Or, Frivolity Isn’t Free

 So learns Scott F. Wnuck, in 136 T.C. 24, filed 5/31/11.  Scott moved for reconsideration of his frivolous arguments after his petition was dismissed from the bench and he was hit with a Section 6673(a) penalty of $1000.

Moving to the next plateau, Judge Gustafson writes a 27-page opinion deconstructing Scott’s ludicrous arguments, affirms the deficiency theretofore assessed, and ups the frivolity penalty to $5000, warning Scott that any more gaming will result in a higher penalty.

Said Judge Gustafson, “Mr. Wnuck advanced frivolous arguments, as we have shown. Both during Mr. Wnuck’s trial and in the bench opinion served several days later, the Court clearly stated to Mr. Wnuck that it found his positions not just unavailing but frivolous. For that reason the Court, in its original decision, imposed on Mr. Wnuck a $1,000 penalty pursuant to section 6673(a); and the Court warned him of steeper penalties to follow if he persisted.

“Mr. Wnuck disregarded that explicit warning when he filed his subsequent motion for reconsideration. That motion made clear that Mr. Wnuck did not have new points to make; he simply repeated the arguments that had already been ruled frivolous and suggested that the Court should have addressed those arguments in more detail in an opinion. He had to know that his motion was foredoomed, but there was a reason (i.e., an improper reason) for him to file the motion nonetheless.” 136 T.C. 24, at pp. 25-26.

Tax Court upbraids Scott for using the automatic stay on filing a motion for reconsideration to delay the proper assessment and collection of tax. Then Judge Gustafson takes aim at the real harm frivolous behavior causes.

He puts it this way: “Moreover, not only the authoring Judge’s time is involved in producing an opinion. To prepare a Tax Court opinion for public release requires substantial work by law clerks, clerical staff, and the Office of the Reporter of Decisions, as well as other Judges.[Footnote Omitted] A Tax Court opinion is thus the product of considerable institutional effort.

“The substantial effort expended to produce a Tax Court opinion is well spent, even in a small case and even where the outcome is clear, if the contentions being adjudicated are made seriously and in good faith. Taxpayers with disputes both large and small need to know that their good-faith disagreements with the tax collector will get serious attention from this Court. However, the peddlers of frivolous anti-tax positions and their clients who file petitions advancing those positions should not be allowed to divert and drain away resources that ought to be devoted to bona fide disputes. If frivolous positions were to bog down the operations of this Court, the resulting disadvantage would accrue not mainly to the Court itself but rather to litigants with legitimate issues and to the public generally. To responsibly manage its resources, the Court should therefore not address every frivolous argument.”[emphasis in original], 136 T.C. 24, at pp. 20-21.

So peddlers and frivoloteers beware. Frivolity isn’t free.

Practitioners, take a look at the law review article by Chief Judge Cohen, cited in Footnote 11 at page 21 of the Wnuck opinion. It’s an excellent overview of Tax Court Operations.

I see from the Wall Street Journal that the Internal Revenue Service is subpoenaing land records information from the State of California (numerous other States having voluntarily complied), to ascertain who has either failed to pay gift tax or failed to file Form 709 even where no tax was due.

Back to basics: the annual exclusion is still $13,000 per donee; interspousals in any amounts are exempt; and all gifts must be present interests. Likewise, direct payment of medicals and educationals (see my post for 12/31/10, “Economic Substance – A Taxpayer Win”), and payments to charitables and politicals, are all exempt. If all these obtain, no 709 is due. If there are non-exempt transfers or tax is due, a 709 must be filed per taxpayer per year, and must list all gifts not exempt. Tax is due once the lifetime exclusion ($5 million) is reached. Of course, GST is a factor, but I’ll leave that to the side for now.

So suppose tax is due and unpaid. If the donee sold the property to a bona fide purchaser before IRS filed its lien, the BFP is safe, absent guilty knowledge on their part. If not, the donee had better start looking for the donor, or considering transferee liability (see my post for 3/15/11, “A Good Day for Taxpayers”). And remember, if no filing, no statute of limitations protection, so IRS could go back for years to assess and collect tax plus interest and penalties.

But what if no tax is due (probably the majority of cases)? Yes, there’s the minimum $135 Section 6651 non-filing penalty where there is a non-exempt transfer but no tax is due. But is IRS going to file liens all over California for $135 a throw?

I started with Abraham Lincoln. He is reputed to have written the following: “Who can be more nearly a fiend than he who habitually overhauls the register of deeds in search of defects in titles, whereon to stir up strife, and put money in his pocket?” Some things never change.

