Or, Cutting Up the Pie

The perennial question that arises when the partners/shareholders/manager-members of personal services firms convene the annual compensation bloodbath (sorry, I meant meeting) is, what part of the pie is compensation for services (deductible as a business expense but generating payroll tax obligations) and what part distribution of profits (nondeductible but not salary or wages and therefore not requiring payroll tax withholding).

The answer to that question can involve heavy numbers, as we learn from Mulcahy, Pauritsch, Salvador & Co., Ltd., T.C. Mem. 2011-74, released 3/31/11.

The founders of the firm, Messrs. Mulcahy, Pauritsch and Salvador, established various entities controlled by them, to which the firm paid what they called “consulting fees”, ostensibly for services rendered by the founders. The firm also paid rent to a founder-controlled entity (not an issue in the case), and interest (disallowed as no proof that such payment was ever made).

Judge Morrison’s analysis is the classic Section 162(a)(1) “ordinary and necessary”, including a “reasonable allowance for salaries or other compensation for personal services actually rendered”.

First, one of the founders claimed that some part of the consulting fees was return of capital, but offered no evidence as to what part of the consulting fees was a return of capital, nor any theory to sustain the deductibility of any return of capital.

“The firm did not withhold payroll taxes on the ‘consulting fee’ payments, as it would have been required to do with respect to employee compensation payments to the founders. It did not include the ‘consulting fee’ payments on the founders’ Forms W-2, Wage and Tax Statement, as it would have been required to do with respect to employee-compensation payments to the founders. It did not issue the founders Forms 1099-MISC, Miscellaneous Income, as it would have been required to do with respect to payments of nonemployee compensation to the founders. Finally, it did not report the ‘consulting fee’ payments on its income tax returns as officers’ compensation.” T.C. Mem. 2011-74, at p. 12 (footnote).

A presumption of reasonableness of compensation for services is tied to investors’ expectation. Would arms’-length investors be happy with excess compensation over industry-wide scales of pay? Yes, said the Court, but only if the return on investment was higher than reasonably expected.

How to compute return on investment? There’s the rub. The firm wanted to take year-over-year increase in gross revenue, and based the methodology on the fact that apparently someone once offered to buy the firm for one year’s gross (and by the way, that calculation is not crazy, for I’ve seen it used in similar contexts for personal services firms such as this one, but here it’s irrelevant).

IRS said they had no fixed formula, but the return-on-investment number had to be based upon net income, because gross income was no indicator of bottom-line cash available for distribution. As the Court put it:  “A corporation’s shareholders do not seek to maximize gross revenue. They seek to maximize profit.”  T.C. Mem. 2011-74, at p. 15. And the founders ran the firm (a C corporation) so that its year-end profit, taking the “consulting fees” into account, was zero or nearly so. No investor would be happy with that result.

The presumption of reasonableness based upon investor satisfaction having been rebutted, founders’ expert brought forth irrelevant data. First he took examples of what other firms paid their “name partners”, but did not distinguish among compensation for services, return of capital and distributions of profit. Next the expert concluded that the payments were reasonable. All very well, says the Court, but that isn’t the question–the question is whether the payments were reasonable as compensation for services. That, the expert never discussed. The firm failed to produce competent evidence to show that the amounts paid to the founders by way of “consulting fees” were in fact paid for services rendered, at a rate reasonable under all the facts and circumstances.

Even though the “consulting fees” were paid to the founders based upon their respective billables, and not in proportion to their shareholdings, that did not save the deduction, as the amounts were paid to “zero-out” the firm’s income at year end. Profits need not be distributed in proportion to shareholdings in order to remain profits and cannot by some formula be transmuted into compensation for services.

So the Court found no intent to compensate but only the intent to “zero-out” whatever cash was left at year end.

The Court sustained the substantial underreporting penalty, as the firm could not show that they relied upon their trial expert’s advice in handing out the year-end cash, because the founders only looked at what cash they had, and didn’t bother with expert’s formulae.

