Partners. (3).  Morven had a large presence in the nutmeat industry, but not much in the way of almonds.  Cloyd told Morven he would sell the whole business for $20 million, a number he thought they would refuse.  To his delight they accepted.  After convincing his son Tyler to sell his 51%, Morven signed a letter of intent.

Of course, Cloyd would have to pay taxes on the sale of his stock to Morven.  Cloyd's taxable gain would be the sale price of his stock less his cost basis, which appears to be zero. (3).  That means Cloyd's taxable gain would be 49% x $20,000,000 minus $-0-, or $9,800,000.  The sale was supposed to take place in 1995.  At that time capital gains rates were approximately 28% (see table here).  Multiplying 28% by Cloyd's share of the sale ($9,800,000) equals $2,744,000 in federal income taxes.  The idea of paying $2.7 million in income taxes was too much for Cloyd to bear.

Fortunately, Cloyd came across a copy of SkyMall.  While perusing through the myriad of wonderful gifts and gadgets, "he spotted an advertisement for books and tapes on offshore tax planning."  Thrilled about the prospect of avoiding income taxes he contacted Jerome Schneider, the man who was selling the books and tapes.

It was not long after meeting Mr. Schneider that Cloyd began setting up offshore business, renouncing his U.S. citizenship, and transferring his stock to companies set up in beautiful places like Turks and Caicos and the British Virgin Islands.  When all was said and done there were six different entities.  I beg you to go to page 10 of the opinion and view the exquisite picture provided by the Tax Court depicting all the moving parts; it is truly a work of art.

Unfortunately, poor Cloyd dies before he can realize his dream of avoiding federal income taxes. (15).  The Tax Court, however, showed no mercy on his estate, and found Cloyd's web of transactions served little to avoid the imposition of federal income taxes on the sale of his stock. (15).  The Tax Court also imposed a 20% accuracy-related penalty because Cloyd did not "act with reasonable cause and in good faith by relying on the professional advice of [SkyMall]. (22).

In the end, Cloyd's estate will pay 48% tax (28% plus the 20% penalty) on the $9,800,000.  He will also have to pay interest on the tax from 1995 until the tax is paid, presumably sometime in the near future.

"Oh what a tangled web we weave, When first we practice to deceive."  Sir Walter Scott

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!

Proposed Regulations Reverse Overstatement of Basis Decisions

I previously posted a tax court opinion (here) holding that an overstatement of shareholder basis was not an omission of gross income for purposes of extending the regular three-year statute of limitations to the six-year statute of limitations.  If you have access to the Journal of Accountancy, there is a good article explaining the debate here.

It seems the IRS has given up litigating (and losing); they are just going to change the law, via recent proposed and temporary regulations to there way of thinking.  How can they do this you ask?  "[So] long as the amended regulations are a reasonable interpretation of the statute . . . the IRS is entitled to amend its regulations in response to adverse judicial decisions." Laura Lee Mannino, Full-Time Medical Residents Not Exempt From FICA, Journal of Accountancy (Sept. 2009) (analyzing the Ninth Circuit's decision in Mayo Foundation v. United States, upholding a treasury regulation that nullified prior court decisions regarding the applicability of FICA tax to medical residents); click here for the article.

Although I do not have a good understanding of the separation of powers provision in the constitution, I would like to understand why the separation of powers provision is not implicated in this scheme.  I suppose the logical response is that Congress, the Legislative Branch, has granted legislative power to the IRS, a part of the Executive Branch.  And just as Congress is undoubtedly allowed to change the law in response to an adverse court decision, so to is the IRS having been given that legislative power by Congress. 

In one sense, this is a very efficient scheme.  It could take Congress months or even years to pass a bill to amend a portion of the internal revenue code.  Passing a bill through both houses of Congress takes considerable time and cost.  Through the process of proposing and codifying regulations, the law can be changed within weeks of an adverse court decision, with only the time and cost of a few people, namely those at the IRS.

