Or, Of What Had You Made Certain, After You Had Made Certain You Had Made Certain Of  Nothing?

Tax Court asks Sherlock Holmes’ acid question (“The Adventure of the Golden Pince-Nez”) of Gertrude Saunders’ estate, in denying a $30 million estate tax deduction.  Estate of Gertrude Saunders, 136 T.C. 18, released 4/28/11.

The question was the value to be placed on a contingent liability of Gertrude’s late husband, William Jr. William Jr. was being sued at his death by the estate of a former client, Stonehill. Stonehill’s estate alleged that William, Jr., was a snitch for the IRS who railroaded his client into a $90 million deficiency, which stripped Stonehill of his business and cash.

Stonehill’s estate sued for the $90 million. To settle William Jr.’s estate, Gertrude’s estate agreed with IRS that Gertrude would carry the weight of any successful judgment or settlement. Gertrude’s estate claimed a $30 million deduction, and IRS allowed $1.00, with any further deduction to be allowed when Gertrude’s estate closed. The amount actually paid during the administration of the estate may be deducted in accordance with section 20.2053-1(b)(3), Estate Tax Regs.

In fact, the estate settled for around $600K, but that was years afterward.

The case comes up based on stipulated facts and experts’ reports, Tax Court stressing that it does not decide the case by way of summary judgment.

First, Tax Court distinguishes between valuation of a claim as at date of death with reasonable certainty for inclusion, as against exclusion. Is the valuation for inclusion in gross estate (taxable) or exclusion (deduction)? Or as the real estate operator’s first-grader answered when the teacher asked him “Johnny, how much is two plus two?”, “Teacher, am I buying or selling?”

Judge Cohen put it simply:  “In other words, a value may be determined for asset inclusion purposes that does not satisfy the “ascertainable with reasonable certainty” standard for deduction purposes. It is essentially undisputed that postdeath events are not considered in valuing assets in an estate because of the rule stated in Ithaca Trust Co. v. United States, 279 U.S. 151, 155 (1929), that an estate ‘so far as may be is settled as of the date of * * * [decedent’s] death.’” 136 T.C. 18, at pp. 20-21.

Liability deduction (exclusion) is another story. Here Tax Court examines a raft of cases and concludes, almost in despair, “‘at times it is like picking one’s way through a minefield in seeking to find a completely consistent course of decision’. Unfortunately, the difficulty has not diminished, and we maintain our position that reconciliation need not be undertaken here. We do not consider the subsequent settlement in our discussion of the question of whether the value of the Stonehill claim was ascertainable with reasonable certainty as of November 2004. We have addressed this dispute only to demonstrate that there is a difference between valuing claims in favor of an estate and allowing deductions for claims against an estate.” 136 T.C. 18, at p.23.

Finally, Gertrude’s estate’s platoon of experts, each with a different number and each with a different rationale for arriving thereat, ultimately win the case for IRS.

Cutting the Gordian knot of expert opinions, Judge Cohen makes it simple: “Our review of the estate’s expert reports, standing alone, convinces us the value of the Stonehill claim against the Saunders estate is too uncertain to be deducted as of November 2004.” 136 T.C. 18, at p. 24. The blind men and the elephant, perhaps?

After an exhaustive (and exhausting) dissection of the several experts’ reports and their proffered testimony brought forward by Gertrude’s estate, Judge Cohen concludes: “In summary, stating and supporting a value is not equivalent to ascertaining a value with reasonable certainty. Neither the estate’s experts nor their offer of proof satisfies the applicable legal standard.” 136 T.C. 18, at p. 26.

In fact, the more experts you have, and the more their conclusions vary, the more certain it is that you have made certain of nothing.

Or, When is a Regulation Not a Regulation?

 This was the riddle with which Tax Court grappled in Carpenter Family Partnership, 136 T.C. 17, released 4/25/11, with Judge Wherry for the majority and Judges Halpern, Hughes and Thornton concurring.

