And, The Best Excuse Yet

Two recent Tax Court cases piqued my interest, picked from among the plethora of levy and lien timewasters. I can’t enjoy my vacation without a small retreat into blogging.

First, Lisa LaFlamme, 2012 T.C. Mem. 36, filed 2/6/12, and not just for the taxpayer’s name.  Lisa was a self-employed, licensed real estate agent in Florida during the year in question, while the boom was still booming and the bubble bubbling. Lisa made a hefty contribution to her pension plan, the Lisa K. LaFlamme Defined Benefit Pension Plan and Trust.

No question the contribution is deductible. But where? Lisa put the magic number on line 19 of her Schedule C, not line 28 of her 1040, and that caused the IRS to fire off a SNOD for tax and accuracy penalty.

Lisa claims she’s entitled because legislation enacted in 1962 allows self-employedniks to deduct pension contributions like corporations. True, but this is a case of “right law, wrong chapter”. Her contribution is not a Section 162 business expense for self-employment tax purposes, but rather an AGI adjustment for income tax purposes.

Thus, she owes self-employment tax on the amount of the contribution, but not income tax. Income tax is a Chapter One tax, SE is a Chapter Two tax, and Section 404(a)(8)(C) doesn’t help Lisa, although the language of the law (which see) looks like it does. Judge Vasquez says the legislative history makes it clear the Section 404(a)(8)(C) deduction is for income tax only, not SE. Judge Vasquez: “The legislative history suggests that the sec. 404(a)(8) rule is limited to the income tax, stating that the 1962 Act ‘allows contributions to retirement plans to be a deduction for income tax purposes’. S. Rept. No. 87-992, supra, 1962-3 C.B. at 310.” 2012 T.C. Mem. 36, footnote 7, at p. 9.

But Lisa acted reasonably and in good faith, obviously not having studied the legislative history of the 1962 statute. Lisa relocated from Connecticut to sunny Naples, FL (not so sunny today, as it’s been raining all night) years ago, and sells waterfront property. Chances are Lisa wasn’t born when Congress enacted the Self-Employed Individuals Retirement Act of 1962, and even I had barely escaped teenagerdom.

So Judge Vasquez gives Lisa a bye: “We find that petitioner had reasonable cause for the position taken on her return regarding the pension contribution and acted in good faith. See sec. 6664(c)(1). Petitioner, knowing that she was entitled to deduct her pension contribution, mistakenly believed she was entitled to deduct it on line 19 of her Schedule C which was labeled as ‘Pension and profit-sharing plans’. See sec. 1.6664-4(b), Income Tax Regs. (stating that a honest mistake of law may indicate reasonable cause and good faith).”

So Lisa, forget the penalty, but recompute your SE and income taxes in a Rule 155 jamboree. And preparers, look out, here be a trap for the unwary.

Now for my personal favorite in The Best Excuse for Late Filing sweepstakes. It comes from Steve and Lori Esrig, and is delivered by none other than the Judge that writes like a human being, The Great Dissenter and Ace Footnoter Judge Holmes. In the immortal and oft-quoted words of the late great Charles Dillon Stengel, “you could look it up”, specifically in 2012 T.C. Mem. 38, filed 2/7/12, under the name and style of Steven A. Esrig and Lori S. Esrig.

There are two cases rolled into one, because once Steve petitioned Case One, IRS fired off some fresh SNODs, so Steve and Lori petitioned Case Two. But you can read the tangled tale of Steve’s trademark dealings and his various unsubstantiated business activities; it’s the usual lack-of-substantiation case.

Until we get to the Section 6651(a)(1) late filing penalty. Steve and Lori were late by anything between one-and-a-half and four-and-a-half years in filing returns over the six-year span at issue. But Judge Holmes throws Steve and Lori a conditional rope: “Section 6651(a)(1) imposes an addition to tax for failing to timely file a tax return. A taxpayer can beat the penalty by showing reasonable cause, id., which here would mean proof that the Esrigs acted with ordinary business care and prudence and nevertheless were still unable to file as required, see United States v. Boyle, 469 U.S. 241, 246 (1985); sec. 301.6651-1(c)(1), Proced. & Admin. Regs.” 2012 T.C. Mem. 38, at p. 17.

