Or, As Alexander Pope Put It

A little learning is a dangerous thing;
Drink deep, or taste not the Pierian spring:
There shallow draughts intoxicate the brain,
And drinking largely sobers us again.

This wisdom is taken from Alex’s Essay on Criticism, which celebrates its three hundredth birthday next month. It’s a lesson that Tax Court taught to Bruce A. and Carol Anfinson Brown, 2011 T.C.Mem.83, filed 4/12/11.

Carol has an LL.M. in tax and is an active State court practitioner. Bruce is a commercial litigation attorney. Their problem started when the loans on Bruce’s life insurance policy with Northwestern Mutual (The Quiet Company) exceeded the cash value (the sum of any dividends plus paid-up value from Northwestern’s tables plus the value of any additional insurance bought with accumulated dividends).  Bruce at first used dividends for additional insurance, but stopped doing so. He then started to use dividends to offset premiums and finally started borrowing against cash value to pay ongoing premiums.

Bruce reported no income from the dividends or the loans, and rightly so (Section 72(e) (4) (B)). But finally Bruce stopped paying, and Northwestern quietly canceled the policy and sent Bruce a 1099-R showing a gain of $29,093.30, being the difference between what Bruce had paid (investment in the contract) and what he had borrowed.

Believing that Northwestern had erroneously determined that the gain was the result of cancellation of indebtedness, Bruce and Carol did not report the $29,093.30 from the 1099-R amount on their 1040, and did nothing else.

Right in theory, because the loan wasn’t canceled, it was paid in full by using the cash value of the policy,  but wrong on the law. The pay-in-full is a taxable event, per Section 72(e) (5) (A) and (C), which cancel the general rule of Section 72(e) (4).

Carol and Bruce’s argument, that Section 72(e)(4)(B) exempted the 1099-R amount from tax on the grounds that it was a dividend taken back by Northwestern, is rejected decisively by Judge Morrison–right church, wrong pew. The operative sections are Section 72(e) (5) (A) and (C). The excess of cash value over Bruce’s investment was not received as an annuity and therefore is subject to tax, as the loan was a true loan, and the effect of using its cash value to pay off a loan against the cash value is the same as if Northwestern had written a check  to Bruce, and Bruce wrote a check back to Northwestern.

Carol and Bruce’s argument that in the controlling cases cited by Tax Court the policyholders used the loan proceeds for purposes other than premium payments, which Bruce did not, doesn’t avail them. It doesn’t matter,  says Judge Morrison; a debt is a debt is a debt. And a debt from a loan against an insurance policy’s cash value, if paid off otherwise than as an annuity, generates gain to the extent of excess of debt over investment in the contract.

Carol and Bruce did get one minor gimme: the deficiency stated in the 90-day letter was less than the number IRS proved at trial. But Tax Court hadn’t jurisdiction to enter judgment for the greater amount (several hundred dollars), because IRS didn’t assert a greater amount at or before the hearing (Section 6214(a)).

As for penalties, Tax Court assesses the substantial understatement penalty because, in Judge Morrison’s words: “The Browns exerted little effort. They understood correctly that there was no discharge of debt. They therefore concluded that Northwestern’s information return, which they misconstrued as having been based on a discharge-of-debt theory, was wrong. Yet they did not research the proper tax treatment of the transaction. They did not even make the simple effort of asking Northwestern why it reported income where there was no discharge of debt. And, finally, the Browns’ experience, knowledge, and education weigh against them: both are licensed attorneys, and one has a master of laws degree (LL.M.) in taxation. In short, the Browns have failed to show that they had reasonable cause for and acted in good faith regarding the underpayment.” 2011 T.C. Mem. 83, at pp. 24-25.

And wouldn’t cancellation of debt be reported, not on a Form 1099-R, but on a Form 1099-C?

Bottom line: No matter what your expertise, do your homework. In fact, the more your expertise, the more you should do your homework. A little learning is an expensive, as well as a dangerous, thing.