On the other hand, this scheme puts significant power in the hands of just a few.  However, the safeguard against the usurpation of power by a collective few is the requirement that the "regulations are a reasonable interpretation of the statute."

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!

Overstatement of Basis and Six-Year SLIM

Intermountain Insurance Service of Vail, LLC v. Commissioner, T.C. Memo. 2009-195 (T.C. 2009).

Question for the Tax Court

Does a basis overstatement constitute a substantial omission from gross income that can trigger and extended 6-year period of limitations. See secs. 6229(c)(2), 6501(e)(1)(A). (2).

Facts

On their 1999 Form 1065, U.S. Partnership Return of Income, Intermountain claimed a stepped-up $2,061,808 basis in the assets it had sold on August 1, 1999.  The return was filed on September 15, 2000. (2).

Almost 6 years later, on September 14, 2006, [the I.R.S.] issued a notice of final partnership administrative adjustment (FPAA) with respect to Intermountain's 1999 tax year . . . [I]ntermountain had . . . overstated capital contributions by $2,197,696, [and] overstated outside partnership basis by $2,061,808 . . . . (3).

Arguments

The taxpayer cites Bakersfield Energy Partners, LP v. Commissioner, 128 T.C. 207 (2007), affd. 568 F.3d 767 (9th Cir. 2009), for the proposition that a basis overstatement cannot trigger an extended 6-year period of limitations . . . . (3).

The I.R.S. asserts that we decided Bakersfield incorrectly and urges us to overrule it. (3).

Law

The Code does not provide a period of limitations within which the Commissioner must file an FPAA.  However, any partnership item adjustments made in an FPAA will be time barred at the partner level if the Commissioner does not issue the FPAA within the applicable period of limitations for assessing tax attributable to partnership items. (4).

The general period of limitations for assessing tax is 3 years from the filing of a Federal income tax return. Sec. 6501(a).  That period is extended to 6 years "If the taxpayer omits from gross income an amount propertly includible therein which is in excess of 25 percent of the amount of gross income stated in the return."  Sec. 6501(e)(1)(A). (5).

Holding

In Bakersfield . . . [W]e applied the Supreme Court's holding Colony, Inc. v. Commissioner, 357 U.S. 28, 33 (1958), and stated that "the extended period of limitations applies to situations where specific income receipts have been 'left out' in the computation of gross income and not when an understatement of gross income resulted from an overstatement of basis." (7).

Analysis

This issue is obviously bugging the I.R.S. This is the third case I have seen in the last two weeks where they asked the court to overrule Bakersfield.  As indicated by the citation, Bakersfield was affirmed by the Ninth Circuit.  The Ninth Circuit's opinion is consistent with the Federal Circuit's opinion in Salman Ranch Ltd. v. Commissioner, ___ F.3d ___, ___ (Fed. Cir., July 30, 2009) (slip op. at 28). (7).

"Duped" into Deducting Passive Losses

Cunningham v. Commissioner, T.C. Memo. 2009-194 (T.C. 2009).

Question for the Tax Court to Decide

 [A]re the taxpayer's losses from horse activities limited by section 469 (known as the passive loss rules). (1).

Facts

[Taxpayer] was employed on the dental faculty at New York University and maintained a private dental practice in Peeksskill, New York. (2).

[On his] joint 2002 Form 1040 . . . [He] claimed losses from five separate horse activities located in California....(2).  [T]he partnership returns reporting the losses from the horse activities were prepared by Robert Gruntz. (2).

Arguments

[Taxpayer] asserts in a posttrial memorandum that he was "duped by a charlatan and in essence Robert Gruntz tacitly implied that I should fabricate a log that would show 'material participation' ".

[Taxpayers] assert that the liability would be a financial burden...and "petition the Court to consider reducing the liability, throwing [themselves] at the mercy of the court."

Law

Section 469 generally limits deduction of losses from "passive activities" to income generated by such activities and prohibits deduction of such losses against the taxpayer's other income.  To avoid the limitations of section 469, taxpayers must establish that they materially participated in the activities. Sec. 469(h). (3).

See my previous post for a thorough explanation of section 469(h).

