Archive for December, 2010|Monthly archive page

Economic Substance- A Taxpayer Win

In Uncategorized on 12/31/2010 at 20:54

We heard a great deal about economic substance this year, what with foreign currency swaps (e.g., LR Development Company LLC, Transferee, T.C. Mem. 2010-203, 09/16/10) and the Health Care Reform bill. Mostly it’s the taxpayer who gets nailed on the doctrine. But for once, the Tax Court gives a New Year’s Eve present to a taxpayer, and the economic substance doctrine gets credit for an assist.

In Judith F. Lang, T.C. Mem. 2010-286, 12/30/2010, the taxpayer’s mother, Mrs. Field, paid $24,559 directly to the medical provider for health care for her daughter, the taxpayer. That gift was not subject to gift tax, of course (see IRC§2503(e)(1)), as it was paid by Mrs. Field directly to the provider, Mrs. Field having no obligation to support the taxpayer, as the taxpayer is not a minor.

Generous Mrs. Field also paid $5,508 directly to a local taxing authority for real estate taxes due and owing from taxpayer.

IRS disallowed taxpayer’s deductions for the gifted amounts, claiming form of the transaction governs, and disallows taxpayer’s medical deduction and real estate tax deduction to the extent each was covered by Mrs. Field’s gifts.

Taxpayer’s position is that in substance it was equivalent to Mrs. Field’s writing a check to taxpayer and taxpayer paying the creditors. The Court expressly refuses to allow the gift tax implications to override State law (in this case Massachusetts) that payment to a creditor of the donee, made with donative intent, is a gift to the donee.

The Court stated at pages 4-5 of its decision: “There is precedent for State law controlling whether a gift at the time of payment affects who is the payor. See, e.g., Ruch v. Commissioner, T.C. Memo. 1982-493, revd. on another issue 718 F.2d 719 (5th Cir. 1983). Mrs. Field made the medical expense payments for her daughter with donative intent. Although Mrs. Field and petitioner would not be subject to the gift tax, the income tax treatment in this context is not controlled by the gift tax consequence. See Pierre v. Commissioner, 133 T.C. 24, 35 (2009). Applying substance over form, we treat petitioner as having received from her mother a gift of $24,559 with which petitioner paid her own medical expenses. Petitioner should be credited with having made the payments for purposes of the income tax deduction in question.” [Footnote omitted]

The Court also does not consider gift tax implications of Mrs. Field’s real estate tax payment. The limited class of nontaxable direct payment gifts (IRC§2503(e)(2)(A) and §2503(e)(2)(B)), educational tuition and medical care, does not include real estate taxes. However, the amount paid, $5,508, is below the annual exclusion. Nevertheless, the Court leaves gift taxes as a question for another day.

Neither gift involves a potential double deduction. Mrs. Field did not claim the deduction for the medical expenses, taxpayer did. And the real estate taxes were solely the obligation of the landowner, the taxpayer, and could only be deducted by her.

In short, a clear win for the taxpayer. Substance does trump form.



In Uncategorized on 12/28/2010 at 17:10

I’ll bet few tax professionals who do not have clients in the United States Virgin Islands (USVI) noticed the Tax Court’s decision in Arthur I. Appleton, Jr., 135 T.C. 23, 11/01/2010.

The decision rejects an attempt by the USVI government to intervene in a case where the IRS raises lack of economic substance in transactions reported to the USVI and audited by the USVI Bureau of Internal Revenue (BIR), which took place more than three years prior to the IRS deficiency notice.

Briefly, IRC 932(c)(4) exempts tax returns filed and taxes paid to the USVI Bureau of Internal Revenue (BIR) from Federal income tax, provided taxpayer satisfies residence requirements (then at end of tax year, now for entire tax year), reports and identifies source of all income, and pays entire tax due to BIR.

The USVI income tax structure is a “mirror image” of the IRC.

The decision is a lengthy discussion of the tripartite bases for intervention in Tax Court, and as such is of interest to a pure technician. Tax Court explicitly refuses to hold that Fed. R. Civ P. 24(a)(2) (intervention as of right) applies to Tax Court proceedings, while at the same time setting forth an exhaustive review of that statute. I leave the technical issues aside here; they may serve some law review editor for filler.

Judge Jacobs’ conclusion in Appleton, I submit, is wrong. The Court’s whole reasoning is based on the premise that effective tax administration is a “merely economic interest.” The Court states that the interest of the taxpayer in a speedy resolution outweighs the specific governmental interest of the Virgin Islands Bureau of Internal Revenue in orderly tax administration of the USVI. But these interests are more than a “purely economic interest”, however hard the decision tries to brush aside USVI.