But Steve and Lori drop the rope. Judge Holmes: “At trial Steven blamed the couple’s return preparer. He said that he’d asked his accountant to request extensions for all the years at issue, but his accountant missed all the deadlines because she had to serve a very long prison sentence for murdering her husband, and the person in her office who took over their account made a slew of mistakes.” 2012 T. C. Mem. 28, at p. 18.

That beats “the dog ate my homework” and “I was kidnapped by Martians” any day.

But Judge Holmes doesn’t buy this murder mystery. “We aren’t convinced. The Esrigs had no evidence to corroborate this lurid tale, and we therefore find that they had no reasonable cause for failing to timely file. Accordingly, we find Steven liable for the failure-to-timely-file additions to tax for 1998-2000 and both Esrigs liable for the failure-to-timely-file additions for the later years.” 2012 T.C. Mem. 38, at p. 18.

Good try, Steve and Lori.

When is interest on unpaid taxes abated? And what does it take for Tax Court to make abatement happen? Judge Goeke tells the story in John Hancock and Lynn Hancock, 2012 T.C. Mem. 31, filed 2/1/12.

John and Lynn got nailed on audit, but their accountant Mr. Biegler got them an offer from IRS that John and Lynn couldn’t refuse: no interest on the deficiencies if they signed at once. So John and Lynn signed the Form 4549 and went away happy.

Until IRS woke up to their mistake, and sent John and Lynn a demand for payment of interest. John and Lynn replied, asking that IRS honor their agreement. IRS replied by grabbing their tax refund to apply to the interest. So John and Lynn correspond with IRS, and IRS offers a partial abatement, but then backtracks.

IRS claims they mistook the date when John and Lynn were informed of the correct amounts of interest, and reduces the partial abatement. John and Lynn claim abuse of discretion, which IRS rejects, so John and Lynn petition Tax Court.

Judge Goeke: “Section 6404(e)(1)(A) provides that the Commissioner may, at his discretion, abate the assessment of interest on any deficiency in tax attributable, in whole or in part, to any unreasonable error or delay by an IRS officer or employee in performing a ‘managerial’ or ‘ministerial’ act.” 2012 T.C. Mem. 31, at p. 7. [Footnote and citations omitted.]

Finding Tax Court jurisdiction pursuant to Section 6404(h)(1), Judge Goeke examines the managerial and the ministerial: A ‘managerial act’ is an administrative act which occurs during the processing of a taxpayer’s case and involves the temporary or permanent loss of records or the exercise of judgment or discretion relating to management of personnel. ‘Ministerial acts’ include procedural or mechanical actions not involving the exercise of judgment or discretion that occur during the processing of a taxpayer’s case after all prerequisite action has taken place.

“Section 6404(e) applies only after the Commissioner has contacted the taxpayer in writing about the deficiency, and this Court will give due deference to the Commissioner’s use of discretion.” 2012 T.C. Mem. 31, at p. 8. [Citations omitted.]

That said, the taxpayer bears the burden of proof. “To qualify for abatement of interest, the taxpayer must: (1) identify an error or delay by the IRS in performing a ministerial or managerial act; (2) establish a correlation between the error or delay by the IRS and a specific period for which interest should be abated; and (3) show the taxpayer would have paid his or her tax liability earlier but for such error or delay.” 2012 T.C. Mem. 31, at p. 9.

If IRS misinforms the taxpayers about their liability, that’s ministerial. And IRS agrees they did misinform John and Lynn. But did John and Lynn provide answers to the three questions: Did they identify the error? Did they tie the error in to the specific period for which they seek abatement of interest (and seeking 100% abatement won’t get it)? Finally, could John and Lynn have paid the liability but for the error?

“Petitioners are not merely searching, groundlessly, for an exemption from interest, nor have they contributed to the many errors by respondent. Instead, petitioners validly seek an interest abatement on account of respondent’s professed errors.