Holding

[Taxpayers] have not shown any participation, much less material participation, in the horse activities in issue.  They simply signed returns claiming substantial losses without investigation or knowledge of the accuracy of the partnership returns for the horse activities.

Analysis

I think the court was wrong to imply the taxpayers lose here because they did not investigate the accuracy of the partnership returns.  The taxpayers failed to show material participation in the activity.  The accuracy of the partnership returns reflecting the losses was not at issue here.

The court probably wanted to respond to the taxpayer's "i was a victim" defense.  Unfortunately, there are very few "victims" before the Tax Court.  Every taxpayer is responsible for their own tax return.   Even if you use a very qualified tax professional, the civil penalties against the tax professional for  mistakes are minuscule compared to the civil penalties against the taxpayer.

I.R.S. Cannot Levy on IRA After Death

Generally I will not post letter rulings, but this one is so close to my previous post, I thought it would be interesting for readers.  Here is the link to the letter ruling:

http://www.irs.gov/pub/irs-wd/0935026.pdf

When does a Federal Tax Lien Attach to Property?

Estate of Brandon v. Commissioner, 133 T.C. No. 4 (T.C. 2009).

Facts

On August 9, 2004, [the I.R.S.] issued Mr. Brandon a proposed assessment regarding section 6672 trust penalties. (3). On February 27, 2006, [the I.R.S.] assessed the . . . trust penalties. (3). Mr. Brandon died in a motorcycle accident on April 27, 2006. (3). On November 2, 2006, [after having been informed about Mr. Brandon's death] the revenue officer issued Mr. Brandon a Letter 3172, Notice of Federal Tax Lien . . . relating to the unpaid trust penalties. [On] November 3, 2006, the next day, the revenue office recorded, with the clerk of Denton County, Texas, Form 668(Y)(c), Notice of Federal Tax Lien, relating to Mr. Brandon's property.

Issue for the Court

[W]hether there was an abuse of discretion in sustaining the notice of Federal tax lien (NFTL) relating to the 2003 trust fund recovery penalties (trust penalties) assessed against Mark Brandon (Mr. Brandon). (2).

Although the court phrases the issue as an abuse of discretion, the court really answers the question of when a lien attaches and whether the lien remains attached when property transfers at death.

Arguments

The estate contends that as of April 27, 2006, Mr. Brandon's date of death, the title to all Mr. Brandon's property "passed to the devisees or legatees of the estate of Mark Brandon, the estate of Mark Brandon, or the executor of the estate of Mark Brandon [and] therefore, the NFTL is invalid." The estate further contends that Mr. Brandon "had no property interest when the NFTL was issued on November 2, 2006" to which any lien could attach. (5).

The [I.R.S.] contends that the lien attached to Mr. Brandon's property on February 27, 2006, the date of assessment . . . further . . . the attachment occurred before Mr. Brandon's death and . . . the lien remained attached even at his death. (5).

Holding

We agree with the [I.R.S.].

[A] lien arises at the time the assessment is made and continues until the liability is satisfied or becomes unenforceable by reason of lapse of time. (5).

After a lien attaches to property, it remains attached and is not invalidated by a transfer of property. See United States v. Bess, 357 U.S. 51, 57 (1958) (holding that the transfer of property after attachment of a lien does not invalidate the lien) . . . . (6). Therefore, Mr. Brandon's death, which occurred 2 months after the lien attached to his property, does not adversely affect the validity of the NFTL. (6).

Valuation Discounts on Transfers of Interests in Disregarded Entity

Pierre v. Commissioner, 133 T.C. No. 2 (T.C. 2009).

Facts

Grandma sets up and transfers $4.25 million to a single-member LLC. (4). Through gifts and loans she transfers her entire interest in the single-member LLC to two different trusts created for her grandchildren. (4).

The Issue for the Tax Court

The issue to be decided is whether certain transfers of interests in a single-member limited liability company (LLC) that is treated as a disregarded entity . . . are valued as transfers of proportionate shares of the underlying assets owned by the LLC or are instead valued as transfers of interest in the LLC, and therefore, subject to valuation discounts for lack of marketability and control. (3).