Trust me, I’ve been in partners’ compensation meetings in personal service firms (and the firm here was an accounting and consulting firm). If polled, the universal response would be “we don’t need no stinkin’ expert formula, gimme my money now!”

The founders got their money. Plus heavy tax liabilities plus interest plus penalties.

The takeaway? Get your experts on board before you start parceling out the money. You may not like the result, but it’s “pay me now or pay me later with interest and penalties”; your call.

Or, Why is Mona Lisa Smiling?

Initially, Mona Lisa Herrington had little to smile about. A single mother of two, she owned an H & R Block franchise, but worked off-season at a prison detention center. She was recently divorced, her father had just died, and her mother moved in with her to care for her children.  And on top of that, she met The Boyfriend.

The Boyfriend had a heavy-duty criminal record. His hobby was beating Mona Lisa. Here’s her story from the pen of Judge Thornton in Mona Lisa Herrington, T.C.Mem. 2011-73, released 3/30/11, at p. 3:  “Petitioner’s relationship with the boyfriend was marked by intimidation and physical abuse. When she failed to do his bidding or attempted to leave him,  he reacted violently. He once threw her from a moving car. Another time when she threatened to leave him, he placed a gun against her forehead and cocked the hammer. On another occasion, in midwinter, he hit her in the head with a beer bottle and threw her from a boat into a lake. On another occasion, she testified credibly, he ‘gave me a picture of my daughter with her face shot out, and told me that’s what would happen to her if I tried to leave’.” A charming fellow, this.

On top of that, this paragon opened a series of video poker  establishments, and when the State lifted his license for selling alcohol to minors, he persuaded Mona Lisa to take out licenses, and proceeded to loot the businesses.  Of course certain income tax returns were not filed, although The Boyfriend claimed he would do so. Mona Lisa wound up pleading guilty to Section 7203 criminal non-filing charges.

Judge Thornton to the rescue. He finds that, while Mona Lisa cannot deduct The Boyfriend’s stolen cash as compensation, because she cannot show any intent to pay, or that the moneys stolen were ordinary and necessary expenses for whatever work The Boyfriend did or services he provided (and for such services one would hardly pay), she can deduct the theft losses and leaves these for a Rule 155 computation.

Reading Louisiana law, where Mona Lisa lived, he finds that her passive acceptance of The Boyfriend’s thievery was not consent, but rather the result of The Boyfriend’s intimidation and battering. Therefore, the moneys he stole were indeed stolen, and constituted a business loss. Also he imposed no fraud penalties, although IRS sought these, apparently because Mona Lisa was a victim.

So Mona Lisa can smile again. And I’m sure we wish her better luck next time.

Or, How Not To Try A Tax Court Case

I’ll repeat the mantra: “I don’t cite the 7463 small tax cases. They’re often entirely fact-driven and rarely if ever raise interesting points of law. Finally, they’re useless to practitioners who need precedents they can cite, even if they provided fresh legal insights.”

But every so often, for want of better material which has been absent from Tax Court reported decisions of late, I do comment on a 7463. And Jennifer M. Dulaney, Petitioner, and Walter Dulaney, Intervenor, T.C. Sum.Op. 2011-38, released 3/29/11, is a prime example of bad IRS lawyering.

Special Trial Judge Lewis Carluzzo (right way to spell “Lewis”, Judge) drew this one, and it was tried by him and tried his patience. The petitioner and the intervenor were divorced when the case came on, although married and filing jointly for the two years at issue. Petitioner sought 6015 innocent spouse relief, although she ran the family finances and kept all the records from which tax returns were prepared. She did not herself prepare the returns; for one year at issue a professional preparer prepared the returns; for the other year, intervenor prepared the return and filed electronically.

Both IRS and intervenor opposed petitioner’s 6015 relief.  The Court found it unclear whether petitioner reviewed the returns, although she signed them both,  “albeit reluctantly” for the second of the two years. IRS assessed deficiencies, apparently related to Schedule A deductions in both years. However, the record did not indicate which of the deductions were disallowed. How an attorney would not enter into evidence the notices of assessment and the bases for disallowance of each deduction eludes me; one would think these were elements of a prima facie case in response to any allegations made by a petitioner.