“Petitioners’ inartful attempt to expressly articulate the period for which interest abatement is warranted is a direct function of the confusion and inconsistency which pervaded respondent’s actions following petitioners’ execution of the Form 4549. Initially, respondent appeared to agree that no interest accrual was warranted on petitioners’ deficiencies when he approved the executed Form 4549. In an unexplained change of posture, respondent then issued a notice and demand to petitioners on November 3, 2008, stating that they owed interest for their 2005 and 2006 tax years. Petitioners, continuing to rely on the executed Form 4549 In an unexplained change of posture, respondent then issued a notice and demand to petitioners on November 3, 2008, stating that they owed interest for their 2005 and 2006 tax years. Petitioners, continuing to rely on the executed Form 4549 and uncertain as to the propriety of the notice and demand, subsequently wrote two letters to respondent seeking clarification of respondent’s position and also requesting that respondent abide by the terms of the executed Form 4549. During the period in which petitioners waited for respondent’s official response to their letters, respondent applied a tax refund from petitioners’ 2008 tax year to their tax liabilities at issue, satisfying the liabilities in full. It was only at this point that petitioners realized that respondent had disregarded what petitioners perceived as the clear calculations in the executed Form 4945 and instead relied on the calculations in the November 3, 2008, notice and demand. Respondent’s position was altered twice thereafter, further complicating matters.

“Given the confusion engendered by respondent’s actions, we find that petitioners’ request for interest abatement is framed by the period following the their receipt of Form 4549 and ending with the payment in full of the liabilities on April 15, 2009. Respondent’s posttrial brief underscores this point by conceding that he was in error from the “date the erroneous interest amounts were provided to the taxpayers until the date on which respondent provided corrected interest amounts.” We find that the date respondent unequivocally provided corrected interest amounts was April 15, 2009.

“Thus, petitioners have satisfied their burden.” 2012 T.C.Mem. 31, at pp. 12-13. [Footnote omitted.]

But what about paying the tax? “The argument that petitioners did not present evidence of their ability to pay the interest liabilities, irrespective of respondent’s error, applied equally to the conceded period; yet respondent accepted that he abused his discretion in failing to abate interest for the period from June 19 to November 3, 2008. As respondent has abandoned the argument in part, we find as a corollary that he abandoned it in whole. We need not address it further.” 2012 T.C. Mem. 31, at pp. 14-15.

John and Lynn raised equitable estoppel, that is, “. . . a judicial doctrine that ‘precludes a party from denying his own acts or representations which induced another to act to his detriment.’” 2012 T.C. Mem. 31, at p. 16.

But Tax Court’s jurisdiction is limited,  so there will not be any excursion around equitable estoppel. Taxpayers must show affirmative misconduct by IRS, and even more, that the misconduct results in serious injustice and the public interest will not be injured by the estoppel sought. Here, that’s not the case.

But the taxpayers win this one.

But Why an Opinion?

Abstract from the Tax Court website. “Generally, a Tax Court Opinion is issued in a regular case when the Tax Court believes it involves a sufficiently important legal issue or principle.” “Generally, a Memorandum Opinion is issued in a regular case that does not involve a novel legal issue. A Memorandum Opinion addresses cases where the law is settled or factually driven.”

So one expects a Tax Court Opinion to have a certain gravitas;  if not an Olympian pronouncement, then at least an oracular quality. But reading the five pages of Francis T. Foster and Maureen P. Foster, 138 T.C. 4, filed 1/30/12, one searches for the “sufficiently important legal issue or principle.” And comes up short (or at least I did).

This is another installment in the Dead Tax Credits series, involving the First Time Home Buyer Credit, Take 2 (the 2008 version, a refundable credit with no payback, unlike Take 1). The facts are simple. Although allegedly moving from the home they purchased in 1974 and listing it for sale, and moving in with Maureen’s parental units, the Fosters never vacated the old house. They “maintained utility services, frequently stayed overnight, hosted family holiday gatherings, kept personal belongings, accessed the Internet, and received bills and correspondence.” 138 T.C. 4, at pp. 2-3.

Maureen’s parents didn’t have an internet connection at their house. That doesn’t help the Fosters, because Maureen renewed her Illinois driver’s license, using the old house’s address; and the Fosters filed one year of their joint income tax returns with the old house address, after they had allegedly quit the old house. The Fosters sold the old house a year after they claimed they had moved out.

Finally, just over three years after the Fosters allegedly moved out, they bought the new house and claimed the FTHBC2.