Orderly tax administration, and the right of taxpayers to know that they are secure in their persons and property after a duly conducted audit of their tax liabilities by the lawfully constituted taxing authority, or after the time established by law for the conduct of such audit has passed without audit, are more than “purely economic interests.”

IRS’ position is based upon Notice 2004-45, I.R.B. 2004-28 (7/12/04). That notice announces a crackdown on false claims of USVI residence by taxpayers whose true residence is elsewhere, and sham income recharacterizations, specifically leased-employee schemes where a highly-compensated employee establishes a sham residence in the USVI, buys into a USVI LLC (taxed as a partnership) that leases the employee to a US employer, and distributes the net lease proceeds to the employee as a guaranteed payment. The employee claims a tax credit against USVI for proceeds from USVI investment (see IRC §934).
No problem there: a sham is a sham. But how far back can the IRS go?
Note that the additions to tax in Appleton do not include civil fraud penalties, just failure to file and pay tax, and failure to pay estimated tax. So fraud is off the table here.

So what is the interest of the USVI and the BIR? Simply put, if it ain’t over until the fat lady sings, when does the fat lady sing? As to the USVI, IRS’ answer is: never.

If IRS prevails, every USVI taxpayer is subject to an IRS audit going back to their inception, no matter what they filed with or paid to BIR, or that a BIR audit was concluded years ago. IRS collection proceedings can be brought independently of BIR.

The hockey players know it’s a penalty: too many players on the ice.

But the Tax Court says “play on”, while offering USVI a chance to file a brief amicus, after the trial has been had and without a chance to offer any evidence of the disruption an open statute of limitations would cause.

I am told that USVI has appealed to the Third Circuit. Let’s follow that decision.

Small Business Tax Tips for Year End

In Uncategorized on 12/22/2010 at 19:41

With year end fast approaching, small businesses can benefit from taking small but meaningful steps to address their tax position before 2011. This list of 23 tips which appeared in the San Francisco Examiner and the micro-business blog Simplicty Mastered gives some great advice to small businesses looking to shore up their tax situation before the New Year.

Best of luck in 2011!

Lessons Learned in Griffin

In Uncategorized on 12/22/2010 at 19:33

Although it is clearly an extreme example, Griffin v. Comm’r, T.C. Memo. 2010-252 (11/17/10) does highlight several important areas for taxpayers to consider when preparing and filing their U.S. Federal income tax returns.

  1. File timely. Late filings will likely receive greater scrutiny and consistently late filings raise a red flag for the IRS. Filing timely will also start the statute of limitations running.
  2. Get your ducks in a row. Having correct and complete supporting documentation is critical to substantiating credits and deductions when a taxpayer is under audit.
  3. Perception beats Reality every time. Regardless of the veracity of the witness or the documentation, the appearance of impropriety or a story that changes from one telling to the next is a disaster for taxpayers trying to defend themselves. Stick to the truth. Always.

The Best Tax Court Memo in a Long Time…

In Uncategorized on 12/09/2010 at 17:08

In Griffin v. Comm’r, T.C. Memo. 2010-252 (11/17/10), the Tax Court gets an early holiday gift in the form of the testimony and documentary evidence (or lack thereof) of Sharon Louise Griffin in defense of her U.S. Federal income tax returns for the years 2001 through 2003. Ms. Griffin worked part time as a videotape operator and technician. But, if her returns are to be believed, she operated nine businesses in her spare time, grossing $2,876,957 during 2001-2003, but with operating losses each year.


Highlights include (but are certainly not limited to):


  • “This is either a transcription error of “hog wild” or “off the hook” or a level of craziness with which the Court is unfamiliar.”
  • “An IRS agent credibly testified about his effort to contact VCR Gary to verify the claimed expenses by calling several different telephone numbers, all of which had been disconnected. Griffin explained that VCR Gary ‘has passed away in the sense of the guy who’s VCR Gary.’”
  • “In Griffin’s records, for example, the name “Xander” appeared five times and “Zander” appeared six times. They were presumably different people because each Xander or Zander had a different surname. According to the Commissioner’s investigation, there are very few Xanders or Zanders in the entire state of California–about 85 Xanders and 95 Zanders. Griffin either had an uncanny ability to find Xanders/Zanders, or her cash receipts are unreliable evidence. We do not believe the former possibility.”


Read the full Memorandum here.