However, as Judge Carluzzo states: “Respondent’s opening statement suggests that the deficiency for each year results from the disallowance of  ‘all of the itemized deductions’  claimed on the joint return for each of those years, but Evidence 101 informs us that statements made during an opening statement do not constitute evidence. Furthermore, the only evidence on the point, petitioner’s testimony, does nothing more than demonstrate the uncertainty regarding what deductions were disallowed for either year.” T.C. Sum.Op. 2011-38, at pp. 6-7.

Thus, petitioner fails to get the 6015(b) “all or apportioned” relief because she cannot show that the items giving rise to the deficiency were items of the non-requesting spouse (the intervenor), as she put in no evidence on that score.

Turning to the 6015(c) “my bad” request for relief as to items other than those for which the requesting party admits responsibility, the Court holds “what’s sauce for the goose is sauce for the gander.” Apparently petitioner provided IRS with a schedule of items that she admitted were her responsibility, but that schedule, though attached to the statement of claim, never got into evidence either, and IRS counsel never challenged that schedule. So the Court assumed, without finding (and Judge Carluzzo stresses “without finding”), that IRS had no objection to that itemization, notwithstanding IRS counsel’s assertion that petitioner had actual knowledge that all the deductions were bogus.

Because IRS has the burden of proof as regards actual knowledge to defeat a 6015(c) claim, and since IRS introduced no evidence as to which specific deductions were bogus and what was the basis for their bogusity (to coin a word), petitioner must prevail. As Judge Carluzzo said with a reasonableness born of lack of patience with incompetence, “After all, if we cannot tell from the record what the items giving rise to the deficiency for each year were, we can hardly find that petitioner had actual knowledge of any of those items.” T.C. Sum.Op. 2011-38, at p. 9. So enter judgment for petitioner, with a Rule 155 computation to follow.

Now to look at the basics: Tax Court Rule 174(b) says that any evidence deemed by the Court to have probative value shall be admissible in a small tax case such as this. How did IRS trial counsel not have the original of the complete statement of claim? How did IRS trial counsel not have the audit report that gave rise to the assessment of tax? How could IRS trial counsel assert in the opening statement that all the deductions claimed were disallowed, without being able to prove a valid basis for each and every disallowance?

Moreover, Tax Court Rule 91(a)(1), applicable to all Tax Court cases, great or small, states: “The parties are required to stipulate, to the fullest extent to which complete or qualified agreement can or fairly should be reached, all matters not privileged which are relevant to the pending case, regardless of whether such matters involve fact or opinion or the application of law to fact. Included in matters required to be stipulated are all facts, all documents and papers or contents or aspects thereof, and all evidence which fairly should not be in dispute.” Though the Court states that some facts were stipulated, apparently the most critical documents, namely, the attachment to the statement of claim, the 90-day statutory notice of deficiency, and any written statement of the basis for disallowance of any deductions claimed for either year, were not stipulated or introduced into evidence.

As petitioner and intervenor were both self-represented, it would be unfair for me to demand knowledge of them that they do not have. Petitioner was at time of filing the returns at issue a registered respiratory therapist, and intervenor was a firefighter. Neither could be expected to know how to try a tax court case.

But IRS trial counsel is another story altogether. I do not wish to disparage another lawyer; I know that there but for the grace of you-know-Who go any of us. So I will refrain from mentioning IRS trial counsel by name here. But I hope she learns from this experience to be better prepared for the next trial.

Or, Taxpayers Who Do Their Own Returns Get Done

So learned Yusufu Yerodin Anyika and Cecelia Francis-Anyika, in T.C. Memo 2011-69, released 3/24/11. They bought TurboTax at the local Costco, and set to work.

Yusufu owned and managed residential realty, while his day job was as an engineer. Yusufu had been an owner-operator for more than 15 years, but his problems only started with his losses reported for tax years 2005 and 2006. IRS disallowed the losses as passives not covered by the $25,000 safe harbor for passive rental losses, as the Anyikas’ combined AGI was in excess of $100,000, and phased out under Section 469(i)(1), and he failed the real estate professional tests.