Not Exactly

So holds Special Trial Judge Dean in Michael Rosenfeld, 2011 T.C. Mem. 110, filed 5/23/11.

Mike was a self-employed public relations consultant, when he pitched the UK Consulate in Los Angeles for work. The Deputy Consul was so impressed he hired Mike for a three-year hitch as a full-time Trade Officer Grade US8. Mike’s engagement letter specified Mike “was required to work 40 hours per week and was not permitted to have outside business interests that could be furthered by virtue of his employment.” 2011 T.C.Mem 110, at p. 10.

The kicker is the engagement letter. That stated that Mike was “self-employed for tax purposes.” Mike took that to mean that his engagement with the Consulate was like any engagement with any client, so he wrote off his business expenses against his pay, and contributed to his SEP based on his business earnings from the Consulate.

STJ Dean goes through the eight factors for common-law employment vs. independent contractor status, and finds for IRS. The Consulate had enough command-and-control, on a fair preponderance of the evidence, to find for IRS, so denies both Mike’s attempts to introduce the UK Consulate Handbook as evidence, and to shift the burden of proof per Section 7491(a). The evidentiary points are of interest to trial counsel, but I leave it to them to parse these directly from the text of the decision.

Two main points: the engagement letter speaks louder than Mike’s uncontested but uncorroborated testimony. “Although petitioner alleged that he was not subject to the BCG’s direction and control, petitioner admitted that the head of the consulate could ask him to prepare or stop assignments and to attend conferences and meetings. His letter of appointment also specified that increases in his annual salary would be awarded only upon satisfactory service. Furthermore, contrary to petitioner’s assertions, the BCG did have the right to modify his employment arrangement. His letter of appointment explicitly stated that the BCG reserved the right to alter his conditions of service at any time.” [footnote omitted; emphasis added]. 2011 T.C. Mem. 110, at p. 9.

Although STJ Dean spends much time on the other seven factors, the letter of engagement is the key. And the Consulate reserves enough command-and-control to scuttle Mike’s ingenious but ultimately self-serving independent-contractor testimony.

What about the “self-employed for tax purposes” language in the letter of engagement? Oh, says Tax Court, that’s to do with payroll taxes; see Section 3121(b) and the Regulations. Employment by a foreign government is not “employment” for FICA and Medicare tax purposes, because IRS cannot levy on a foreign sovereign for its share of those taxes, so their US employees must file Form 1040-SE and pay those taxes. But the self-employment characterization is limited to FICA and Medicare, not income tax.

Mike also gets hit with the 6% excise for excessive contribution to his SEP. His Consulate earnings don’t count. Tax Court does an extensive analysis of Sections 401, 404 and 4979, which I leave to the specialists to decipher.

However, Mike does get a bye. Because for 25 years he had been self-employed, and used the same tax preparer, and because of the complex interface between the engagement letter, Section 3121(b), the Section 404 ramifications, and Mike’s ongoing work for other clients, STJ Dean finds for Mike on the Section 6662(a) accuracy-negligence-disregard penalty.

Takeaway? If you want independent contractor status, review your engagement letter very carefully.

Or, Payback of Loan Principal is Not Income

 Judge Paris so holds in Rick Fishman, T. C. Mem. 2011-102, filed 5/18/11.

Rick ran what amounted to a multi-level insurance sales operation. He first sold policies and recruited subordinates to sell insurance policies; later, as the business grew, he recruited subordinate managers who sold and recruited and managed other salespeople. Every link in the chain was an independent contractor, and IRS doesn’t dispute that.

Because everyone was paid on commission, and because the premium dollars to fund the commissions came in monthly, Rick would advance six months’ worth of commission to each salesperson for each policy sold. If six months’ worth of premium was eventually paid, the salesperson was compensated and owed nothing. But if the premiums remained unpaid for any portion of the six months, the salesperson owed the advanced premium to Rick, with interest.

Likewise Rick would advance certain business expenses to salespeople. He kept what Tax Court called “rudimentary” records, showing advances and repayment to his subordinate managers (called “district leaders”).

There was a written business plan that said all this, and the IRS was given a copy (twice), but the IRS agent never mentioned it in her report.

Now let’s see what Judge Paris said: “Respondent determined deficiencies based solely on the following two-pronged argument: (1) Petitioner paid expenses on behalf of the district leaders and deducted the expenses on his Schedules C; [footnote omitted](2) the district leaders eventually reimbursed petitioner for these expenses, and the reimbursements constituted gross income to petitioner, which he omitted from his return. To establish an underpayment based on this position, respondent must produce clear and convincing evidence that the reimbursements were properly characterized as gross income.” 2011 T.C. Mem. 102, at pp. 16-17.