Arguments

[The taxpayer] argues that, for Federal gift tax valuation purposes, State law, not Federal tax law, determines the nature of a taxpayer's interest in property transferred...Accordingly...we must look to State law to determine what interest was transferred. . . . (7).

[The I.R.S.] argues that, because the LLC . . . is disregarded under the check-the-box regulations, . . . transfers of interests in the LLC should be "treated" as . . . proportionate shares of [the] LLC's [underlying] assets. . . . (6).

Holding

A fundamental premise of transfer taxation is that State law creates property rights and interests, and Federal tax law then defines the tax treatment of those property rights. See Morgan v. Commissioner, 309 U.S. 78 (1940). (9).

Pursuant to New York law [the taxpayer] did not have a property interest in the underlying assets of the LLC, which is recognized under New York law as an entity separate and apart from its members. Accordingly, there was no State law "legal interest or right" in those assets for Federal law to designate as taxable, and Federal law could not create a property right in those assets. (11).

Check-the-Box Regulations Issue

[W]hether the check-the-box regulations require us to disregard a single-member LLC, validly formed under State law, in deciding how to value and tax a donor's transfer of an ownership interest in the LLC under the Federal gift tax regime . . . . (15).

Holding

[W]e do not agree that the check-the-box regulations apply to disregard the LLC in determining how a donor must be taxed under the Federal gift tax provisions on a transfer of an ownership interest in the LLC. If the check-the-box regulations are interpreted and applied as [the I.R.S.] contends, they go far beyond classifying the LLC for tax purposes. The regulations would require that Federal law, not State law, apply to define the property rights and interests transferred by a donor . . . . [T]o conclude that because an entity elected the classification rules set forth in the check-the-box regulations, the long-established Federal gift tax regime is overturned. . . . (20).

Dissent

In every case involving questions of statutory or regulatory interpretation, the starting point is the language itself. The regulations we here construe are . . . [the check-the-box regulations]. (31).

Contrary to the majority's suggestion that State law, not Federal law, defines for valuation purposes under the Federal gift tax the property rights and interests a donor transfers (see majority op. p. 19), McNamee v. Dept. of the Treasury, supra, stands for the proposition that Federal law, in the form of the check-the-box regulations, does define the property rights and interests so transferred. (41-42).

The majority fails to apply the plain language of [the check-the-box regulations], which require that a single-member LLC be disregarded for "federal tax purposes." (49).

The regulations provided that the owner of a disregarded entity is treated as the owner of its property. Likewise, the Court of Appeals for the Second Circuit, the court to which this case is appealable, has said " 'if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship . . . of the owner.' " McNamee v. Dept. of Treasury, 488 F.3d 100, 107-108 (2d Cir. 2007).

For What its Worth

I agree with the Majority opinion in this case. The regulations' plain language should be respected but not out of context. The majority provides a long history of the regulations starting on p. 11. I am sure this decision will get appealed.

Outside Sales: Statutory Employee or Common Law Employee?

Rosemann v. Commissioner, T.C. Memo. 2009-185 (T.C. 2009).

Mr. Rosemann performed outside sale for his employer. (3). He claimed he was a statutory employee, thus entitled to deduct his business expenses on Schedule C. (5). The I.R.S. disagreed. (5) And so did the Tax Court. (9).

Background

The taxpayer was an outside salesman for Cooper Container Corp. (3). He received a salary, commissions, paid vacation and sick leave, a 401(k), and a company car. (3-4). Further, his company reimbursed him for his travel expenses, including meals and mileage. (4). On his 2004 and 2005 tax returns, Mr. Rosemann deducted auto repair and maintenance expenses, depreciation, and section 179 expense.

Statutory Employee or Common Law Employee: Why Does it Matter?