No, says IRS. The old house was still your principal residence two years before you bought the new, and FTHBC2 applies only if you hadn’t owned a principal residence for three years before you bought a new principal residence.

Judge Foley:  “Whether property is used by a taxpayer as a principal residence depends upon all the facts and circumstances. See sec. 36(c)(2); sec. 1.121-1(b)(2), Income Tax Regs. In addition to the taxpayer’s use of the property, relevant factors include, but are not limited to, the address listed on the taxpayer’s tax returns and driver’s license and the mailing address for bills and correspondence. Sec. 1.121-1(b)(2), Income Tax Regs.

“The old house remained petitioners’ principal residence after July 27, 2006. Petitioners continued to identify the old house as their address when Mrs. Foster renewed her driver’s license and when they filed their Federal income tax returns. Furthermore, petitioners readily acknowledge that, at the old house, they continued to receive bills and correspondence, maintained utilities, kept furniture and other possessions, frequently slept overnight, and hosted family during holidays. Conversely, at the parents’ house, petitioners did not pay rent or contribute towards the cost of utility services.” 138 T.C. 4, at pp. 4-5.

No credit. But did this really merit an Opinion rather than a Memorandum?

We know Tax Court’s love affair with stipulations between parties. Rule 91(a) says it all: “The parties are required to stipulate, to the fullest extent to which complete or qualified agreement can or fairly should be reached, all matters not privileged which are relevant to the pending case, regardless of whether such matters involve fact or opinion or the application of law to fact.” And Tax Court may deem matters admitted against the recalcitrant or gameplayers. So it’s stipulation or flagellation, guys.

But suppose the parties do stipulate, and the stipulation is dead wrong on the law?

Judge Holmes, the Judge who writes like a human being, gives us an answer in Robert Jay and Elizabeth T. Brooks, 2012 T. C. Mem. 25, filed 1/26/12, while I was at the New York State Bar Association’s Annual Meeting soaking up wisdom and CLE credits.

RJ was a stockbroker with a golden handcuffs deal. His firm gave him $500K up front, for which he signed a promissory note in usual form, calling for annual payments of principal and interest. If RJ was still around at each anniversary, the brokerage was supposed to write RJ a check for the installment of p&i less withholding, and RJ was supposed to write the brokerage a check for the entire amount of that p&i installment, so RJ paid out more than he got. If RJ bailed before the note matured, he had to pay whatever he hadn’t paid or been forgiven to date. RJ stayed the course, but of course no one wrote checks or withheld anything.

RJ reported the principal as income in the last year of the deal, when the brokerage tore up the note, but not the interest. He claimed that the interest would be a deduction if he reported it, and so it would wash the income, claiming Section 108(e)(2) treatment. In this  case it wouldn’t, finds Judge Holmes, because the deduction would arise from RJ’s stock market investments, and the investment interest rule of Section 163(d)(1) trumps Section 108(e) and torpedoes RJ, because his net investment income is laughably below the amount of forgiven interest.

Now what happened to the stipulation? “The parties both assume that figuring out whether Brooks’s forgiven interest is taxable income is an issue only for the 2003 tax year.” 2012 T.C. Mem. 25, at p. 4.

Except it might not be. “In form, the agreement between Brooks and Dain [the brokerage] appears to be a loan: There is a note evidencing indebtedness and a stated interest rate. In substance, however, the up-front payment looks a lot like the advance in . . .–one that we held was compensation for personal services subject to a conditional obligation to repay. Brooks received the payment from Dain as part of his compensation arrangement and only had to repay it–on a pro rata basis–if he didn’t stay employed.

“This is a potential problem for the Commissioner. If Brooks’s ‘loan’ was compensation for personal services subject to a conditional obligation to repay, then Brooks should have reported the income from the forgivable note agreement in 1998–the year he received the money–and not 2003. And 1998 is not the tax year before us.” 2012 T. C. Mem. 25, at pp. 5-6. (Citations and footnotes omitted.)

Parenthetically, it might be too late for IRS to issue a deficiency for 1998. And anyway, IRS and RJ stipulated that the issue was what RJ did in 2003, not in any other year. What to do?