The issue was which statute of limitations (hereinafter the “SOL”) applied–either the three-year statute of limitations (hereinafter “3SOL”) applied to the partnership’s return for tax year 2000, or the substantial understatement six-year statute (hereinafter the “6SOL”). Taxpayer agreed to an extension of time to assess in 2007; if 3SOL applied, it had already run and there was nothing to extend, as an extension is valid only if made prior to running of the applicable SOL. See Section 6501(c)(4).

The underlying tax issue was the phony stock or foreign currency transaction, whereby a low basis in property is inflated by contributing it to a partnership, with a simultaneous but unrecognized offsetting contribution. The basis thus increased, the property is sold, and gain minimized. See my blog for January, 2011, for Stobie Creek and its offspring.

But the heart of the question is the SOL. 3SOL or 6SOL? IRS claims it issued temporary regulations in 2009, clarifying that overstatement of basis equals understatement of tax, other than in a trade or business, neither of which taxpayer concededly is, and therefore 6SOL. Of course, Tax Court struck down the temporary regulations, so IRS made them permanent and is trying to apply them here.

No way, says Judge Wherry. Ditto, say Judges Halpern and Hughes, and “Amen” says Judge Thornton, though their reasoning differs.

To begin with, the applicability date of the permanent regulations was circular, as it applied the regulations to unclosed years, which were rendered unclosed solely by virtue of those self-same regulations. Treasury tries to solve the problem with a semantic song-and-dance, which Tax Court brushes aside.

Tax Court parses the Colony decision (Colony, Inc. v. Commissioner, 357 U.S. 28 (1958)), the Supreme Court’s Chevron decision (Chevron USA Inc. v. Natural Res. Def. Council, 467 U.S.837 (1984), and the most recent Supreme Court pronouncement, Mayo Foundation for Medical Education and Research v. United States, 562 U.S.___, 131 S.Ct. 704 (2011). Did Congress leave a gap for the agency to fill? If Congress did and the agency fills the gap, “arbitrary or capricious in substance, or manifestly contrary to the statute”, are the only grounds upon which a court can set a regulation aside.

Tax Court says, however you slice it, the regulations cannot extend 6SOL to this case. I leave a detailed analysis of Judge Wherry’s 43-page exegesis, and Judges Halpern, Hughes and Thornton’s 15-page concurrences, to the law review writers. I am a simple practitioner. The takeaway–until Congress or the Supreme Court say otherwise, the 3SOL controls substantial understatement anywhere but in a trade or business.

And you may be sure there will be an appeal.

 The Doctrine Explained, and My Inventory Discussed

The doctrine of mitigation, found in Sections 1311 through 1314, allows a party to apply an adjustment to an item of gross income embodied in a Tax Court determination as to an open year, to the same class of item in an otherwise closed year. A thorough explanation is found in a 7463 not-for-nothin’ opinion, Tuwana Jynne Anthony, 2011 T.C. Sum. Op. 50, released 4/18/11.

Tuwana was the sole proprietor of a cosmetic consultancy. She also sold cosmetics and kept an inventory for sale to her customers. In the course of an IRS examination, Tuwana adjusted her year-end inventory valuation to reflect her purchase price of the goods, rather than the price at which she sold the goods to her customers. As she marked up her goods by more than 100%, the adjustment was considerable.

However, the adjustment was embodied in a stipulation, which in turn was embodied in a final Tax Court order, in a prior proceeding resulting from that examination. IRS asserted a deficiency for a closed year in the present proceeding, based upon the stipulated adjustment in the prior proceeding. Tuwana petitioned timely, and Judge Swift held for IRS.