Generally, an employee may deduct unreimbursed employment expenses on Schedule A subject to an overall 2-percent of adjusted gross income limitation. See secs. 62(a), 67(a). A statutory employee is not an employee for purposes of sec. 62. See sec. 3121(d); Prouty v. Commissioner, T.C. Memo. 2002-175. (7)

A statutory employee may properly reflect business income and expenses in full on Schedule C of Form 1040 . . . thereby avoiding the Schedule A limitations on the deduction of employee business expenses and the phaseout of itemized deductions. (6-7).

An individual qualifies as a statutory employee under section 3121(d)(3) only if he is not a common law employee under section 3121(d)(2).

The Tax Court uses eight factors to determine if Mr. Rosamenn is a common law employee or an independent contractor. (9).

1. The degree of control exercised by the principal
2. Which party invests in work facilities used by the individual
3. The opportunity of the individual for profit or loss
4. Whether the principal can discharge the individual
5. Whether the work is part of the principal's regular business
6. The permanency of the relationship
7. The relationship the parties believed they were creating
8. The provision of employee benefits

The Court Analyzes Each Factor

Degree of Control: Mr. Rosemann's schedule was flexible, but he was required to attend meetings, work a 40-hour week, produce results, and follow company policy. (9).

Investment in Facilities: Mr. Rosemann had none. He kept a home office, but the Court points out this is not enough. (10).

Opportunity for Profit or Loss: Commissions do not mean profit or loss. (10).

Right to Discharge: Cooper could fire Mr. Rosemann. (10).

Integral Part of Regular Business: Cooper makes containers. To stay in business, Cooper needs to sell those containers. Mr. Rosemann's work is more than integral. (11).

Permanency of Relationship: Mr. Rosemann was a twelve-year employee of Cooper. That sounds permanent. (11).

Relationship Parties Thought They Created: Just ask Mr. Rosemann's boss. (11).

Provision for Employee Benefits: Health insurance, life insurance, paid sick leave, retirement plan; these are commonly called "employee benefits."

It should be obvious that Mr. Rosemann loses 8-0. Consequently, Mr. Roseman must use Schedule A to deduct his expenses. (13).

My Notes

Most of the time taxpayers are going to lose this issue. In fact, the I.R.S. works with many States to uncover improper worker classification.

The Tax Court starts its opinion discussing the difference between a common law employee and a statutory employee. But then the Court switches to common law employee vs. independent contractor. This makes the opinion a bit confusing. The I.R.S. discusses the difference between a common law employee, a statutory employee, and an independent contractor here.

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.

Back From Vacation

If you follow me on twitter, or read my twitter updates on the right side of this blog, you know that I just spent five great days with my wife and son in Jackson, Wyoming. I must confess, I did not read the Tax Court opinions published during that time! I will work to catch up by the end of the week.

Award of Litigation Costs Denied to Taxpayer

Trollope v. Comm'r, T.C. Memo 2009-177 (T.C. 2009).

The IRS challenged Mr. Trollope's transactions with Arrow Capital Associates, Inc. After receiving certain documents during discovery, however, the IRS conceded the issue. The Tax Court must decide if Mr. Trollope is entitled to an award of litigation costs pursuant to section 7430.

Mr. Trollope's Transactions With Arrow

Mr. Trollope and Mr. Larik each owned 1,500 shares of Arrow. Through a series of transactions, Mr. Trollope purchased Mr. Larik's 1,500 shares, or a 50% interest in Arrow. The initial transaction involved Arrow lending $1.9 million and $.7 million to Mr. Trollope and Mr. Larik respectively ($1.9 + $.7 = $2.6; keep this figure in mind). Through a stock purchase agreement, Mr. Trollope then agreed to purchase Mr. Larik's 50% interest for $2.6 million. To fund the purchase, Mr. Trollope used the $1.9 million he was lent from Arrow, and assumed Mr. Larik's $.7 million note. After becoming the sole shareholder, and owning 3,000 shares, Mr. Trollope sold 1,500 shares to Arrow in exchange for cancellation of his $1.9 million note and cancellation of the $.7 million note he had assumed on behalf of Mr. Larik.

