Just a tax protester case from Tax Court today, with nothing really new about it, just a banking warehouse scheme, where the participants deposited all their income in a single pooled account in the name of a dummy, to hide it from IRS. A few subpoenas, and game over for taxpayer, who gets the 75% fraud penalty.

But the case I noted in passing two days ago, F. Lee Bailey, 2012 T.C. Mem. 96, filed 4/2/12 (see my blogpost “Service Trumps Sickness”, 4/2/12), has gotten a bit of buzz. Peter Reilly picked up the case and my blogpost, and commented on his blog. His post got some activity from the groundlings, so I thought I’d throw in my take.

I met Mr. Bailey forty years ago in my youthful days in our State’s Attorney General’s office, when we put a client of his out of business. He already possessed a formidable reputation, which only grew over the years. I best remember him as a member of the O.J. Simpson Dream Team in 1995, at the same time the witches’ brew of facts later described in his Tax Court case was percolating.

Mr. Reilly thinks Mr. Bailey had a fool for a client, as he tried the case himself, with apparently no idea of burdens of proof or recordkeeping requirements. Mr. Bailey seems to have thought it was a criminal trial.

But maybe it’s not that simple.

I was surprised at the DOJ lawyers, who entrusted Mr. Bailey with $5.9 million worth of publicly-traded stock belonging to his incarcerated client, and allowed Mr. Bailey to deal with the stock in an account he controlled in a Swiss bank, with no requirement to account periodically (only at the end), pay at stated intervals, and with no written agreement embodying this extraordinary deal.

But the AUSA (who later became a US Attorney) who made this deal stated: “…Mr. Bailey’s work on the repatriation of Mr. …’s assets was very good; and the Court of Federal Claims found that his work was ‘far more than usual for a defense attorney’.” 2012 T.C. Mem. 96, at p. 15.

Moreover, the AUSA also said he “…he has never heard of any other case in which a criminal defense attorney agreed with the Government to manage assets, to postpone for years any payment of his fees, and to risk complete nonpayment of fees if the assets’ value declined.” 2012 T.C. Mem. 96, at p. 72, footnote 35.

Obviously the AUSA was star-struck by the extraordinary undertakings of this famous lawyer. The AUSA never thought to question the great man, much less dare to require him to put in writing these incredible terms. The AUSA was not alone; many were spellbound. And remarkably, the great man delivered.

Once a tyrant asked one of his minions, “What is the most deadly poison gas?” The minion replied, “Incense is invariably fatal, Excellency.”

Mr. Bailey obviously believed himself to be everything his reputation said he was. A Tax Court trial should be a stroll on the boardwalk for him. It wasn’t.

Takeaway–Never believe your own press releases. Never fool yourself.

Or, The Case of the Vanishing Note

What is genuine becomes bogus in Roy Zeluck, 2012 T.C. Mem. 98, filed 4/3/12. Roy goes into an oil and gas deal at the urging of his brother Kevin’s old buddy, mass-tortist trial lawyer Weitz. Roy has his accountants suss out the deal, and they say it appears okay.

So Roy ponies up $110K, signs a note to the partnership for $200K, putting up his partnership interest and his rights to distributions as collateral. The note is payable at stated times with stated interest and stated maturity. The partnership agrees to withhold interest and deduct from any liquidating distributions to Roy to pay whatever is due on the note, and Roy is personally liable.

The note is then hocked to a turnkey driller owned by the promoter of the deal, and for one year all the required payments are withheld.

The partnership is supposedly managed by Weitz’s brother-in-law, a CPA with zero oil drilling experience.

In year two, the promoter dissolves the partnership without telling his partners. But distributions keep getting paid, at first with token withholding against the sums due on the note but nowhere near what should be withheld, and then for years without withholding.

IRS blows up the deal and hits Roy with a SNOD, claiming Section 465(e) at-risk requires Roy to recognize the whole $200K as income, as he was no longer at risk from year two onward. IRS doesn’t raise cancellation of debt income, interestingly.

Roy says if I’m not at risk because there is no debt, I never was at risk from day one, so IRS should assert I got the $200K in year one. But everyone agrees that’s a closed year and no fraud asserted, so good night, IRS.

No, says IRS, and Judge Goeke agrees. The note was a genuine debt obligation in year one. Let’s review what is a debt:  written evidence of indebtedness (note duly signed); interest charged and collected per note during year one; fixed and stated dates of repayment; collateral given to secure repayment (partnership interest and right to receive distributions); whether payments were made (and they were in year one, although in years two and beyond payments were minimal); and had borrower (Roy) a reasonable prospect of repaying the loan (Roy testified at trial he didn’t have $200K, but he did have $110K in 2003, and if proper withholding had been taken from his distributions he would have paid 80% of the interest due).