I wish Tim Micek had not opted for small tax case, the ever-to-be-deplored Section 7463 treatment, in Timothy Owen Micek, T.C. Sum Op, 2011-45, filed 4/6/11. This case would be great precedent for an alimony fight in Third Circuit (and when will we get a single Federal tax Circuit, to end the case-shopping and forum-shopping, and different results on a national issue in places separated by a few miles, a State line, and the lines on the Court of Appeals map?).

IRS assessed deficiencies for four years’ worth of Tim’s alimony payments to Karen, starting from two years after they separated after 31 years of marriage. At the split, Tim lived in New Jersey and Karen in Pennsylvania. Two years after they split, Tim agreed to pay Karen $1250 bi-weekly, and to prove it, he executed and acknowledged before a New Jersey notary public a “spousal support affidavit”,  so stating. And pay he did, in accordance with the affidavit, for all the years at issue, except the last, when Tim was diagnosed with MS and had to quit work.  Karen promptly divorced him but the spousal support affidavit was not mentioned in the divorce decree (nor in an amendment to the decree). And Karen waived any support or alimony payments in the divorce decree.

In issuing the deficiency, IRS said, “No, not a proper Section 215 deduction, as what Tim paid were not proper Section 71 payments. The spousal support affidavit is none of  ‘a decree of divorce or a written instrument incident to such a decree, a written separation agreement, or a decree requiring a spouse to make payments for the support or maintenance of the other spouse.’” T.C. Sum. Op. 2011-45, at p. 5.

IRS does not dispute the spousal support affidavit meets Section 71(b) tests: (a) doesn’t say not includible in payee’s income; (b) payor and payee not in same household; and (c) no liability to pay after payee spouse’s death, T.C. Sum. Op. 2011-45, at p. 4, footnote 2. And IRS concedes Tim made all payments claimed.

Judge Haines disposes of IRS’ key objection, that the spousal support affidavit is not a proper divorce or separation instrument, thus:  “The issue before us is whether the spousal support affidavit qualifies as a written separation instrument as defined by section 71(b)(2). The spousal support affidavit is a written instrument, signed by petitioner, promising to pay Ms. Micek $1,250 every 2 weeks. As discussed above, a separation instrument does not require a specific medium or form and does not have to be signed by both husband and wife. Further, even though Ms. Micek did not sign the spousal support affidavit, petitioner testified that he reached an oral agreement with Ms. Micek with respect to support payments during their separation. This meeting of the minds not only is memorialized by the spousal support affidavit, but also is supported by the letter from Ms. Micek’s attorney received by petitioner’s attorney on April 21, 2003, describing the payments she had been receiving from petitioner as alimony payments. Accordingly, the spousal support affidavit qualifies as a written separation instrument as defined by section 71(b)(2), and petitioner is entitled to his claimed alimony deductions for the years at issue.” T. C. Sum. Op. 2011-45, at pp.5-6.

Unhappily, this case is not precedent. But I would hardly suggest we ignore it for that reason. Judge Haines has given us a useful template for drafting a written separation agreement that will pass muster–at least as to deductibility.

Tax Court Tells IRS

That’s the takeaway from Agripina D. Smith and James F. Smith, Jr., 2011 T.C. Memo. 82, filed 4/6/11. Agripina was a member of the Tribal Council of the Nooksack Indian Tribe of Washington State during the years in question, a paid position.

Most of Judge Morrison’s decision deals with what portion of Agripina’s pay as Councilmember is exempt pursuant to Section 7873. That section exempts income derived from fishing-rights related activities by Indians.

Judge Morrison finds Agripina provided insufficient substantiation of what activities she (and her fellow Councilmembers whose petitions are consolidated for trial) performed, and no evidence specifically distinguishing between fishing and non-fishing activities. In a typographical error in her petition, Agripina claimed all her activities were fishy (see T.C. Mem. 2011-82, footnote 7 at pp.13- 14; Judge Morrison kindly corrects the error).