Pre-Trial Activities

The IRS issued a 30-day letter stating that the last transaction, Arrow's purchase of 1,500 shares from Mr. Trollope, was a constructive dividend. Mr. Trollope argued in response that he "had not received a constructive dividend from Arrow, but rather had stepped in to facilitate a stock redemption as Arrow's agent." Despite Mr. Trollope's argument, the IRS issued a Notice of Deficiency (NOD). Shortly thereafter, Mr. Trollope filed a petition with the Tax Court challenging the NOD.

During the discovery process, Mr. Trollope provided additional documentation that resulted in the IRS conceding the issue. Mr. Trollope filed a motion to recover $122,402 in litigation costs under section 7430.

Section 7430 Requirements

The Tax Court provides the four-part test taxpayers must satisfy to receive an award of litigation costs under section 7430:

To qualify under section 7430, taxpayers must establish that they: (1) Were the prevailing party within the meaning of section 7430(c)(4); (2) exhausted the applicable administrative rememdies; (3) did not unreasonably protract the proceedings; and (4) have claimed costs that are reasonable.

Section 7430(c)(4) defines the term prevailing party. As is usually the case, the section provides a general rule and then states exceptions. The first exception to the term prevailing party is section 7430(c)(4)(B). Under this section, if the IRS's position is substantially justified, then the taxpayer will not be considered a prevailing party. Despite the seemingly strong language, the threshold here is quite low.

"Substantially justified" is defined as "justified to a degree that could satisfy a reasonable person" and having a "reasonable basis both in law and fact" . . . Respondent's position may be incorrect and yet be substantially justified "if a reasonable person could think it correct." Whether respondent acted reasonably ultimately turns on the available information which formed the basis for respondent's position as was as on the relevant law.

[Further] For a position to be substantially justified, "substantial evidence" must exist to support it. That phrase does not mean a large or considerable amount of evidence, but rather 'such relevant evidence as a reasonable mind might accept as adequate to support a conclusion.'

The IRS's Position was Substantially Justified

The IRS's constructive dividend argument was based on the view that the transactions between Arrow and Mr. Trollope were "independent transactions resulting in a dividend . . . under section 301(a) and 302(b)(1)." While Mr. Trollope's view, supported by the facts, showed the transactions were a "single integrated transaction resulting in exchange treatment under section 302(a).

The Tax Court holds for the IRS because Mr. Trollope did not provide "all of the relevant information under his control" prior to the issuance of the NOD. Mr. Trollope provided only the stock purchase agreement to the IRS prior to the formal discovery process. Despite a "multiyear dialogue" between the IRS and Mr. Trollope prior to issuing the NOD, Mr. Trollope never provided the loan documents, corporate minutes, or any other documentation to support the "integrated transaction" argument. All of which were under his control. Thus, relying solely on the stock purchase agreement, it was reasonable for the IRS to take the legal position that the transaction in question was a constructive dividend.

Analysis

I often wonder what is the "real story" behind these types of facts. Why, for example, wouldn't Mr. Trollope provide any and all necessary documentation to support his position? Particularly since this was supposedly a "multiyear" dialogue. Did Mr. Trollope simply become frustrated during the audit process and refuse to cooperate?

Also, the Court's opinion does not discuss what specific documents were provided to the IRS during discovery that caused the IRS to concede the issue. These facts might help illuminate the real story here. 

Constructive Dividends to C-Corporation Shareholders

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

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

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

Rent Expense

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

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

Employee Benefit Expense

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

Other Expenses

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

Constructive Dividends

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

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

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

Analysis

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

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

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

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

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

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

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

Background

The events that follow occurred between 1999 and 2005.