Of course the turnkey driller, to whom the note was hocked, did nothing to collect, even though Roy was getting distributions and was personally liable. Most of the partners never even found out the partnership had been dissolved years before until they got SNODs.

No one demanded payment when the note matured. The contract driller never notified Roy or anyone else that it held the note, or demanded full payment of interest for years. Roy testified at trial he didn’t know who held the note, but no one asked him for money. The note evidenced a genuine debt in year one, but by year two it was a dead letter.

So Roy owes tax on $200K from 2003 onward.

Roy could not have relied on Weitz because Weitz was in the deal himself, was a crony of the promoter, and his brother-in-law supposedly ran the partnership. Besides, Weitz may have been a mass-tortist of high degree, but what he knew about taxation is nowhere stated (yet lawyers can practice in Tax Court with even less knowledge than that).

Roy could not rely on his accountants, although he had given them all the dope when he entered the deal, because he didn’t tell them anything in the year the debt went south, not even that he got a big check from the partnership that year. Moreover, Roy never asked what was going on or tried to find out anything about the deal.

20% accuracy penalty for Roy.

That’s the lesson Judge Haines has for Ramona Mitchell in the eponymous Ramona L. Mitchell, 138 T.C. 15, filed 4/3/12.

It’s another conservation easement case, so back to Section 170(h)(5)(a) and Regulation 1.170A-14(g)(2). Ramona, through the family limited partnership she and her late husband set up when his health was failing, gives Montezuma Land Conservancy, a qualified donee, the appropriate easement in gross, files the Form 8283 and appraisal. IRS wants to contest the appraisal, but as Tax Court disallows the deduction altogether, that never is decided.

The land was encumbered by a purchase money mortgage Ramona and her late husband had given to Lonesome Charley Sheek years before, that was being paid currently.

Judge Haines: “At the time the easement was granted, the deed of trust securing the debt to Sheek was not subordinated to the conservation easement held by Conservancy. From 2003 to 2005 the partnership had the money to pay off the promissory note, which the deed of trust secured, at any time. There were no lawsuits, potential or otherwise; all bills were paid; payments on the promissory note to Sheek were current, and casualty insurance was in place. Two years after the conservation easement was granted, Sheek agreed to subordinate his deed of trust to the conservation easement but received no consideration for the subordination. On December 22, 2005, Sheek signed the Subordination to Deed of Conservation Easement in Gross (subordination agreement).” 138 T.C. 15, at pp.6-7 (footnote omitted.)

We all know the easement must be “in perpetuity”, but we also know that “perpetuity” is a long time, and a lot can happen between now and then, so there is the Regulation 1.170A-14(g)(3) saver, “so remote as to be negligible.”

Ramona argues that between 2003 and 2005, when she finally got Lonesome Charley to subordinate, the risk of forfeiture was so remote as to be negligible, and she and Lonesome Charley had an oral agreement protecting the property.

IRS argues Regulation 1.170A-14(g)(2), and not (g)(3), controls. The mortgage was not subordinated, her oral agreement did not prevent Lonesome Charley from foreclosing, and the specific statutory enactment controls–as of date of granting the easement, any mortgage must be subordinated.

Case of first impression, says Judge Haines, because Ramona got a subordination, albeit two years too late. But the caselaw says that remoteness has nothing to do with subordination. See Gordon and Lorna Kaufman, 136 T.C. 13, filed almost a year ago to the day, 4/4/11, and my blogpost “A Joy Forever”, of the same date.

Judge Haines: “Though the subordination regulation is silent as to when a taxpayer must subordinate a preexisting mortgage on donated property, we find that the regulation requires that a subordination agreement be in place at the time of the gift. In order to be eligible for the charitable contribution deduction for 2003, petitioner had to meet all the requirements of section 170(h) and the underlying regulations, including the requirement that the Sheek deed of trust be subordinate to the conservation easement deed of trust. See sec. 1.170A-14(g)(2), Income Tax Regs. Sheek did not subordinate his deed of trust to the conservation easement deed of trust until December 22, 2005. Had petitioner defaulted on the promissory note before that date, Sheek could have instituted foreclosure proceedings and eliminated the conservation easement. The conservation easement was therefore not protected in perpetuity at the time of the gift. As a result, petitioner failed to meet the requirements of section 170(h) and the underlying regulations for 2003.” 138 T.C. 15, at p. 14.