Duck the issue, says Judge Holmes. Apparently because he is going to nail RJ for tax on the unreported forgiven interest, he finesses as follows: “There are limits to what parties can stipulate, and pure statements of law that are just plain wrong may well be out of bounds. But we read the stipulation in this case as an agreement that Brooks received at least $506,300–the principal of the loan–as income in 2003. Because neither party has argued that the stipulation on this mixed question of fact and law doesn’t bind us, we deem this issue waived. See Buchsbaum v. Commissioner, T.C. Memo. 2002-138; see also Bartel v. Commissioner, 54 T.C. 25 (1970) (applying ‘duty of consistency’ in similar circumstances even without stipulation).

“We will therefore, like the parties, avert our eyes from this problem, and turn to the proper treatment of the forgiven interest.” 2012 T. C. Mem. 25, at p. 6. (Footnotes omitted.) And he nails RJ.

Ya gotta like a Judge who takes the bull by the horns, doesn’t flinch from the tough choices when confronted by a blatant error of law, and makes it all go away, preserving the error by means of the sanctity of the plainly erroneous stipulation. My kind of Judge.

The only case out of Tax Court today (1/24/12) was a failure-to-submit-documents in a collections alternative, that isn’t worth commenting on. So here is a scrap that may be of interest.

Don’t throw to the wrong base, it could be expensive. Case in point, Shawn P. Bowen & Michelle L. Bowen, Docket No. 24457-11S, order entered 1/24/12. Taxpayers filed at 400 Second Street, N.W., 134 days after SNOD, so IRS says “Class dismissed!”

Taxpayer says  “Our CPA mailed the petition and the $60 check payable to US Tax Court on the last day set forth in the SNOD to Internal Revenue Service, P.O. Box 331, Bensalem, PA 19020-8517, and when that was returned unprocessed he sent it to 400 Second Street, N.W.”

No good, says Chief Judge Colvin. Section 7502(a) doesn’t apply because you mailed to the wrong place. The magic language in 7502(a)(2)(B) is “properly addressed to the agency, officer, or office with which the return, claim, statement, or other document is required to be filed….” Your petition wasn’t properly addressed. And I have no authority to extend the statutory time to file your petition.

Tax professionals– if you’re petitioning the Tax Court, go to the Tax Court website and read the Taxpayer Information, even if you’ve done it many times.

No Tax Court decisions released today (1/23/12), and only one more football game before withdrawal sets in, so to take my mind off football withdrawal symptoms (and even though Eli Manning didn’t run Judge Kroupa’s beautifully-diagrammed play from Scott A. and Audrey R. Blum, 2012 T.C. 16, filed 1/17/12; see my blogpost “OPIS Finis”, 1/18/12), I have to write about something.

So here’s an Order, certainly not for citation or reliance as authority, but an interesting view of a busted play. This involves Khadija Duma, Docket No. 11042-07, filed 1/23/12. Khadija was a FNMA (Fannie Mae) employee who had problems declaring what income she received. Judge Gustafson dealt with this in 2009 T.C. Mem. 304, filed 12/23/09, finding Khadija owed substantial tax, interest and penalties and sending her off for a Rule 155 bean-count.

Of course Khadija submitted nothing. So Judge Gustafson told her to submit or file a status report. The day before Khadija’s papers were due, Khadija filed a document she styled “Petitioner’s Motion for an Enlargement of Time to Locate Material Documents, or in the Alternative, Petitioner’s Notice of Appeal of This Court’s Order in Favor of the Internal Revenue”.

Judge Gustafson takes up the story: “… the Court denied the motion to the extent that it sought an enlargement of time; and as to the alternative “Notice of Appeal”, the order stated:

“‘Ms. Duma’s alternative–a notice of appeal–is premature, because a decision (stating the amount of the deficiency) has not yet been entered.” Order, p. 2. But the denial was without prejudice to renew when the decision was entered.

Judge Gustafson also politely told Khadija to stop stalling and do the numbers. But the copy of his order mailed to Khadija was returned as “Undeliverable”. Meantime, IRS presented their numbers, and the decision was duly entered. This time, the copy of the decision mailed to Khadija wasn’t returned.

