No, Nor Your Cash Neither

Not in Judge Wherry’s courtroom, as he teaches John P. Owen and Laura L. Haskell Owen, et al., 2012 T.C. Mem. 21, filed 1/19/12, a famous date that happens to be the birthday of a certain Director in a major accounting firm, stationed in Houston, TX; though neither she nor her firm is involved in this case, I wish her a happy birthday.

There’s a lot going on here: personal service corporations, income assignments, employment agreements and Section 1244 stock sales followed by an attempted Section 1045 rollover.  I’m just going to focus on two of the goings-on: the Section 1045 small business corporation rollover, and the “cursory glance” requirement for good-faith reliance on your tax professional.

John P., who is a high school dropout, and his friend Nick Michaels (education unstated), with John P.’s spouse Lovely Laura L.,who stayed in school and graduated, and Nick’s girlfriend Chris Larson, started an insurance business that employed 150 people, and that they sold within five years for $7.5 million, with performance-based sweeteners, employment and non-compete agreements and other goodies if the business prospered under new management. It did. So did John P.

Relying on the advice of Robert Hall, EA, his first tax consultant, John P. and Nick incorporated and elected Section 1244 treatment for their corporation. Of course, their basis in their stock was a few thousand, and their capital gain enormous. Realizing Robert Hall, EA, was out of his depth, John P. sought out Greg Mogab, CPA, who sports a Masters’ in Taxation.

Says Greg, start a new Section 1244, throw in all the proceeds from the sale of the old Section 1244 within 60 days, elect Section 1045 treatment by due date of return for year of sale, and run the new Section 1244 as an active trade or business using 80% of the proceeds in the active trade or business. John P. claims at the trial he doesn’t remember the 80% bit, and only used 8% for the very little business the new corporation did. Greg says on the stand he darn sure did tell John P. 80% for first two years.

In any event, the $1.916 million John P. says he put into the new business generated gross receipts of $12K after two years, from six sales, of which four were to John P., his companies or his pal Nick. Judge Wherry says that’s not an active trade or business, and John P. can’t sell Judge Wherry the claim he was going slow to learn the business before plunging in, and kept a big cash reserve. Judge Wherry doesn’t buy whatever John P. is selling: “…we leave for another day what amount of cash on hand can be considered actively used in a trade or business under section 1045 that has been in existence for less than 2 years. We hold that under the surrounding facts here the fact that 92 percent of  . . .  assets were held in cash causes it to fail the active business requirement.” 2012 T.C. Mem. 21, at p. 45 (footnote and name omitted). So no deferral, and inclusion in income in year of sale.

By the way, the 80% use-in-business requirement falls to 50% after two years, but that doesn’t help John P. You can’t bury your cash.

Nor can you bury your mistakes. Among the miscommunications between John P. and Greg the Master of Taxation was a little matter of $1.5 million performance enhancement that John P. got in Year Two when the business he sold made the new owners rich.

Judge Wherry tells the story: “In January 2003 Mr. Owen called Mr. Mogab and informed him that the … Companies had met the target operating earnings and that he would be receiving an additional $1,500,000 for the sale of the … Companies. However, because Mr. Mogab did not yet have a 2003 tax return file for the Owens, he did not make a written record of this fact for future use.

“At trial Mr. Mogab explained that by mistake the accounting firm did not report the $1,500,000 capital gain on the Owens’ personal tax return for 2003. He explained that ‘A year and a half later when we prepared the ‘03 return honestly it was not recalled by me. There was not a 1099 issued by the company. If there were a 1099 they would have given me the 1099 and I would have had that document and it darn well would have been picked up’.” 2012 T.C. Mem. 21, at pp. 11-12.

Darn well it should have been memorialized somewhere when you got the phonecall, Greg, and then found its way into the 2003 tax file, especially when the money showed up as paid-in capital on the 2003 return of the new Section 1244 you told John P. to form. 2012 T.C. Mem. 21, at p. 12, footnote 10.

Howbeit, John P. and Laura L. want to get out of the Section 6662 (a) penalty because they told Greg, and his team blew the hand-off.

Judge Wherry blows the play dead. “The Owens argue that they are not liable for the section 6662(a) penalty because they relied on . . . [Greg’s] staff to accurately prepare their return. We conclude that the Owens did not rely in good faith on their accountants’ advice because their reporting of this payment was oral and was long before the return was prepared. Further, they did not carefully examine their return before it was submitted to the IRS, and this standing alone, given the material amount involved, would trigger the penalty under these facts. See Woodsum v. Commissioner, 136 T.C. 584, 595 (2011) (‘In signing the return thus erroneously prepared, petitioners were not deliberately following substantive professional advice; they were instead unwittingly (they contend) perpetuating a clerical mistake. The defense of reliance on professional advice has no application here.’); Neonatology Associates v. Commissioner, 115 T.C. at 99. Although the Owens attempted to convince the Court at trial that they were simply unsophisticated taxpayers at the mercy of their accountants, we find this extremely hard to accept given that Mr. Owen with Mr. Michaels built a company from four people into one that garnered over $7,500,000 when it was sold. A cursory glance at the return would have shown that the amount reported was less than half of the amount required.” 2012 T.C. Mem. 21, at pp. 54-55.

Not only can’t you bury your own mistakes, you can’t bury your tax professional’s mistakes either.

Takeaway for tax professionals–There are no casual conversations with clients. The electron is your best friend; type it on your Smartphone or iPad and send an e-mail confirming it to the client, then and there. That will keep the client on the straight-and-narrow (hopefully), and you from under the wheels of the bus.