Judge Swift thus defines the parameters of the doctrine: “…the mitigation provisions… permit the correction of an item that is shown to be erroneous by a determination in an administrative or judicial proceeding relating to another year or to a related taxpayer. Fruit of the Loom, Inc. v. Commissioner, T.C. Memo. 1994-492, affd. 72 F.3d 1338 (7th Cir. 1996). The limited conditions under which the mitigation provisions will be applied may be described generally as follows: (1) There has been a determination (as defined in section 1313(a)); (2) the determination must fall within one of the specified “circumstances of adjustment” or  “doubling-up” situations described in section 1312; (3) with respect to the treatment of the item in question for the determination year, the party against whom the mitigation provisions are invoked must have maintained a position inconsistent with the treatment of the item in another year of the same (or related) taxpayer, which year is barred by the generally applicable period of limitations or by some other rule of law, see sec. 1311(b); and (4) the party who seeks to employ the mitigation provisions must act timely thereunder and in the proper manner to make a corrective adjustment, see sec. 1314.” T.C. Sum.Op. 2011-50, at pp. 6-7.

Note that general statements concerning a stipulation in a Tax Court order, but not particularizing stipulated terms, is insufficient to trigger mitigation, as the order is not a “determination” within the meaning of Section 1313(a). Here, the order in the prior proceeding had sufficient particulars to qualify under Section 1313(a), the only real disputed factor in Tax Court’s mitigation analysis.

So Tuwana had to adjust her ending inventory for the prior (closed) year to harmonize with the opening inventory for the (stipulated) year, thus triggering the mitigating adjustment and the deficiency for the (otherwise closed) year.

Takeaway for the practitioner–less is more. If you don’t want to open the door to mitigation, keep it simple; no details about stipulations. And watch out for the colloquies in Court; the transcripts can contain enough particulars to haunt you.

Further takeaway–Tuwana was self-represented in the first and the second proceedings. When the draft order was prepared in the first proceeding, she didn’t object to the particularizing. Warning–even when you settle, your adversary is not your friend.

Tuwana wanted to bring in some unrelated items to offset the closed-year deficiency, but Section 1314(c) makes that a non-starter. Taxpayer has no credits or off-sets for any item other than the specific item adjusted.

And now for a different kind of inventory. I’ve been running this blog for four months. I’ve had no feedback and no comments.

Does anybody read this stuff? If you do, even a simple “yeah” in the “Comment” section of each of my posts would be appreciated. I’d appreciate suggestions on how to make the blog more useful to the practitioner in the trenches even more. I’m writing for the front-line tax professional, not for the academician or the theoretician, although they’re welcome here too. I’m always happy to adjust my inventory.

So says Judge Dawson in James Bruce Thornberry and Laura Anne Thornberry, 136 T.C. 16, released 4/19/11, to both the taxpayers and IRS. IRS sent James and Laura notices of lien and notices of intent to levy. James and Laura timely responded with a request for due process hearings, attaching to their requests a form they downloaded from a tax protesters’ website. A settlement officer in Appeals replied with a SO 4380 letter, treating James’ and Laura’s request as no request, pursuant to the Section 6702 frivolity kick-out. Frivolous requests for hearings, installment agreements and hardship relief are treated as no requests at all, and are not reviewable by Tax Court; no hearing, no response necessary. See also Section 6330(g).

James and Laura petitioned Tax Court. IRS says “no jurisdiction. Once IRS determines the request is frivolous, Tax Court is ousted of jurisdiction.”

Not so, says Judge Dawson. After a lengthy review of the procedures for requests for hearings following notice of lien and notice of intent to levy (which I recommend to practitioners as a good review of the procedural aspects), Tax Court dealt with IRS’ argument that the SO 4380 letters were not “determinations.” The heading of a paper does not determine its function, says Judge Dawson. The SO 4380 letters say “we’re ignoring your non-request.” That is a determination.

Tax Court said: “Essentially, respondent’s position is that because the Appeals Office treated petitioners’ request in toto as if it were never submitted, the determination to proceed with collection was not in response to a request for an administrative hearing. Respondent asserts that the Appeals Office’s determination regarding petitioners’ request is not subject to any judicial review by this Court pursuant to section 6330(g)” 136 T.C. 16, at p.15.

Reviewing the legislative history behind the adoption of Section 6330(g), Tax Court finds it was intended to clean out frivolous requests and petitions used by tax protesters to stall collection of revenue. But Section 6703 requires a hearing before any Section 6702 penalty (the $5,000 frivolity penalty) may be imposed.