Yusufu failed to turn over his trial evidence pre-trial, causing IRS to seek sanctions (denied). On the trial, he changed his testimony from his 4564 Document Information Request responses as to the hours he worked to try to qualify as a real estate professional (at least half of all hours worked devoted to real estate activity, but not less than 750). This flip-flop availed Yusufu not, and caused the Court to discredit his testimony generally.

Even worse, Yusufu’s account of his hours devoted to real estate was unsubstantiated. Once again, our old friend Temp Reg 1.469-5T(f)(4) sets forth the requirements necessary to establish the taxpayer’s hours of participation. I can’t do better than quote the regulation as the Court quoted it, T.C. Mem 2011-69 at p. 6: ‘The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.”

Once again this proves the old saying: That which is temporary becomes permanent, and that which is permanent becomes temporary. This regulation, temporary in name, is permanent in the Court’s memory.

Yusufu tries to avoid the Section 6662 negligence penalties by blaming TurboTax, as he did his own returns for those years with the ubiquitous software. The Court admonishes him thus: “Petitioners contend that they used TurboTax software to prepare their returns for both years and that the software program is to blame for any miscalculations in their income. However, petitioners have not provided any evidence showing the information that they entered into the software program, a preliminary showing that would be required to decide whether the software program is in any way at fault for petitioners’ underpayment. See Paradiso v. Commissioner, T.C. Memo. 2005-187. Such software is only as good as the information the taxpayer puts into it. See Bunney v. Commissioner, supra at 267. We have held that the misuse of tax preparation software, even if unintentional or accidental, is no defense to penalties under section 6662. See Lam v. Commissioner, T.C. Memo. 2010-82.” T.C. Mem. 2011-69, at p. 15.

In short, garbage in equals garbage out.

And, most warming to the heart of any tax professional, the Court recognizes us as the taxpayers’ first line of defense: “A reasonable person in Mr. Anyika’s position, understanding that the tax law governing the deductions he claimed was complex, would have consulted a tax professional instead of merely assuming that he qualified on the basis of his own conclusions.” T.C. Mem. 2011-69, at p. 13.

So, like the jolly testator who makes his own will, or the person who represents themselves and has you-know-what for a client, let us all fill our glasses and raise them high to the person who trusts the online guru or the shrink-wrapped expert to solve all their tax problems.

What is a lease? Most of us have a “seat of the pants” answer—a writing that permits a person we call tenant to occupy exclusively all or part of realty owned by someone else (who we call landlord or owner) on whatever terms and conditions the parties negotiate and the law requires be included or excluded.

But Judge Chiechi spends a lot of time parsing what a lease does or does not permit in Christina A. Alphonso, 136 T.C. 11, released 3/16/11.

Christina was a tenant-shareholder in a qualified cooperative housing corporation (see Section 216) known as Castle Village Owners Corp.(CV). Her stock ownership entitled her to occupy a certain residential apartment in an apartment building owned by CV. To memorialize the terms and conditions of Christina’s occupancy, she and CV entered into what is known as a “proprietary lease”, “proprietary” because of her (admittedly minimal) ownership interest in CV.

CV’s realty sits far above the waters of the lordly Hudson River, a city upon a hill, held in place by a massive retaining wall. In the tax year in question, the retaining wall gave way (whether as a result of natural wear, tear and deterioration occurring as the result of the passage of time and the elements, or as a sudden, unexpected and extraordinary event we need not decide, as Judge Chiechi didn’t have to decide that either), and great was the fall thereof.

Christina’s proprietary lease called for her to pay her share of whatever it took to operate, repair, maintain, fix up or improve CV’s property. And Chrstina did; she paid more than $25,000 to CV to put the property back. Now a qualified cooperative housing corporation is a C corp, not an S (and CV had far too many shareholders to elect S treatment), so the casualty loss, if casualty it was, cannot flow through to the shareholders.