The 90-days-to-appeal had run, when Khadija filed yet another motion in Tax Court, asking to proceed in forma pauperis with an appeal to the DC Circuit, where an appeal would lie (assuming it was timely). Federal Rules of Appellate Practice (FRAP) allow forma paups, but the application must go to the Court of Appeals and it must be timely (FRAP 24). And so must be the notice of appeal.

Khadija’s sad story: “‘I did not receive the order from this court regarding my case in this court which was returned because the post office claimed non-payment. I did not find out that the box had been closed for sometime until I went in to claim my mail. I disputed the post office claim of non-payment to no avail, and I had no way of finding out how much mail had been returned. Today the records office gave me the details of the order issued by Judge Gustafson (which was not delivered to me). I had already filed a notice of appeal, but I don’t know that it is effective now.’” Order, p. 2-3.

All is not lost, Khadija. Judge Gustafson: “Under FRAP 4 (a) (2), as amended in 1979, a premature notice of appeal filed after a district court issues its opinion but before it enters judgment will be treated as timely; but FRAP 14 makes FRAP 4 inapplicable to appeals of Tax Court cases. However, even before and apart from the 1979 amendment of Rule 4 (a), ‘premature notices of appeal have sometimes been given effect in both criminal and civil cases to avoid injustice. E.g., Lemke v. United States, 346 U.S. 325, 74 S.Ct. 1, 98 L.Ed. 3 (1953).’ Feistman v. Commissioner, 587 F.2d 941, 942 (9th Cir. 1978). See also the Advisory Notes to the 1979 Amendment to FRAP 4 (a) (2) (‘Despite the absence of such a provision in Rule 4 (a) the courts of appeals quite generally have held premature appeals effective’) (citations omitted).” Order, pp. 3-4.

However, the question of timeliness or otherwise is for the DC Circuit, not for the humble Tax Court. Still, Judge Gustafson the Merciful gives Khadija a boost: “Pending before us now is the question of how to characterize Ms. Duma’s recent filing. We construe it to be in part a notice of appeal. See Feistman v. Commissioner, 587 F.2d at 942 (‘We treat taxpayers’ request to transmit the record to this court as a notice of appeal: taxpayers are proceeding Pro se [sic], and their request clearly evinced an intent to appeal. Under such circumstances, we construe an appellant’s filing liberally’). As a notice of appeal her recent filing would appear to be untimely; but, again, it will be for the Court of Appeals to decide the timeliness of her appeal. We simply discern that the recent filing ‘clearly evinced an intent to appeal’, as in Feistman.” Order, p. 4.

So Judge Gustafson denies the forma paup motion, again without prejudice, and directs the Clerk to file Khadija’s latest as a notice of appeal.

Takeaway- Even though a late notice of appeal will probably not get much sympathy, it might be worth a try. Of course, if a tax professional takes that tack, I dare say the late notice will evoke even less sympathy.

As Tax Court has released no new cases today, I thought I’d memorialize the defeat of SOPA/PIPA by referring to a fifty-five-year-old statement from China, a nation where internet freedom and intellectual piracy are burning issues. “Letting a hundred flowers blossom and a hundred schools of thought contend is the policy for promoting progress in the arts and the sciences and a flourishing socialist culture in our land.”

Well, I don’t know about a “flourishing socialist culture”, but it sure must be nice not to have to pay royalties for grabbing someone else’s ideas. Nevertheless, I am in favor of blossoms. And a hundred schools of thought, or even one single thought, contending is how we make progress in the arts and sciences, and maybe even in the law of taxation. And culture will flourish, or not, depending upon what we do with those thoughts.

Now, as I’ve said before, this is not a political blog. I grind no axes here. I hold no more brief for the stealers of thoughts or ideas than I do for the stealers of wallets or purses. I also do not like censorship; my motto is simple: “Say what you like, and I will do likewise”. And by the fruits of our thoughts and words the world will know us.

So let’s get on with blossoming and schooling and contending–and most of all, thinking.

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.

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.

Judge Kroupa tells the sad story of the orphan boy who makes his fortune, only to be led astray (he claims) by a “Big Four” accounting firm, at the end of whose rainbow was no pot of gold. The rainbow is the so-called OPIS (Offshore Portfolio Investment Strategy), this being Tax Court’s first encounter with this convoluted tax dodge.