The legislative history shows Congress required IRS to state periodically what positions IRS deems frivolous. Tax Court extends this to require IRS to state in the instant case what argument is advanced by James and Laura to delay collection of revenue, or is frivolous.

Judge Dawson said: “Section 6703(a) clearly contemplates judicial review of a determination by the Appeals Office that a specified submission, including a request for an administrative hearing under sections 6320 and 6330, is a specified frivolous submission. Consequently, while section 6330(g) prohibits judicial review of the portion of a request for an administrative hearing that the Appeals Office determined is based on an identified frivolous position or reflects a desire to delay, it does not prohibit judicial review of that determination by the Appeals Office.” (emphasis by the Court) 136 T.C. 16, at p. 19.

Judge Dawson had already observed: “The determination letters did not specify which statements or individual grounds listed in petitioners’ requests or the attachments thereto were frivolous issues or otherwise identify anything in the request, the attachment, or petitioners’ administrative file or conduct that reflected a desire to delay or impede Federal tax administration.” 136 T.C. at p. 5.

Patience exhausted, Judge Dawson admonishes both sides:  “The delay in resolving this case has been caused by both parties’ using boilerplate ‘one size fits all’ forms. Thus, in these circumstances, this Court has jurisdiction, and respondent’s motion to dismiss for lack of jurisdiction will be denied. … we conclude that the settlement officer could not treat petitioners’ entire request as if it were never submitted. Section 6330(g) requires the Appeals Office to determine the specific portions of petitioners’ request for a hearing that are regarded as frivolous or reflect a desire to delay or impede the administration of Federal tax laws, leaving only for hearing the legitimate and bona fide issues petitioners raised. The Appeals Office has not yet done this. Petitioners, on the other hand, have set forth in their administrative hearing request a litany of recitations lifted from an Internet Web site, many of which tend to show an attempt to delay or impede the administration of Federal tax laws. We have in this Opinion notified petitioners that merely attaching a list downloaded from the Internet that includes grounds that clearly do not apply to their case without identifying specific issues and grounds relevant to their hearing request does not satisfy the requirements of sections 6320(b)(1) and 6330(b)(1). Accordingly, the Court will require petitioners to identify the specific issues and the grounds they wish to raise before taking further action in this case.” 136 T.C. 16, at pp. 27-28.

In short, you’ve both got to be more specific.

When it comes to mark-to-market foreign currency deals.

The issue for Tax Court in Ricardo A. and Tari Scurlock Garcia, T.C. Mem. 2011-85, filed 4/13/11, is whether the foreign exchange options Ricardo contributed to the Holy Innocents Building Fund were in fact Section 1256 foreign exchange contracts.  If so, the $3,000,000 loss that Ricardo claimed was valid. If not, Ricardo owes much tax, interest and penalties.

Note that facts are not found in a summary judgment motion like this one; they are assumed from the pleadings, as there is no substantial question of fact for the Court to determine. See Fed R. Civ. P. 52(a).

The deals were made between Ricardo’s sole member-sole manager LLC (disregarded entity) and  Montgomery Global Advisors V LLC, based in San Francisco. Ricardo lived in Texas and his LLC was Georgia-domiciled. While the options had “knock-in” and “knock-out” barriers, meaning the rate of exchange during the option period had either to hit or miss a certain level before the option could be exercised, Tax Court held that this feature did not convert the option to a contract.

The good news for taxpayers is that Section 1256(a)(1) generally permits certain financial instruments to be marked to market on the last business day of the taxable year and any gain or loss on those contracts to be included on the taxpayer’s Federal income tax return. And gain or loss is recognized immediately upon contribution to a Section 501(c)(3) entity, as Holy Innocents presumably was.  Any gain or loss with respect to a “section 1256 contract” is treated as a short-term capital gain or loss to the extent of 40 percent of such gain or loss and a long-term capital gain or loss to the extent of 60 percent of such gain or loss. Section 1256(a)(3).