But could Christina take a Section 165 deduction as a lessee of the property? No, says Judge Chiechi. All the lease does is let Christina use the area that collapsed, but doesn’t demise it to her or give her anything more than a revocable license, although the Judge didn’t use those words.

Judge Chiechi said “The model proprietary lease did not provide that Castle Village leased to petitioner any portion of the Castle Village grounds and did not provide that Castle Village granted to her any other property interest in those grounds. Although petitioner, like the other stockholders of Castle Village, had the right to use the Castle Village grounds subject to the Castle Village board house rules regarding the use of those grounds that were made part of the model proprietary lease by paragraph 13 thereof, we conclude that that lease and those rules did not grant to petitioner a leasehold interest, an easement, or any other property interest in the Castle Village grounds that entitles her to a deduction under section 165(a) and (c)(3) for damage to those grounds.” 136 T.C. 11, at p. 22.

Christina’s argument that the pass-though provisions of Section 216 should be judicially expanded from mortgage interest and real estate taxes to include the monies paid to fix the collapse fared no better.

Judge Chiechi said: “As the Supreme Court of the United States has held, ‘Where Congress explicitly enumerates certain exceptions to a general prohibition, additional exceptions are not to be implied, in the absence of evidence of a contrary legislative intent.’ Andrus v. Glover Constr. Co., 446 U.S. 608, 616-617 (1980). Petitioner does not cite any legislative history establishing that Congress intended section 216(a) to permit the stockholders of a cooperative housing corporation to deduct any of such corporation’s expenses that it paid or incurred except for the two deductions that Congress expressly allowed in that section.” 136 T.C. 11, at pp. 25-26.

So Christina’s case collapses like the retaining wall, and her deduction is disallowed.

Taxpayers 3, IRS 1

Two transferee liability cases yield wins for the transferees. The facts of both do not differ widely.

We once again have the successful businesspeople selling the corporations that carried them to exalted financial heights, with a basis in pennies. In both cases, sale of the corporation, whether by way of a stock sale or an asset sale, was followed by vendee shenanigans, of which the vendors were unaware, triggering astronomical tax liability in the sold corporation, and setting up the transferees of the sales proceeds for Section 6901 transferee liability.

The cases are Griffin, T.C. Mem. 2011-61, and Starnes, T.C.Mem.  2011-63, both released 3/15/11. In both cases, the guileless selling stockholders sold their profitable businesses to a subsidiary of Mid-Coast Financial, a strip-miner of worthless debt.  Mid-Coast, by reason of acquiring stock in a corporation with almost no basis in valuable assets, landed the corporation with an enormous tax liability by selling off the corporation’s assets.

Mid-Coast played the variation on the interest rate swap, foreign currency game, as in Stobie Creek (see my 1/2/11 post). They bought a Producers type “collar”, that either produced a lottery-size win (on lottery-sized odds) or a dead loss (that was worth an enormous tax savings), and married the loss on the swap to the gain on the assets. And of course there was no substantial business purpose for a corporation that operated warehouses (as in Starnes), or made swimming-pool heat pumps (as in Griffin), to play Las Vegas style options trades. Huge tax assessed on corporation, and selling shareholders as insider-transferees.

Tax Court went off the uniform fraudulent conveyance statutes. The transferees of the purchase price had no idea that Mid-Coast was playing games (in fact Griffin sued Mid-Coast, spent $125,000 in legal fees to get a judgment directing Mid-Coast to pay the taxes as they had agreed, and of course didn’t collect Dime One).

The taxpayers are injured innocents, said Tax Court. IRS should pursue Mid-Coast.

Winner number three is the Estate of Sylvia Riese T.C. Mem 2011-60, released 3/15/11.  The late Sylvia was the  widow of a co-owner of the largest franchisee of chain restaurants in New York City. The late Sylvia sets up a QPRT for her mansion (IRS says it’s worth $11 million). QPRT ends, but Sylvia never gets around to signing a lease or paying rent before she dies suddenly and unprepared, but before the end of her current tax year. Even the fair market rent had not then been determined, although her daughter and co-executor said she intended to get it done. And of course the trustees never deed the property to the trust beneficiaries.