In Judge Morrison’s words: “The exact nature of the work of the Nooksack tribal council on salmon fishing issues is unclear in the record, as is the magnitude of the work in  comparison to the council’s other activities. The trial record does not even contain the minutes of the meetings of the council. The only concrete piece of relevant evidence is that the tribe spent 11.9 percent, 10.9 percent, and 9.7 percent of its budget on fishing expenses….”

IRS allocated the Tribe’s percentages to Councilmembers’  exempt income, and issued a deficiency as to the balance. This Tax Court sustains.

That’s all very well, and no doubt interesting to specialists in “Indians not taxed” taxation.

Now for the rest of us. IRS claimed the Councilmembers were liable for self-employment tax on the non-exempt Tribal Council compensation. The Councilmembers never reported the income, so a fortiori they never filed 1040-SEs or paid SE tax.

But IRS never claimed that Agripina owed SE tax in the deficiency notice, nor yet in the answer to the petition. IRS first raised the issue in IRS’ pretrial memorandum.

No fair.

Judge Morrison thus rebukes IRS:  “The belatedness with which the IRS raised the issue of self-employment liability for the tribal-council compensation is a violation of Rule 31(a), which provides that the answer and other pleadings should give the other party fair notice of the matters in controversy. In Stewart v. Commissioner, 714 F.2d 977, 986 (9th Cir. 1983), affg. T.C. Memo. 1982-209, the Court of Appeals for the Ninth Circuit explained that the most appropriate times for the IRS to raise the legal theories on which it intends to rely are in the deficiency notice and in the answer. The failure of the IRS to raise a legal theory at these times does not cause the IRS to forfeit its right to rely on the theory if the taxpayer is not surprised and disadvantaged by the delay in raising the theory. Id. at 986-987. The petitioners would suffer prejudice from the belated raising of the issue of self-employment tax liability stemming from the tribal-council compensation. The issue does not hinge on the same factual questions as does petitioners’ liability for income taxes stemming from the tribal-council compensation. Therefore the IRS is barred from raising the issue.” T.C. Mem. 2011-82, at pp.20-21.

So, IRS, when you go on the warpath, don’t ambush the taxpayer–whether or not the taxpayer is an Indian.

It may be a thing of beauty, but Tax Court says it must be a joy forever. So Tax Court held in Gordon and Lorna Kaufman, 136 T.C. 13, released 4/4/11.

Lorna owned a rowhouse in Boston’s South End, with a façade worthy of historic preservation. Lorna gave a historic preservation easement to National Architectural Trust (hereinafter “NAT,” n/k/a Trust for Architectural Easements). In exchange for a hefty cash contribution to provide a trust fund for enforcing the easement, NAT shepherded Lorna’s application through the National Parks Service to get the coveted historic preservation designation that would give the Kaufmans a substantial Section 170(h)(1) deduction for the diminution of property value caused by the granting of the easement. The Kaufmans took the deduction, IRS disallowed it, and Tax Court granted partial summary judgment to IRS in Kaufman, 134 T.C. 182 (2010). Now Kaufman moves for reconsideration, joined by various preservationist groups.

Tax Court denies the preservationists the right to file briefs, telling them to devise a joint brief with Kaufman’s counsel that raises all their issues.

The whole problem is perpetuity. The easement must be enforceable forever. Certain events that might be “remote possibilities” do not impair “forever”. In any event, Kaufman claims that eminent domain, mechanics’ liens foreclosure, changed circumstances, Marketable Title acts and casualty losses do not impair “forever”, as all net proceeds arising out of any such event go to the Trust, which is permissible under Treas. Reg.1.170A-14(g)(6)(ii), a sort of cy pres application.

Tax Court cites Treas.  Reg. 1.170-14(g)(2), which requires mortgagees to subordinate their lien to the easement, as foreclosure is not a remote possibility as a matter of law.

There’s the rub. While the other possibilities for extinguishment cataloged by Tax Court: “Condemnation (eminent domain), the foreclosure of pre-existing liens, foreclosure for unpaid taxes, Marketable Title Acts, merger or abandonment, the doctrine of changed conditions, and release by the holder” 136 T.C.13, at pp. 15-16, may be so remote as not to invalidate the “in perpetuity” requirement (Reg. 1.170-14(g)(3)), a mortgage foreclosure is not.