The tale unfolds in Scott A. and Audrey R. Blum, 2012 T.C. Mem. 17, filed 1/17/12.

Judge Kroupa sets the scene: Scotty “the only adopted child of an engineer and a secretary, was an entrepreneurial child and prone to selling his toys. After parking cars for a hotel and selling women’s shoes, he started his first company when he was 19 years old to sell computer memory products. He sold that company two years later for over $2 million. During the same year, at the age of 21, Mr. Blum started Pinnacle Micro, Inc. (Pinnacle) with his parents. Mr. Blum and his parents ran Pinnacle for nine years, including when it was a public company. Mr. Blum entered into an Internet-based business after leaving Pinnacle.

“Mr. Blum founded Buy.com, an online retailer, in 1997, and it set a record for being the fastest growing company in United States history during its first year of operation. In . . . Mr. Blum sold a minority interest in Buy.com stock for a total of $45 million. The sales comprised a $5 million stock sale in August and a $40 million stock sale at the end of September. His basis in the stock was zero, and in response to the potential gain Mr. Blum entered into a $45 million OPIS transaction during . . . , creating a capital loss of approximately $45 million. The OPIS transaction was created, managed and promoted by Mr. Blum’s accounting firm.” 2012 T. C. Mem. 17, at pp. 3-4.

Scotty needed to offset his gain. The accountants set up a three-tier collar on the Swiss Franc, packing UBS stock into the mix, to make sure that the deal Bialystoked (homage to the late great Zero Mostel in the original Producers) on schedule.

New verb: to “Bialystok” is to guarantee that a transaction is an economic disaster on paper, generates huge tax loss for little cash, and provides the promoters thereof with a “get into jail free” card.

Scotty of course got no private placement memo, never did the math on the deal, had one two-hour meeting with the accounting firm’s salesman (after which he spoke to that person once by telephone as the deal was going down), and had no idea what the accounting wizards were doing.

If wheeling and dealing strokes your shell, you can read as Judge Kroupa scoots down the rainbow, plows through Cayman Islands exempted companies, Isle of Mann (so in original; apparently neither the attorneys nor Judge Kroupa’s clerk was too hot on spelling or geography) corporations, and Cayman Islands limited partnerships, and finds the pot, but no gold, at the end thereof. “At the conclusion of this convoluted and contrived series of transactions, the net cost of the OPIS transaction to Mr. Blum was approximately $1.5 million. For that cost, the OPIS transaction yielded over $45 million in capital losses to offset capital gains on tax returns petitioners filed.” 2012 T.C. Mem. 17, at p. 17.

Judge Kroupa has to draw a diagram to show how the deal worked, which see, on page 18 of her decision. If Eli Manning runs this against the Niners on Sunday, the Giants might just win it all.

“The . . . engagement letter stated that . . . would provide a tax opinion letter regarding the OPIS transaction, if requested.[. . . ] sent to Mr. Blum a letter, dated after petitioners filed an income tax return for . . ., asking Mr. Blum to represent certain information about the OPIS transaction. [. . . ] agreed to finalize and issue its tax opinion after receiving the signed representation letter. Mr. Blum signed the representation letter in May . . .. In that letter, Mr. Blum represented that he had independently reviewed the economics underlying the investment strategy and believed it had a reasonable opportunity to earn a reasonable pre-tax profit. He made this representation even though he had not performed an economic analysis of the transaction or consulted with his investment advisers about the transaction.” 2012 T.C. Mem 17, at pp. 19-20 [Names and dates omitted].

You can guess the rest. IRS comes down on these shenanigans like the Assyrian wolf on the fold, and strips Scotty and his cohorts of silver and gold. The accounting firm makes a plea bargain. Some of its employees, agents and servants, alleged perpetrators of this raid on the Treasury, are pursued by agents of the Fisc over hill, over dale.

Not a whit dismayed, Scotty sues his erstwhile accountants, claiming they deceived him and now IRS wants to denude him, a poor orphan, of his American Dream. He’s an injured innocent.