The bad news for Ricardo and Tari is that Section 1256(b) excludes from the definition of a “section 1256 contract” any option on a currency futures contract unless the option is subject to the regulations of, and traded on, a regulated exchange, like a national securities exchange which is registered with the Securities and Exchange Commission, a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of section 1256. See Section 1256(g) and Section 1256(g)(7).

First, Tax Court held an option is not a contract for Section 1256 purposes. Relying on Summitt v. Commissioner, 134 T.C. 248 (2010), Tax Court holds that Section 1256 (a)(1) does not apply, because the option allows Ricardo to walk away rather than be required to settle, whether in cash or by physical delivery of currency, at expiry of the option. The plain words of the statute require a binding contract, says Judge Haines, not what Sam Goldwyn called a “definite maybe”.

Second, Tax Court held that Section 1256(b) requires the contracts be subject to regulation by, and be traded on, a regulated exchange, and these non-contracts weren’t so regulated or traded.

The game here, as in Summitt, is to straddle a currency position with offsetting puts and calls. The puts are written in “major currencies” (yen, euros, sterling), the calls in “minor” currencies (Danish kroner). The major put was claimed to fall within Section 1256 mark-to-market and take-the-loss rules when assigned to Holy Innocents (how innocent in fact was Holy Innocents is not explored in the decision); the minor call was not, so the offsetting gain on the minor currency call didn’t have to be marked or reported. And the barrier was claimed to qualify an otherwise disqualified deal. No go, says Judge Haines; the deals are not subject to the rules of, nor traded on, a regulated exchange, and besides, there is no requirement to settle in cash or kind at maturity, so barrier or no barrier, Section 1256 does not apply.

Ricardo and Tari argued that testimony of a foreign currency exchange expert was necessary to determine this case. No, says Judge Haines. “The testimony suggested by petitioners is nothing more than the legal conclusions of a supposed industry expert. We made our legal determination on the section 1256 issue in Summitt.” 2011 T.C. Mem. 83, at p.13.

Takeaway? As Job said, “He disappointeth the devices of the crafty, so that their hands cannot perform their enterprise.” Job 5:8. Don’t be too clever.

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Or, As Alexander Pope Put It

A little learning is a dangerous thing;
Drink deep, or taste not the Pierian spring:
There shallow draughts intoxicate the brain,
And drinking largely sobers us again.

This wisdom is taken from Alex’s Essay on Criticism, which celebrates its three hundredth birthday next month. It’s a lesson that Tax Court taught to Bruce A. and Carol Anfinson Brown, 2011 T.C.Mem.83, filed 4/12/11.

Carol has an LL.M. in tax and is an active State court practitioner. Bruce is a commercial litigation attorney. Their problem started when the loans on Bruce’s life insurance policy with Northwestern Mutual (The Quiet Company) exceeded the cash value (the sum of any dividends plus paid-up value from Northwestern’s tables plus the value of any additional insurance bought with accumulated dividends).  Bruce at first used dividends for additional insurance, but stopped doing so. He then started to use dividends to offset premiums and finally started borrowing against cash value to pay ongoing premiums.

Bruce reported no income from the dividends or the loans, and rightly so (Section 72(e) (4) (B)). But finally Bruce stopped paying, and Northwestern quietly canceled the policy and sent Bruce a 1099-R showing a gain of $29,093.30, being the difference between what Bruce had paid (investment in the contract) and what he had borrowed.

Believing that Northwestern had erroneously determined that the gain was the result of cancellation of indebtedness, Bruce and Carol did not report the $29,093.30 from the 1099-R amount on their 1040, and did nothing else.

Right in theory, because the loan wasn’t canceled, it was paid in full by using the cash value of the policy,  but wrong on the law. The pay-in-full is a taxable event, per Section 72(e) (5) (A) and (C), which cancel the general rule of Section 72(e) (4).