This IRS could not do. All IRS could show was a stipulation that Rick paid for certain of the salespeoples’ business expenses and that he was reimbursed. But the salespeople were independent contractors and were obligated to repay Rick the sums he advanced.

Tax Court said:  “Simply put, respondent has not produced clear and convincing evidence that the reimbursements constitute gross income.[footnote omitted]. Rather, petitioner’s receipt of the reimbursements gave rise to nothing more than a loan repayment. Because receiving repayment of a loan does not give rise to gross income, respondent has not met his initial burden. Thus, petitioner need not produce evidence of offsetting expenses. Therefore, the Court holds that respondent has not proven that petitioner underpaid the Federal income tax required to be shown on his returns for the tax years at issue. Because respondent did not prove that petitioner underpaid his Federal income tax during the tax years at issue, the Court need not discuss whether petitioner acted with fraudulent intent.” 2011 T.C. Mem. 102, at pp. 21-22.

Moreover, since IRS conceded that, if IRS could not prove fraud, the statute of limitations would bar assessment of deficiencies for the years at issue, Rick walks.

Takeaway: Rudimentary records plus a written and adhered-to business plan are indispensable aids to a winning case.

Sorting through much financial maneuvering, the details of which I’ll spare you,  Judge Marvel gives us a roadmap to business activities that permit a controlled entity to be considered a separate entity for tax purposes, even when there is no substantial business purpose, in Weekend Warrior Trailers, Inc., T.C. Mem 2011-105, released 5/19/11.

Weekend Warrior (“WW”) created a management services C Corp called Leading Edge (“LE”). IRS contended LE was formed with no legitimate business purpose or economic substance, and should be disregarded as a sham. 2011 T.C. Mem. 105, at p. 44.

Tax Court rejects IRS’ position, and expressly denies that it reaches its conclusion on Section 482 grounds.

Citing Moline Props., Inc. v. Commissioner, 319 U.S. 436 (1943), at pp. 438-439, Tax Court states: “Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator’s personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity. [Fn. refs. omitted.]”. 2011 T.C. Mem. 105, at p.45.

Now for the kicker. Moline sets out alternative methods of deciding the validity of a controlled entity. Substantial business purpose is one, and business activity is another; either will do to save the controlled entity. But how do you (or more to the point, how does Tax Court) define an “equivalent of a business activity”, absent a valid business purpose (and Tax Court found none here)?

Judge Marvel tells us, at least based on the facts of this case: “Even if a corporation was not formed for a valid business purpose, it nevertheless must be respected for tax purposes if it actually engaged in business activity. . . .

“Leading Edge provided personnel services to Weekend Warrior. It maintained an investment account and bank accounts. It paid its employees by check, adopted a retirement plan, which respondent does not timely argue was a sham, kept books and records, and engaged Mr. . . . to appraise its stock. Leading Edge invested excess funds and at least from August 2003 through December 2004 purchased and sold stocks and received dividends. Corporate formalities were followed. Leading Edge filed Federal income tax and employment tax returns. We conclude Leading Edge carried on sufficient business activity to be recognized for Federal income tax purposes. 2011 T.C. Mem 105, at pp.48-49.

So bank accounts and corporate books by themselves aren’t enough, it seems. The personnel services and employment tax filings, together with the financial activities, over a 15-month period, seem to save LE.

The takeaway? Even a little substance matters.

If You Rely On State Law, Especially If It’s Unclear

That’s the takeaway from Richard J. and Jacqueline Rocchio, 2011 T.C. Sum. Op. 58, released 5/11/11. It’s another 7463 with some good principles, so you can argue it even if you can’t cite it. Unclear State law could save the taxpayer.

Richard J. was a stockholder in the family Sub S along with his siblings, but the Sub S was run exclusively by Papa. When Mama died and Papa married Wife Number 2, Papa spent all the Sub S’s profits on Wife Number 2 and cut Richard J. and the siblings out. The Sub S was a New York corporation, so under New York law Richard J. and the siblings sued for dissolution of the Sub S.

New York law provides that where stockholders seek dissolution, the non-dissolvers can buy out the dissolvers’ shares at fair value. Papa bought out Richard J. and siblings, but between buy-out and pay-out, the Sub S had taxable income, for which the Sub S filed an 1120-S, and sent Richard J. a K-1. Richard J. did not report the K-1 income on his and Jacqueline’s 1040, claiming he had been bought out before the income was earned and never got any of the income.

IRS sought unpaid tax, interest and Section 6662(a) substantial understatement penalty.

