In Uncategorized on 01/19/2012 at 19:38

Well, Just One

 There isn’t much to say about L.A. and Rayani Samarasinghe, 2012 T. C. Mem. 23, filed 1/19/12, and Judge Marvel says it as well as I can. It’s the evidence aliunde that’s the hook for me here.

As for the case, footnote 2 on page 2 of 2012 T.C. Mem 23 says it all: “The parties stipulated that if the self-rental rule of sec. 1.469-2(f)(6), Income Tax Regs., is applicable, then petitioners are liable for the deficiency. If the self-rental rule is not applicable, then petitioners are not liable for the deficiency. The parties also stipulated that the Westwood property ‘was rented for use in a business activity in which petitioner-husband materially participates.’”

The self-rental rule is a major exception to the “all rental activity is passive and all rental income is passive” rule. If you, or an entity which you control and whereby you carry on an active TOB,  rent from yourself,  the rental income isn’t passive and cannot be offset with passive losses, e.g., depreciation.

L.A. (hereinafter “Lala”) and Mrs. Lala, the Sweet Rayani, bought a building and leased the office space therein to Lala’s professional services corporation, pursuant to written lease made and entered into prior to February 19, 1988.

The magic of the 2/19/1988 date? “Section 1.469-11(c)(1)(ii), Income Tax Regs., provides that, in applying section 1.469-2(f)(6), Income Tax Regs., a taxpayer’s rental income is passive if it is attributable to the rental of property ‘pursuant to a written binding contract entered into before February 19, 1988.’ To qualify for transitional relief under the regulation, a taxpayer must prove that the rental income in question was paid pursuant to a written lease that was entered into before February 19, 1988, and was still in effect; i.e., was binding and enforceable for the year at issue.” 2102 T.C. Mem. 23, at pp. 12-13.

Whether the document proffered is a binding written contract (lease) is a question of State law. Judge Marvel canvasses New Jersey, the relevant State, law, and finds there is a binding written contract entered into before February 19, 1988 (lease).

But Lala comes unglued because neither he, his corporation, nor his trusty accountant Ramesh Sarva, CPA, ever bothered to follow the terms of said lease, at least during the years at issue. The periodic rent payments were never made, increases in base rent were never calculated or collected per the lease terms, but tenant leasehold improvements were made without lessors’ consent. Lessors didn’t recognize income in some years, even when the lessee was deducting rental payments. Mr. Sarva “determined the rent after the fact on the basis of his analysis of petitioner’s financial situation at the time. On these facts, we conclude that petitioners have not proved that the 1980 lease was a binding contract during 2005 and 2007.” 2012 T. C. Mem. 23, at p. 19.

Mr Sarva was the sole witness on the trial, neither Lala nor the Sweet Rayani appearing. Mr. Sarva’s testimony and records spoke loud and clear. The lease, though facially satisfactory, was a dead letter during the years at issue.

However, Judge Marvel gives Lala and the Sweet Rayani a bye on the Section 6662 penalties. “Respondent contends that petitioners are liable for the accuracy-related penalties because the underpayments of tax are attributable to either negligence or disregard of rules or regulations (2005 and 2007) or to a substantial understatement of income tax (2007). Respondent’s contentions necessarily reflect alternative grounds for imposing the section 6662 penalty because only one section 6662 accuracy-related penalty may be imposed with respect to any given portion of any underpayment, even if the underpayment is attributable to more than one of the types of listed conduct. New Phoenix Sunrise Corp. v. Commissioner, 132 T.C. 161, 187 (2009), affd. 408 Fed. Appx. 908 (6th Cir. 2010); sec. 1.6662-2(c), Income Tax Regs.” 2012 T. C. Mem. 23, at p. 20.

Judge Marvel finds negligence, so no substantial understatement penalty need apply. However, reliance on professionals can trump negligence. “Mr. Sarva has been a practicing C.P.A. for over 30 years. He has extensive experience in tax planning and return preparation and has advised clients with respect to real estate transactions. Petitioners relied on Mr. Sarva’s judgment in purchasing the Woodside property in 1979, in setting up the leasing transaction, and in preparing their and the medical corporation’s tax returns each year. Given Mr. Sarva’s credentials and the longstanding professional relationship between petitioners and Mr. Sarva, we find that petitioners were justified in relying on Mr. Sarva.” 2012 T.C. Mem. 23, at p. 23.

And even though neither Lala nor the Sweet Rayani bothered to testify on the trial, Judge Marvel still finds they were justified. So no penalty.

Now I said I was not going to say much about this case. But when I read footnote 13 at page 23 of 2012 T.C. Mem. 23, the lightbulb went on: “Mr. Sarva also has real estate investment experience.” Sure he does. It took me half an hour of online research, but I proved I still have a working memory bank. I represented an entity he controlled as sponsor of a cooperative housing conversion in New York City in 1989. Both our signatures are on the recorded deed. But I don’t remember giving him any tax advice, then or thereafter.

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