Carol and Bruce’s argument, that Section 72(e)(4)(B) exempted the 1099-R amount from tax on the grounds that it was a dividend taken back by Northwestern, is rejected decisively by Judge Morrison–right church, wrong pew. The operative sections are Section 72(e) (5) (A) and (C). The excess of cash value over Bruce’s investment was not received as an annuity and therefore is subject to tax, as the loan was a true loan, and the effect of using its cash value to pay off a loan against the cash value is the same as if Northwestern had written a check  to Bruce, and Bruce wrote a check back to Northwestern.

Carol and Bruce’s argument that in the controlling cases cited by Tax Court the policyholders used the loan proceeds for purposes other than premium payments, which Bruce did not, doesn’t avail them. It doesn’t matter,  says Judge Morrison; a debt is a debt is a debt. And a debt from a loan against an insurance policy’s cash value, if paid off otherwise than as an annuity, generates gain to the extent of excess of debt over investment in the contract.

Carol and Bruce did get one minor gimme: the deficiency stated in the 90-day letter was less than the number IRS proved at trial. But Tax Court hadn’t jurisdiction to enter judgment for the greater amount (several hundred dollars), because IRS didn’t assert a greater amount at or before the hearing (Section 6214(a)).

As for penalties, Tax Court assesses the substantial understatement penalty because, in Judge Morrison’s words: “The Browns exerted little effort. They understood correctly that there was no discharge of debt. They therefore concluded that Northwestern’s information return, which they misconstrued as having been based on a discharge-of-debt theory, was wrong. Yet they did not research the proper tax treatment of the transaction. They did not even make the simple effort of asking Northwestern why it reported income where there was no discharge of debt. And, finally, the Browns’ experience, knowledge, and education weigh against them: both are licensed attorneys, and one has a master of laws degree (LL.M.) in taxation. In short, the Browns have failed to show that they had reasonable cause for and acted in good faith regarding the underpayment.” 2011 T.C. Mem. 83, at pp. 24-25.

And wouldn’t cancellation of debt be reported, not on a Form 1099-R, but on a Form 1099-C?

Bottom line: No matter what your expertise, do your homework. In fact, the more your expertise, the more you should do your homework. A little learning is an expensive, as well as a dangerous, thing.

I wish Tim Micek had not opted for small tax case, the ever-to-be-deplored Section 7463 treatment, in Timothy Owen Micek, T.C. Sum Op, 2011-45, filed 4/6/11. This case would be great precedent for an alimony fight in Third Circuit (and when will we get a single Federal tax Circuit, to end the case-shopping and forum-shopping, and different results on a national issue in places separated by a few miles, a State line, and the lines on the Court of Appeals map?).

IRS assessed deficiencies for four years’ worth of Tim’s alimony payments to Karen, starting from two years after they separated after 31 years of marriage. At the split, Tim lived in New Jersey and Karen in Pennsylvania. Two years after they split, Tim agreed to pay Karen $1250 bi-weekly, and to prove it, he executed and acknowledged before a New Jersey notary public a “spousal support affidavit”,  so stating. And pay he did, in accordance with the affidavit, for all the years at issue, except the last, when Tim was diagnosed with MS and had to quit work.  Karen promptly divorced him but the spousal support affidavit was not mentioned in the divorce decree (nor in an amendment to the decree). And Karen waived any support or alimony payments in the divorce decree.

In issuing the deficiency, IRS said, “No, not a proper Section 215 deduction, as what Tim paid were not proper Section 71 payments. The spousal support affidavit is none of  ‘a decree of divorce or a written instrument incident to such a decree, a written separation agreement, or a decree requiring a spouse to make payments for the support or maintenance of the other spouse.’” T.C. Sum. Op. 2011-45, at p. 5.

IRS does not dispute the spousal support affidavit meets Section 71(b) tests: (a) doesn’t say not includible in payee’s income; (b) payor and payee not in same household; and (c) no liability to pay after payee spouse’s death, T.C. Sum. Op. 2011-45, at p. 4, footnote 2. And IRS concedes Tim made all payments claimed.