No, says Judge Kroupa, the whole deal was bogus, despite the accountants’ mix-and-match games with IRC. “We agree with respondent (IRS) that the OPIS transaction lacked economic substance. We admit [. . . ] painstakingly structured an elaborate transaction with extensive citations to complex Federal tax provisions. The entire series of steps, however, was a subterfuge to orchestrate a capital loss. A taxpayer may not deduct losses resulting from a transaction that lacks economic substance, even if that transaction complies with the literal terms of the Code.” 2012 T. C. Mem. 17, at p. 27 (Citations and names omitted).

Economic substance means matching tax losses with economic losses. But note that Congress’ codification of economic substance in the Health Care and Education Reconciliation Act of 2010 is not retroactive, so it plays no role here, 2012 T.C. Mem. 17, at p. 28, footnote 21.

So Judge Kroupa is back to the caselaw. “A court may disregard a transaction for Federal income tax purposes under the economic substance doctrine if it finds that the taxpayer failed to enter into the transaction for a valid business purpose but rather sought to claim tax benefits not contemplated by a reasonable application of the language and purpose of the Code or its regulations. There is, however, a split among the Courts of Appeals as to the application of the economic substance doctrine. An appeal in this case would lie to the Court of Appeals for the Tenth Circuit absent stipulation to the contrary and, accordingly, we follow the law of that circuit.

“The Court of Appeals for the Tenth Circuit applies a socalled unitary analysis in which it considers both the taxpayer’s subjective business motivation and the objective economic substance of the transactions. The presence of some profit potential does not necessitate a finding that the transaction has economic substance. Instead, that Court of Appeals requires that tax advantages be linked to actual losses. It has further reasoned that ‘correlation of losses to tax needs coupled with a general indifference to, or absence of, economic profits may reflect a lack of economic substance’.” 2012 T. C. Mem. 17, at pp. 28-29 (Citations and footnotes omitted).

A true Bialystok (noun form of verb) is generally indifferent to economic profits, and makes sure they are absent.

Judge Kroupa blows off Scotty’s trial testimony that he wanted to make money, and that his accountants sold him to the Swiss-Cayman-Manx con-artists. “Mr. Blum testified that $5 million was a relatively sizable amount of money to him. The record indicates that Mr. Blum essentially entrusted this sizable amount of money to an unknown investment adviser based on two hour-long presentations from his tax adviser. Mr. Blum did not perform an economic analysis of the OPIS transaction, nor did he ask his existing investment advisers to review it. He had no general knowledge of the participants (except for . . . and UBS) and no understanding of the transaction. Furthermore, Mr. Blum did not track his investment, except to the extent that he received a call from . . . a month into the deal.

“Mr. Blum’s actions belie his testimony. His lack of due diligence in researching the OPIS transaction indicates that he knew he was purchasing a tax loss rather than entering into a legitimate investment.” 2012 T. C. Mem. 17, at p. 32. (Names omitted)

Likewise Scotty’s averments in his lawsuit against his erstwhile chums are at odds with his claims of innocence. “In his suit, Mr. Blum alleges that he was induced to invest millions of dollars in a tax strategy and to conduct his business so as to realize taxable income that would be offset by losses generated by OPIS. He further claims that, in reliance on . . . , he did not adopt other strategies to defer or minimize his tax liability or make different decisions regarding share sales. Mr. Blum’s actions during and after the OPIS transaction do not indicate a profit motive.” 2012 T. C. Mem., at pp. 32-33.

No profit, no economic substance. Judge Kroupa boils it all down in a heading: “E. The Numbers Do Not Add Up.” 2012 T. C. Mem. 17, at p. 35.

But the penalties do. And because Scotty said he reviewed the deal and sussed it out, when he had done no such thing, he hadn’t told his accountants the truth, so he couldn’t rely on their tax opinion (which was based on his representation that he had). And anyway, they were promoters. So negligence with gross undervaluation (40% of tax due) rains down on Scotty. And Scotty, a “savvy, experienced businessman” as Judge Kroupa calls him, 2012 T. C. Mem. 17, at p. 46, should know that when a deal sounds too good to be true, it probably is, and he should check it out with people who have no piece of the action. So the good faith reliance on experts defense is out.

OPIS finis.