What should have been a slam-dunk for IRS hit the rim and bounced out (sorry, it’s March), because the decedent died before tax year-end, and the Regulations don’t say when rent must commence or lease be signed. As decedent died before either act had to take place, the mansion is out of the taxable estate.

The fourth case was a run-of-the-mill unamended retirement plan case, Christy & Swan, Profit Sharing Plan, T.C. Mem. 2011-62, released 3/15/11. No amendment means disqualification, even if the plan never involved any of the matters required to be amended by the statutory enactments. Taxpayer loses, even though the result flies in the face of reason. So what else is new?

Or, Little Pigs, Big Pigs

I gratefully acknowledge the assistance of Stuart D. Gibson, Esq., Senior Litigation Counsel, Tax Division, DOJ, who brilliantly shredded taxpayer’s experts in Stobie (see my posting of 1/10/11), and who provided the raw materials for this column. Of course, all the interpretations, errors and omissions herein are mine alone.

He and I must agree to disagree about the result in Appleton (see my posting of 12/28/10). In any event, still waiting for Third Circuit to tell us all.

However, the assault on the Virgin Islands non-virgins goes on apace, and Mr. Gibson kindly sent me Judge Sanchez’s memorandum decision in VI District Court in VI Derivatives v. Com’r, Civil 06-12, decided 2/18/10.

The background is the usual. Mr. Vento made fortune from an IT start-up in which he had minimal basis, but sold for millions in 2000, just before that bubble burst. Mr. Vento faced an astronomical taxable capital gain. Now comes the usual consultant with the tax dodge du jour: save millions by residing in the VI as of 12/31/01, as a result of Congress’ unguided largesse toward our broke but beautiful Islands in the Sun. Move there, invest in some business, and your tax bill shrinks like cheap boiled blue jeans. (Section 932, the dispenser of largesse, was since amended to require a full year residency.)

Mr Vento thither bends his joyful footsteps, buys a dilapidated compound that cannot be rendered fit for human habitation for two years, and celebrates Christmas 2001 en famille with his daughters and their families, significant others, and such hangers-on as he needs to restore his not exactly island paradise.

Having gifted pieces of his IT empire to the daughters aforesaid, Mr Vento decides that they too shall be beneficiaries of Congress’ unguided largesse. The daughters claim VI residency as well on the magic date, notwithstanding their sworn statements before and since, and actions speaking far louder in Judge Sanchez’s ears than the arguments of their counsel.

The residency arguments evaporated. It isn’t that one can’t have a residence, or even residences, different to one’s domicile, and the test for residency is clearly less precise than that for domicile. A recent Presidential candidate took flak because his spouse owned and maintained seven different residences, but on emotional grounds, for there is nothing illegal in having more than one residence. But Mr Vento and family fail the ultimate test–good faith.

Judge Sanchez lists the eleven factors of Sochurek v. Com’r, 300 F.2d 34 (CA 7, 1962). He individually weighs Mr Vento and spouse, and each daughter, in the Sochurek balance and finds each one wanting. Especially significant is the dilapidated condition of the “residence”; no air conditioning, no running water, abundant physical hazards. Mr Vento left his art collection behind in Nevada. The entire family did not move any possessions except some clothing to the “residence”. And they spent virtually no time at this “residence”.

It may be the Judge Sanchez imposed a tougher test, akin to a domicile rather than residence test, even though giving lip service to Sochurek, because Mr Vento had created a dubious charitable foundation, whose main function seemed to be to afford Mr Vento a charitable deduction for contributing his old house in Nevada, while his new house, costing double what he paid for the VI “residence”, was a-building.

And the move to the VI was so clearly tax-driven.

The takeaway for tax advisers is that it isn’t enough to give clients a good idea. You have to follow up and build the record–tell them to get the drivers’ licenses, get a library card, join the local social scene (deadly dull though it may be), open a bank account, hang out, hang around–and remember: little pigs go back to the trough, but big pigs get slaughtered.