Judge Haines disposes of IRS’ key objection, that the spousal support affidavit is not a proper divorce or separation instrument, thus:  “The issue before us is whether the spousal support affidavit qualifies as a written separation instrument as defined by section 71(b)(2). The spousal support affidavit is a written instrument, signed by petitioner, promising to pay Ms. Micek $1,250 every 2 weeks. As discussed above, a separation instrument does not require a specific medium or form and does not have to be signed by both husband and wife. Further, even though Ms. Micek did not sign the spousal support affidavit, petitioner testified that he reached an oral agreement with Ms. Micek with respect to support payments during their separation. This meeting of the minds not only is memorialized by the spousal support affidavit, but also is supported by the letter from Ms. Micek’s attorney received by petitioner’s attorney on April 21, 2003, describing the payments she had been receiving from petitioner as alimony payments. Accordingly, the spousal support affidavit qualifies as a written separation instrument as defined by section 71(b)(2), and petitioner is entitled to his claimed alimony deductions for the years at issue.” T. C. Sum. Op. 2011-45, at pp.5-6.

Unhappily, this case is not precedent. But I would hardly suggest we ignore it for that reason. Judge Haines has given us a useful template for drafting a written separation agreement that will pass muster–at least as to deductibility.

Tax Court Tells IRS

That’s the takeaway from Agripina D. Smith and James F. Smith, Jr., 2011 T.C. Memo. 82, filed 4/6/11. Agripina was a member of the Tribal Council of the Nooksack Indian Tribe of Washington State during the years in question, a paid position.

Most of Judge Morrison’s decision deals with what portion of Agripina’s pay as Councilmember is exempt pursuant to Section 7873. That section exempts income derived from fishing-rights related activities by Indians.

Judge Morrison finds Agripina provided insufficient substantiation of what activities she (and her fellow Councilmembers whose petitions are consolidated for trial) performed, and no evidence specifically distinguishing between fishing and non-fishing activities. In a typographical error in her petition, Agripina claimed all her activities were fishy (see T.C. Mem. 2011-82, footnote 7 at pp.13- 14; Judge Morrison kindly corrects the error).

In Judge Morrison’s words: “The exact nature of the work of the Nooksack tribal council on salmon fishing issues is unclear in the record, as is the magnitude of the work in  comparison to the council’s other activities. The trial record does not even contain the minutes of the meetings of the council. The only concrete piece of relevant evidence is that the tribe spent 11.9 percent, 10.9 percent, and 9.7 percent of its budget on fishing expenses….”

IRS allocated the Tribe’s percentages to Councilmembers’  exempt income, and issued a deficiency as to the balance. This Tax Court sustains.

That’s all very well, and no doubt interesting to specialists in “Indians not taxed” taxation.

Now for the rest of us. IRS claimed the Councilmembers were liable for self-employment tax on the non-exempt Tribal Council compensation. The Councilmembers never reported the income, so a fortiori they never filed 1040-SEs or paid SE tax.

But IRS never claimed that Agripina owed SE tax in the deficiency notice, nor yet in the answer to the petition. IRS first raised the issue in IRS’ pretrial memorandum.

No fair.

Judge Morrison thus rebukes IRS:  “The belatedness with which the IRS raised the issue of self-employment liability for the tribal-council compensation is a violation of Rule 31(a), which provides that the answer and other pleadings should give the other party fair notice of the matters in controversy. In Stewart v. Commissioner, 714 F.2d 977, 986 (9th Cir. 1983), affg. T.C. Memo. 1982-209, the Court of Appeals for the Ninth Circuit explained that the most appropriate times for the IRS to raise the legal theories on which it intends to rely are in the deficiency notice and in the answer. The failure of the IRS to raise a legal theory at these times does not cause the IRS to forfeit its right to rely on the theory if the taxpayer is not surprised and disadvantaged by the delay in raising the theory. Id. at 986-987. The petitioners would suffer prejudice from the belated raising of the issue of self-employment tax liability stemming from the tribal-council compensation. The issue does not hinge on the same factual questions as does petitioners’ liability for income taxes stemming from the tribal-council compensation. Therefore the IRS is barred from raising the issue.” T.C. Mem. 2011-82, at pp.20-21.

