In Uncategorized on 05/19/2011 at 17:39

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.

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