It doesn’t matter that Ramona had cash on hand so she could have paid Lonesome Charley in full at any time during the two years. Congress said mortgages are never too remote to be negligible.

But Ramona avoids the accuracy penalty, in light of all the facts and circumstances. “We found all of petitioner’s witnesses to be credible and truthful. Petitioner attempted to comply with the requirements for making a charitable contribution of a conservation easement. Petitioner hired an accountant and an appraiser; however, she inadvertently failed to obtained [sic] a subordination agreement from Sheek. That said, upon being made aware of the need for a subordination agreement she promptly obtained one. Given the circumstances, we find that petitioner acted with reasonable cause and in good faith. Therefore we hold that petitioner is not liable for the accuracy-related penalty under section 6662(a) for 2003.” 138 T.C. 15, at pp. 27-28.

Thanks for setting out the reasonable cause parameters, Judge Haines.

 Disability Retirement Pay May Be Taxable

I’m skipping today’s big Tax Court case, Judge Gustafson’s 143 page extravaganza anent the decline and fall of F. Lee Bailey, formerly of the O.J. Simpson Dream Team. Judge Gustafson rightly calls it an archeological expedition, and brings out no new principles; the only interesting point is that the Department of Justice and Mr. Bailey failed to put in writing a massive asset repatriation agreement that provoked years of litigation. It goes to show that sloppiness is not merely the province of the small taxpayer.

The case with a lesson for the preparer in the trenches is Jay Sewards and Frances Sewards, 138 T.C. 15, filed 4/2/12, Judge Foley telling the story in eight pages. Jay was a 34-year employee of the L.A. County Sheriff’s Department who suffered a career-ending line-of-duty injury. He had a choice of retirement plans: a length-of-service plan (with no reference to injury) or a service-connected plan (known as an SCD), where his injury was taken into account. He took the service option at first, but then applied for an SCD, which was awarded retroactive to the beginning of his service-connected plan.

Judge Foley spells it out: “Thus, his SCD retirement replaced his service retirement. Individuals were eligible for SCD retirement if they were permanently incapacitated because of an injury or disease arising from their county employment. The SCD retirement plan would provide him with one-half of his final compensation (i.e., $7,046) or his full service retirement allowance (i.e., $12,861), whichever was higher. Thus, Mr. Sewards received his full service retirement allowance of $12,861 per month.” 138 T.C. 15, at p. 4 (citations omitted.).

Jay first got 1099-Rs, showing his service-connected was taxable, but then L.A. County sent amended 1099-Rs for the same years, stating taxability not determined. This continued until, five years into the program, L.A. County told Jay that 50% of his pension would be taxable.

Jay never reported the income. SNOD and petition follow.

Section 104(a)(1) exempts from taxable income pensions like workers’ compensation or equivalent. No one says that part of what Jay is getting isn’t from a statute equivalent to workers’ compensation. But, as always, there’s an exception: “Section 104(a)(1) does not apply, however, to the extent the payments are determined by reference to the employee’s age or length of service or the employee’s prior contributions, even if the employee’s retirement is occasioned by occupational injury. Sec. 1.104-1(b), Income Tax Regs.” 138 T.C. 15, at pp. 5-6.

Since the equalizer in Jay’s pension (the greater of one-half final compensation or full retirement allowance) is based on age and length or service, Judge Foley delivers the bad news: “SCD retirees were guaranteed an annual retirement allowance payable in monthly installments equal to 50% of their final compensation (guaranteed amount). If an individual qualified for a service retirement benefit that exceeded the guaranteed amount, however, that person was eligible to receive the higher amount. Accordingly, because Mr. Sewards’ service retirement benefit (i.e., $12,861) was higher than the guaranteed amount (i.e., $7,046), his SCD retirement benefit amount was increased to his service retirement benefit amount, which was determined by reference to his length of service. See sec. 1.104-1(b), Income Tax Regs.; cf. Picard v. Commissioner, 165 F.3d 744 (9th Cir. 1999) (holding that reduction of taxpayer’s disability retirement benefits was determined by reference to his date of hire rather than by his age or length of service), rev’g T.C. Memo. 1997-320. Thus, the portion exceeding the guaranteed amount is not excludable from income.” 138 T. C. 15, at pp. 6-7 (footnote and citations omitted.).

Now does Jay owe substantial understatement penalty? No, because L.A. County sent him inconsistent and variable statements of what was and was not taxable. Jay acted in good faith. He owes tax, but not penalty.