So, IRS, when you go on the warpath, don’t ambush the taxpayer–whether or not the taxpayer is an Indian.

It may be a thing of beauty, but Tax Court says it must be a joy forever. So Tax Court held in Gordon and Lorna Kaufman, 136 T.C. 13, released 4/4/11.

Lorna owned a rowhouse in Boston’s South End, with a façade worthy of historic preservation. Lorna gave a historic preservation easement to National Architectural Trust (hereinafter “NAT,” n/k/a Trust for Architectural Easements). In exchange for a hefty cash contribution to provide a trust fund for enforcing the easement, NAT shepherded Lorna’s application through the National Parks Service to get the coveted historic preservation designation that would give the Kaufmans a substantial Section 170(h)(1) deduction for the diminution of property value caused by the granting of the easement. The Kaufmans took the deduction, IRS disallowed it, and Tax Court granted partial summary judgment to IRS in Kaufman, 134 T.C. 182 (2010). Now Kaufman moves for reconsideration, joined by various preservationist groups.

Tax Court denies the preservationists the right to file briefs, telling them to devise a joint brief with Kaufman’s counsel that raises all their issues.

The whole problem is perpetuity. The easement must be enforceable forever. Certain events that might be “remote possibilities” do not impair “forever”. In any event, Kaufman claims that eminent domain, mechanics’ liens foreclosure, changed circumstances, Marketable Title acts and casualty losses do not impair “forever”, as all net proceeds arising out of any such event go to the Trust, which is permissible under Treas. Reg.1.170A-14(g)(6)(ii), a sort of cy pres application.

Tax Court cites Treas.  Reg. 1.170-14(g)(2), which requires mortgagees to subordinate their lien to the easement, as foreclosure is not a remote possibility as a matter of law.

There’s the rub. While the other possibilities for extinguishment cataloged by Tax Court: “Condemnation (eminent domain), the foreclosure of pre-existing liens, foreclosure for unpaid taxes, Marketable Title Acts, merger or abandonment, the doctrine of changed conditions, and release by the holder” 136 T.C.13, at pp. 15-16, may be so remote as not to invalidate the “in perpetuity” requirement (Reg. 1.170-14(g)(3)), a mortgage foreclosure is not.

Lorna Kaufman had mortgaged the property to now-defunct Washington Mutual Bank, F.A. (“WaMu”). NAT had guided Lorna to a deal with WaMu, whereby WaMu subordinated to the easement, but reserved to itself all casualty insurance proceeds and condemnation awards until the mortgage was paid in full.

No good, says Tax Court. Kaufman’s argument that foreclosure was a remote possibility does not survive Tax Court’s analysis:  “The drafters of section 1.170A-14, Income Tax Regs., undoubtedly understood the difficulties (if not impossibility) under State common or statutory law of making a conservation restriction perpetual. They required legally enforceable restrictions preventing inconsistent use by the donor and his successors in interest. See sec. 1.170A-14(g)(1), Income Tax Regs. They defused the risk presented by potentially defeasing events of remote and negligible possibility. See sec. 1.170A-14(g)(3), Income Tax Regs. (sometimes, simply, the so-remote-as-to-be-negligible standard). They did not, however, consider the risk of mortgage foreclosure per se to be remote and negligible and required subordination to protect from defeasance. See sec. 1.170A-14(g)(2), Income Tax Regs. (sometimes, simply, the subordination requirement).” 136 T.C. 13, at p. 21.

If there’s a mortgage on the property, however remote the chance of foreclosure, the mortgagee must subordinate all the way.  No priority to the mortgagee in any condemnation awards, casualty insurance proceeds, or anything else; everything must go first to the Trust.

Tax Court denies IRS substantial undervaluation penalties, because the valuation of the easement never comes into play, the deduction being denied in principle regardless of the value of the easement.

The takeaway? If you do one of these deals, the bank must subordinate all the way. As John Keats would say, “the thing of beauty must be a joy forever.”