Another in a Long Line of Phony Foreign Currency Tax Scams

Tax evasion is a growth industry. Yet another example is found in Mark and Lucy Kerman, 2011 T.C. Memo. 54, released 3/8/11.

Mark Kerman founded Kenmark, a successful eyeglass frame importing business. He built it up to a multimillion dollar S Corp. He sold part of his stock for a huge capital gain. Not wishing to pay tax, he turned to his old friend Bruce Cohen, who attended a seminar sponsored by Chenery, marketer of tax avoidance deals. Intrigued by the complex series of offshore intermediaries, counterparties and sleight of hand, Bruce passed the Chenery specialty, the Custom Adjustable Rate Debt Structure (CARDS) on to his friend Mark.

We take up the story in the words of Judge Goeke’s decision. “Mr. Cohen, a longtime friend of Mr. Kerman and one of his financial advisers, introduced him to Mr. Hahn and Mr. Stone of Chenery, the CARDS promoters. Mr. Cohen learned about the CARDS transaction while attending a meeting discussing ways to avoid paying taxes and knew that Mr. Kerman was interested in a way to eliminate his large income tax liability from selling his Kenmark stock. Mr. Cohen’s gross fee from Chenery for Mr. Kerman’s CARDS transaction was 10 percent of Chenery’s fee, or $50,000. Mr. Cohen testified that before the CARDS transaction, Mr. Kerman had considered another tax shelter called the “basis boost” to mitigate petitioners’ tax liability. He also testified that Mr. Kerman’s interest in the CARDS transaction had nothing to do with Kenmark or its operating needs but was based solely on reducing petitioners’ tax liability from their sale of the Kenmark stock.” 2011 T.C. Memo 54, at pp. 3-4.

The scheme itself is a purported loan, fully collateralized by top-class collateral, initially made to an offshore entity (a Delaware LLC with offshore members) by another offshore entity (in this case Bayerische Hypo-und Vereinsbank AG). Mark buys into this arrangement as a minority partner, becoming jointly and severally liable to repay the entire loan. The loan is so structured as to be without economic effect. In fact, the lender bails out of the loan in year one, collecting some interest and some fees, but leaving Mark with a tax loss in excess of $4,000,000, offsetting his gain from the sale of the Kenmark stock.

Not even analyzing the Code and Regulations, Judge Goeke finds the deal to be a sham. The loan proceeds were so tied up that the lender ran no risk, and the borrower merely paid some fees and interest. No economic benefit from the loan proceeds ever got to Mark.

His tax loss evaporates, leaving Mark facing the 20 and 20 penalty, 20% substantial underreporting and the second 20% for gross overvaluation of an asset to increase basis.

Mark turns to friend Bruce, whose valuable assistance netted Bruce $50,000, while hanging Mark out to dry. Mark claims reasonable reliance. Judge Goeke puts the brakes on that one: “Reliance on the professional advice of a tax shelter promoter is unreasonable when the advice would seem to a reasonable person to be ‘too good to be true’.” 2011 T.C. Memo. 54, at p. 41.

The three-legged stool of reasonable reliance requires taxpayer to show that: (1) The adviser was a competent professional who had sufficient expertise to justify the taxpayer’s reliance on him; (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.

Chenery provided Mark with an off-the-rack tax opinion from Brown & Wood, a well-known New York City law firm. Judge Goeke shreds this opinion. “The Brown & Wood tax opinion contains several misstatements, and petitioners admitted that the representations in the tax opinion are false and fraudulent. It states that the assets were released to petitioners when they purchased them and that they provided substitute collateral. … [P]etitioners never received any of the loan proceeds and never substituted collateral. Additionally, the tax opinion states that petitioners sold the assets on December 28, 2000, even though they actually exchanged portions of the euro on December 22 and 27, 2000. The tax opinion states that petitioners represented that they had reviewed the transaction summary in the tax opinion and that it was ‘accurate and complete’. However, Mr. Kerman testified that he never reviewed the transaction summary.” 2011 T.C. Memo. 54, at pp. 46-47.