Lorna Kaufman had mortgaged the property to now-defunct Washington Mutual Bank, F.A. (“WaMu”). NAT had guided Lorna to a deal with WaMu, whereby WaMu subordinated to the easement, but reserved to itself all casualty insurance proceeds and condemnation awards until the mortgage was paid in full.

No good, says Tax Court. Kaufman’s argument that foreclosure was a remote possibility does not survive Tax Court’s analysis:  “The drafters of section 1.170A-14, Income Tax Regs., undoubtedly understood the difficulties (if not impossibility) under State common or statutory law of making a conservation restriction perpetual. They required legally enforceable restrictions preventing inconsistent use by the donor and his successors in interest. See sec. 1.170A-14(g)(1), Income Tax Regs. They defused the risk presented by potentially defeasing events of remote and negligible possibility. See sec. 1.170A-14(g)(3), Income Tax Regs. (sometimes, simply, the so-remote-as-to-be-negligible standard). They did not, however, consider the risk of mortgage foreclosure per se to be remote and negligible and required subordination to protect from defeasance. See sec. 1.170A-14(g)(2), Income Tax Regs. (sometimes, simply, the subordination requirement).” 136 T.C. 13, at p. 21.

If there’s a mortgage on the property, however remote the chance of foreclosure, the mortgagee must subordinate all the way.  No priority to the mortgagee in any condemnation awards, casualty insurance proceeds, or anything else; everything must go first to the Trust.

Tax Court denies IRS substantial undervaluation penalties, because the valuation of the easement never comes into play, the deduction being denied in principle regardless of the value of the easement.

The takeaway? If you do one of these deals, the bank must subordinate all the way. As John Keats would say, “the thing of beauty must be a joy forever.”

Or, Cutting Up the Pie

The perennial question that arises when the partners/shareholders/manager-members of personal services firms convene the annual compensation bloodbath (sorry, I meant meeting) is, what part of the pie is compensation for services (deductible as a business expense but generating payroll tax obligations) and what part distribution of profits (nondeductible but not salary or wages and therefore not requiring payroll tax withholding).

The answer to that question can involve heavy numbers, as we learn from Mulcahy, Pauritsch, Salvador & Co., Ltd., T.C. Mem. 2011-74, released 3/31/11.

The founders of the firm, Messrs. Mulcahy, Pauritsch and Salvador, established various entities controlled by them, to which the firm paid what they called “consulting fees”, ostensibly for services rendered by the founders. The firm also paid rent to a founder-controlled entity (not an issue in the case), and interest (disallowed as no proof that such payment was ever made).

Judge Morrison’s analysis is the classic Section 162(a)(1) “ordinary and necessary”, including a “reasonable allowance for salaries or other compensation for personal services actually rendered”.

First, one of the founders claimed that some part of the consulting fees was return of capital, but offered no evidence as to what part of the consulting fees was a return of capital, nor any theory to sustain the deductibility of any return of capital.

“The firm did not withhold payroll taxes on the ‘consulting fee’ payments, as it would have been required to do with respect to employee compensation payments to the founders. It did not include the ‘consulting fee’ payments on the founders’ Forms W-2, Wage and Tax Statement, as it would have been required to do with respect to employee-compensation payments to the founders. It did not issue the founders Forms 1099-MISC, Miscellaneous Income, as it would have been required to do with respect to payments of nonemployee compensation to the founders. Finally, it did not report the ‘consulting fee’ payments on its income tax returns as officers’ compensation.” T.C. Mem. 2011-74, at p. 12 (footnote).

A presumption of reasonableness of compensation for services is tied to investors’ expectation. Would arms’-length investors be happy with excess compensation over industry-wide scales of pay? Yes, said the Court, but only if the return on investment was higher than reasonably expected.

How to compute return on investment? There’s the rub. The firm wanted to take year-over-year increase in gross revenue, and based the methodology on the fact that apparently someone once offered to buy the firm for one year’s gross (and by the way, that calculation is not crazy, for I’ve seen it used in similar contexts for personal services firms such as this one, but here it’s irrelevant).