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

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

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

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

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

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

The Lohrke Test

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

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

The Lohrke test requires, 

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

The Tax Court finds here that,

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

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

Notes

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

Taxpayer's Attorney Abuses Discovery - IRS Awarded Attorney Fees

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

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

Taxpayer’s Belligerence 

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

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

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

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

Attorney’s Defense

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

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

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

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

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

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

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

Analysis

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

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

Foreign Earned Income Exclusion and Tax Home

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

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

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

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

The Foreign Earned Income Exclusion 

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

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

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

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

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

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

Analysis 

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

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

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

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

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

Jurisdiction and Affected Items

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

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

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

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

Limited Jurisdiction and Affected Item

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

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

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

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

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

 

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

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

Tax Court’s Analysis

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

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

Notes

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

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

Unreimbursed Employee Business Expenses

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

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

Unreimbursed Employee Business Expenses

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

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

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

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

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

Farming Losses

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

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

Frivolous Arguments and Labor Theory

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

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

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

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

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

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

Analysis

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

Defense of Marriage Act

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

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

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

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

Tax Court Denies Domestic Partners MFJ Status

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

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

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

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

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

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

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

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

The California Quandary

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

Other blogs referencing this case:

TaxProf

TaxGirl

Pensions and Divorce Agreements

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

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

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

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

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

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

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

Qualified Domestic Relations Orders

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

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

Passive Activity Losses and LLC Interests

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

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

The Garnett’s Entity Holdings

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

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

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

Passive Activity Rules and Seven Material Participation Tests

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What Really Changes

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

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

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

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

Litigation Costs Awarded to Taxpayer

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

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

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

The Story of Bud and Sally

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

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

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

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

Issue for the Tax Court

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

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

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

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

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

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

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

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

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

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

Vehicle Expenses & Substantiation Requirements

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

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

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

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

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

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

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

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

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

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Penalties And Reasonable Cause

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

Summary

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

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

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

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

Section 6654(a) Penalties

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

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

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

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

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

2003 Penalties

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

2004 Penalties

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

Analysis

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

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Collection Due Process Hearings

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

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

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

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

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

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

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

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

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

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

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Day Trading & Trade or Business Expenses

The Manning brothers are successful day traders – not Payton and Eli; Jim and John. But make no mistake, the IRS went after these boys with all the aggression of a 250lb middle linebacker. The tax year at issue is 2003.

The Tax Court’s opinion is pretty long, but the facts are pretty straightforward. Jim Manning – the taxpayer in the suit – ran a day trading office in Austin, TX for Assent, LLC, a broker-dealer. Jim was not Assent’s employee, he operated the office through his own LLC.

Customers (other day traders) paid commissions to Assent for making stock trades. The normal commission paid was $5 per 1,000 shares traded. Customers with very large trading volumes would receive discounts. But even if a customer did not achieve high trading volumes, Jim could ask Assent for commission reduction to stay competitive – there were other broker-dealers day traders could go to. Out of those commissions paid to Assent Jim would receive a cut.

In addition to individual accounts, Jim also brought in other entities to conduct their day trading through his office. One of these entities was Warrior, LLC, formed by Jim’s brother John. Warrior was the office’s biggest customer and paid average commissions of $3.75 - $4.25 per thousand shares traded. Assent kept $2 profit and Jim’s cut was the rest

Sometimes it took so long to get Assent’s approval to lower commission rates, that Jim would enter into “outside” agreements to take less of a cut and pass the savings on to the customers. Jim entered into just such an agreement with Warrior. For example, Warriors commissions were reduced to $2.25 per thousand shares traded. In this situation Warrior would still pay Assent $3.75 per thousand shares. Assent would keep $2.00 and pay $1.75 to Jim. Jim in turn would pay $1.50 to Warrior and net $.25.

For tax reporting purposes, Jim treated all “outside” commission adjustments the same. He reported the commission rate adjustment payments to each customer on a 1099-B (Proceeds From Broker and Barter Exchange Transactions). He then took a deduction on his Schedule C. Warrior reported all the commission rate adjustment payments it received as income for tax purposes.

The IRS challenges Jim’s deduction for the rate adjustments related to Warrior. Conversely, they allowed deductions for rate adjustments to unrelated parties. The IRS asserts the payments to Warrior were (1) not ordinary and necessary under section 162(a), (2) illegal payments under section 162(c)(2), and (3) lacked economic substance. The Tax Court rejects all three arguments.