Bottom line? Mark gets thoroughly nailed, and friend Bruce walks away with his $50,000. With friends like him….

I reiterate my aversion to posting 7463 “don’t quote me” decisions, which have no precedential value. But, given the paucity of exciting Tax Court quotables (if  “exciting Tax Court quotables” isn’t an oxymoron), I fall back on the gleanings.

In this case, Chief Special Trial Judge Panuthos gives a review of the rules  regarding active-passive-real estate professionals losses. The case is Todd D. Bailey, Jr. and Pamela J. Bailey, T.C. Summary Opinion 2011-22, filed March 2, 2011.

Todd was a doctor with an AGI to match his prominence. Pamela ran their  rental real estate operations. I won’t paraphrase Judge Panuthos’ exhaustive review of Pamela’s working life, or the extensive review of the statute and regulations, which I recommend to all tax professionals as non-credit CPE. The takeaway is that rentals averaging less than one week throw off business income that should be reported on Schedule C, along with the relevant deductions. This income is not passive, and taxpayer’s involvement therein doesn’t count toward the magic 750 annual hours to permit deduction of rental losses.

Thus hard-working Pamela defers her losses in accordance with the passive activity rules and loses her current years’ deductions.  And the $25,000 active participation loss is phased out because of the couple’s heavy duty AGI north of $150,000.

Nothing like hard work and success for ruining one’s tax posture.

Too Good to be True Might Even Be Good Enough

My Exhibit A for this seemingly oxymoronic headline is Jeffrey S. and Mary F. Charlton, T.C. Memo. 2011-51, filed 3/1/11.  Jeffrey, a perpetual seeker of pots of gold at the ends of dubious rainbows, finally found his way to Aegis Co., marketer of tax-evasive business trusts (it was subsequently shut down, and its principals convicted of fraud). This Jeffrey achieved after voyaging through a Sargasso Sea of multi-level marketing schemes (reminiscent of my early days as an apprentice thief-catcher in our State’s Attorney General’s office),  get-rich-quick bookselling, and another phony tax dodge.

Jeffrey’s accountant Mr. Moore went with Jeffrey to meet with the Aegis promoters, and they came away converts to the legality of the Aegis offshore trust shellgame. As soon as IRS showed up at his door, Mr Moore of course rolled on Jeffrey, and, testifying for the IRS at trial, gave what Judge Foley (a jurist of superhuman patience) called “convincing testimony regarding the perceived legitimacy of the techniques and accuracy of the returns. His testimony relating to his advice to Jeffrey…, however, was inconsistent, incoherent, and at times incomprehensible.” T.C. Memo. 2011-51, at p. 11. Remind you of any tax advisers you know?

It was Mr. Moore who saved Jeffrey and Mary from deficiencies, interest, and the dreaded 75% fraud penalty. The three-year statute had run when IRS descended on the hapless Jeffrey, but frauds, like diamonds, are forever. So IRS asserted fraud, and trundled in the incoherent, incomprehensible Mr. Moore to prove it. With friendly witnesses like him, who needs adversaries?

Mr. Moore’s naïveté, coupled with his ineffable incomprehensibility, gave Jeffrey the wiggle room he needed. IRS has the burden of proof in a fraud case, and “clear and convincing” is there the standard, not just “tip the scales.” See Beaver v. Commissioner, 55 T.C. 85, 92 (1970).

Judge Foley said it best: “Simply put, respondent [IRS] has failed to meet his burden. See Petzoldt v. Commissioner, 92 T.C. 661, 700 (1989) (providing that the existence of fraud may not be found under ‘circumstances which at the most create only suspicion.’).’’ T.C. Memo. 2011-51, at p. 11.

While Henry David Thoreau was right when he said, “Some circumstantial evidence is very strong, as when you find a trout in the milk,” even the best circumstantial evidence fails to win the day when you put an incoherent accountant on the stand.