IRS said they had no fixed formula, but the return-on-investment number had to be based upon net income, because gross income was no indicator of bottom-line cash available for distribution. As the Court put it:  “A corporation’s shareholders do not seek to maximize gross revenue. They seek to maximize profit.”  T.C. Mem. 2011-74, at p. 15. And the founders ran the firm (a C corporation) so that its year-end profit, taking the “consulting fees” into account, was zero or nearly so. No investor would be happy with that result.

The presumption of reasonableness based upon investor satisfaction having been rebutted, founders’ expert brought forth irrelevant data. First he took examples of what other firms paid their “name partners”, but did not distinguish among compensation for services, return of capital and distributions of profit. Next the expert concluded that the payments were reasonable. All very well, says the Court, but that isn’t the question–the question is whether the payments were reasonable as compensation for services. That, the expert never discussed. The firm failed to produce competent evidence to show that the amounts paid to the founders by way of “consulting fees” were in fact paid for services rendered, at a rate reasonable under all the facts and circumstances.

Even though the “consulting fees” were paid to the founders based upon their respective billables, and not in proportion to their shareholdings, that did not save the deduction, as the amounts were paid to “zero-out” the firm’s income at year end. Profits need not be distributed in proportion to shareholdings in order to remain profits and cannot by some formula be transmuted into compensation for services.

So the Court found no intent to compensate but only the intent to “zero-out” whatever cash was left at year end.

The Court sustained the substantial underreporting penalty, as the firm could not show that they relied upon their trial expert’s advice in handing out the year-end cash, because the founders only looked at what cash they had, and didn’t bother with expert’s formulae.

Trust me, I’ve been in partners’ compensation meetings in personal service firms (and the firm here was an accounting and consulting firm). If polled, the universal response would be “we don’t need no stinkin’ expert formula, gimme my money now!”

The founders got their money. Plus heavy tax liabilities plus interest plus penalties.

The takeaway? Get your experts on board before you start parceling out the money. You may not like the result, but it’s “pay me now or pay me later with interest and penalties”; your call.

Or, Why is Mona Lisa Smiling?

Initially, Mona Lisa Herrington had little to smile about. A single mother of two, she owned an H & R Block franchise, but worked off-season at a prison detention center. She was recently divorced, her father had just died, and her mother moved in with her to care for her children.  And on top of that, she met The Boyfriend.

The Boyfriend had a heavy-duty criminal record. His hobby was beating Mona Lisa. Here’s her story from the pen of Judge Thornton in Mona Lisa Herrington, T.C.Mem. 2011-73, released 3/30/11, at p. 3:  “Petitioner’s relationship with the boyfriend was marked by intimidation and physical abuse. When she failed to do his bidding or attempted to leave him,  he reacted violently. He once threw her from a moving car. Another time when she threatened to leave him, he placed a gun against her forehead and cocked the hammer. On another occasion, in midwinter, he hit her in the head with a beer bottle and threw her from a boat into a lake. On another occasion, she testified credibly, he ‘gave me a picture of my daughter with her face shot out, and told me that’s what would happen to her if I tried to leave’.” A charming fellow, this.

On top of that, this paragon opened a series of video poker  establishments, and when the State lifted his license for selling alcohol to minors, he persuaded Mona Lisa to take out licenses, and proceeded to loot the businesses.  Of course certain income tax returns were not filed, although The Boyfriend claimed he would do so. Mona Lisa wound up pleading guilty to Section 7203 criminal non-filing charges.

Judge Thornton to the rescue. He finds that, while Mona Lisa cannot deduct The Boyfriend’s stolen cash as compensation, because she cannot show any intent to pay, or that the moneys stolen were ordinary and necessary expenses for whatever work The Boyfriend did or services he provided (and for such services one would hardly pay), she can deduct the theft losses and leaves these for a Rule 155 computation.