The payments are ordinary because it is a common occurrence to lower commissions in the day trader industry. It did not matter whether the adjustment was paid by Assent or Jim so long as the adjustments were negotiated at arm’s length. The payments were necessary because Assent was slow to adjust rates. The Tax Court states, “an expense may be necessary even where the taxpayer could have avoided it by pursuing a different course of conduct.”

Illegal payments under section 162(c)(2) are those that specifically violate “federal statutes, including state laws which are assimilated into federal law by federal statutes, and legislative and interpretive regulations thereunder.” Here, the IRS relies on an ethics rule promulgated by the NASD (National Association of Security Dealers) against commission-sharing as foundation for its illegality argument. First, these were not commission-sharing arrangement as that term is defined. Moreover, since the IRS did not cite any federal statute that was violated, the payments are not illegal under section 162(c)(2).

Finally, the IRS argues the commission adjustments lacked economic substance because the agreement was not at arm’s length. Taxpayer Manning provided enough evidence to show the Court that Warrior could have received the same rates elsewhere.

Just goes to show you, when dealing with the Service, the best offense is a good defense.

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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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Comments & Suggestions

For the three people who are reading my blog, please let me know if you have any comments or suggestions that would make this blog more useful.

My goal is to provide updates and analysis of U.S. Tax Court decisions. While I would love to post every decision the Tax Court announces, I probably don't have enough time. But if executive summaries are useful, I could manage that. Perhaps an executive summary on those decision I choose not to analyze?

In any event, the blog is still new so please check back from time-to-time. I will continue to tinker with the format until I think the goal of the blog is being somewhat achieved.

Opinion: Metro Crash & Tax Law

I originally intended to write about President Obama's DOJ Tax Division nomination. But this week brings the tragedy of Washington's Metro crash, and unexpectedly (at least in my mind) an assault on Tax Law as one of the "but for" causes. An argument even Mrs. Palsgraf would not make.

The premise, articulated by Professor Sarah Lawsky, suggests a connection between tax-advantaged sale-leaseback transactions WMATA entered into for rail-cars and Monday's crash. At the outset, I have no real issue with exploring the idea and kicking it around the academic water cooler. These are the kinds of topics I expect professors and policy think-tanks to explore, and which I enjoy reading and thinking about myself. Unfortunately, the idea seems to have generated a life of its own, and in my mind is being twisted.

Sen. Grassley has latched on to the suggested connection between sale-leasebacks and the crash. The tragedy is not yet five days old, causes of the crash are unknown, and already members of Congress are drafting a spending bill using some of their favorite rhetoric, tax-shelters and banks. (here).

So allow me to untwist this. Tax law did not cause nor contribute to Monday's crash. Even if it turns out that old rail-cars were solely the cause of Monday's crash, tax law still has nothing to do with it. There, I said it. My short life as tax blogger may be over . . . but my wife will still read my posts.

If equipment is kept beyond its useful life the tendency to break down increases. Here, there were no tax incentives for WMATA to keep the rail-cars in service beyond their useful life (in fact, most tax law provides an incentive to get rid of old equipment and buy new equipment, e.g. section 179). There were financial pressures for keeping the rail-cars, WMATA had no money. WMATA could break their lease, but they made a financial decision not to break their lease and keep the rail-cars in service. Their decision did not consider the tax consequences; and why would it, they are tax-exempt. In hindsight, a financial decision put before safety - maybe, we do not even the cause of the crash. But make no mistake, they were not tax-induced into keeping old rail-cars.

Did the counter-party to the sales-leaseback benefit? Sure. But so do thousands of other Americans when we buy tax-favored municipal bonds. If WMATA had kept the cars in service because they didn't have the credit rating to float additional bonds for new rail-cars, would we blame municipal bonds as well? I do not think so.

Does WMATA need money? You bet. Will Congress give it to them? You bet. But let's be clear, tax laws are not the reason WMATA needs new rail cars. Tax law did not cause nor contribute to Monday's crash.

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.

Download Pa8ck.TCM.WPD

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.