No penalty, says Tax Court. While New York law says you value the stock as of the day before dissolution, New York law seems to be that the stockholder isn’t out until he’s out. There isn’t a totally clear answer from the New York State Court of Appeals, New York State’s highest court. Under New York State’s somewhat eccentric structure, the Court of Appeals is New York State’s highest court; paradoxically, the New York State Supreme Court is its lowest court of general jurisdiction. As they say in New York, go figure.

So while various New York trial courts and intermediate appellate courts say that the bought-out but not paid-out shareholder is entitled to dividends and other income, and perhaps other benefits and burdens of share ownership, given the complexities of Sub S taxation and no clear guidance from the New York Court of Appeals, Richard J. at least had the minimal reasonable basis and good faith excuse for not paying.

He does owe the tax and interest, of course. But Special Trial Judge Armen softens the blow at the very end of his decision: “Finally, we observe, without commenting on the validity of such, that petitioner may have a remedy pursuant to New York State law with respect to the undistributed earnings…reported on the Schedule K-1….” 2011 T.C. Sum. Op. 58, at p. 13.

Or, Don’t Jump the Gun

 That’s the lesson Judge Kroupa delivers in Lattice Semiconductor Corporation, 2011 T.C. Mem. 100, released 5/9/11.

Lattice wanted to change its accounting method to take advantage of the proposed change in the regulations to Section 263,  that took effect 2004. The old rule for accrual basis taxpayers, and the one Lattice had followed, was that expenses fully incurred in one tax year and not applicable to more 12 calendar months, but in part applicable to the succeeding tax year, had to be capitalized. But the rules changed in 2004 to allow all such expenses to be deducted in the tax year incurred, even for accrual basis taxpayers.

Lattice applied for the change for years prior to the effective date of the new regulations, but IRS rejected the application, because the final regulations were not effective at the time Lattice applied. Lattice argued that IRS failed to take into account the proposed change and a Seventh Circuit case (even though Lattice was a Ninth Circuit domiciliary).

No go, says Judge Kroupa. IRS warned taxpayers in the Notice of Proposed Rulemaking not to apply for a change prior to the final regulations becoming effective. Lattice’s argument that IRS’ warning amounted to an “automatic rejection” policy fails for want of substantiation.

More importantly, IRS consent underpins the proper collection of revenue. Absent consent, taxpayers would cherry-pick accounting methods and eviscerate the proper collection of revenue. IRS has broad discretion over accounting method changes. Tax Court finds no abuse of IRS’s discretion.

The takeaway? Don’t jump offside, taxpayers. Wait for the regulations.

No, Intertwined and Inseparable Result

“A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines.” Ralph Waldo Emerson, 1803-1882. Well, maybe so, but not for FSCs owned by IRAs, says Judge Nims in Michael S. and Pamela S. Ohsman, 2011 T.C. Mem. 98, filed 5/3/11.

Relying on Hellweg v. Commissioner, 2011 T.C. Mem. 58, filed 3/9/11, Tax Court held that, as IRS permitted the Ohsmans’ IRA to own the shares of the Foreign Sales Corporation (FSC) to which the Ohsmans directed their sales commissions, and allowed the tax treatment the Ohsmans used for their FSC, IRS was bound to accord the same treatment to the Ohsmans’ IRA. Tax Court granted the Ohsmans summary judgment.

IRS first contended they needed discovery to resolve factual issues in dispute, without stating what those factual issues were. Judge Nims gave IRS short shrift, stating: “Respondent has not contested any part of [Ohsmans expert’s] affidavit and claims only that he is unable to do so because he has not had a reasonable opportunity to conduct discovery. While respondent may require discovery to obtain the evidence necessary to resolve the factual issues that are in dispute, the absence of discovery should not prevent him from being able to identify what those disputed issues are. Respondent may not rely on generalized allegations that material issues of fact potentially exist.” 2011 T.C. Mem. 98, at p. 5.

IRS next wanted to use the good old standby substance-over-form, to argue that the FSC’s payments to the IRA were really payments to the Ohsmans, who then made excess IRA contributions, invoking the 6% Section 4973 excise tax.

No go, says Judge Nims, unless IRS recharacterizes the income tax as well as the excise tax aspects of Ohsmans dealings. Tax Court finds, citing Hellweg, that “(W)e held that the Commissioner could not do so without also making a corresponding income tax adjustment because (1) section 4973 was intertwined with and inseparable from the income tax regime and (2) the Commissioner’s approval of the transactions for income tax purposes undermined his attempted use of the substance-over-form doctrine.” 2011 T.C. Mem. 98, at p. 6.

Here no recharacterization for income tax purposes, so no recharacterization for the “intertwined and inseparable” excise tax purposes.

Takeaway? Consistency is not always foolish.