Reading Louisiana law, where Mona Lisa lived, he finds that her passive acceptance of The Boyfriend’s thievery was not consent, but rather the result of The Boyfriend’s intimidation and battering. Therefore, the moneys he stole were indeed stolen, and constituted a business loss. Also he imposed no fraud penalties, although IRS sought these, apparently because Mona Lisa was a victim.

So Mona Lisa can smile again. And I’m sure we wish her better luck next time.

Or, How Not To Try A Tax Court Case

I’ll repeat the mantra: “I don’t cite the 7463 small tax cases. They’re often entirely fact-driven and rarely if ever raise interesting points of law. Finally, they’re useless to practitioners who need precedents they can cite, even if they provided fresh legal insights.”

But every so often, for want of better material which has been absent from Tax Court reported decisions of late, I do comment on a 7463. And Jennifer M. Dulaney, Petitioner, and Walter Dulaney, Intervenor, T.C. Sum.Op. 2011-38, released 3/29/11, is a prime example of bad IRS lawyering.

Special Trial Judge Lewis Carluzzo (right way to spell “Lewis”, Judge) drew this one, and it was tried by him and tried his patience. The petitioner and the intervenor were divorced when the case came on, although married and filing jointly for the two years at issue. Petitioner sought 6015 innocent spouse relief, although she ran the family finances and kept all the records from which tax returns were prepared. She did not herself prepare the returns; for one year at issue a professional preparer prepared the returns; for the other year, intervenor prepared the return and filed electronically.

Both IRS and intervenor opposed petitioner’s 6015 relief.  The Court found it unclear whether petitioner reviewed the returns, although she signed them both,  “albeit reluctantly” for the second of the two years. IRS assessed deficiencies, apparently related to Schedule A deductions in both years. However, the record did not indicate which of the deductions were disallowed. How an attorney would not enter into evidence the notices of assessment and the bases for disallowance of each deduction eludes me; one would think these were elements of a prima facie case in response to any allegations made by a petitioner.

However, as Judge Carluzzo states: “Respondent’s opening statement suggests that the deficiency for each year results from the disallowance of  ‘all of the itemized deductions’  claimed on the joint return for each of those years, but Evidence 101 informs us that statements made during an opening statement do not constitute evidence. Furthermore, the only evidence on the point, petitioner’s testimony, does nothing more than demonstrate the uncertainty regarding what deductions were disallowed for either year.” T.C. Sum.Op. 2011-38, at pp. 6-7.

Thus, petitioner fails to get the 6015(b) “all or apportioned” relief because she cannot show that the items giving rise to the deficiency were items of the non-requesting spouse (the intervenor), as she put in no evidence on that score.

Turning to the 6015(c) “my bad” request for relief as to items other than those for which the requesting party admits responsibility, the Court holds “what’s sauce for the goose is sauce for the gander.” Apparently petitioner provided IRS with a schedule of items that she admitted were her responsibility, but that schedule, though attached to the statement of claim, never got into evidence either, and IRS counsel never challenged that schedule. So the Court assumed, without finding (and Judge Carluzzo stresses “without finding”), that IRS had no objection to that itemization, notwithstanding IRS counsel’s assertion that petitioner had actual knowledge that all the deductions were bogus.

Because IRS has the burden of proof as regards actual knowledge to defeat a 6015(c) claim, and since IRS introduced no evidence as to which specific deductions were bogus and what was the basis for their bogusity (to coin a word), petitioner must prevail. As Judge Carluzzo said with a reasonableness born of lack of patience with incompetence, “After all, if we cannot tell from the record what the items giving rise to the deficiency for each year were, we can hardly find that petitioner had actual knowledge of any of those items.” T.C. Sum.Op. 2011-38, at p. 9. So enter judgment for petitioner, with a Rule 155 computation to follow.

Now to look at the basics: Tax Court Rule 174(b) says that any evidence deemed by the Court to have probative value shall be admissible in a small tax case such as this. How did IRS trial counsel not have the original of the complete statement of claim? How did IRS trial counsel not have the audit report that gave rise to the assessment of tax? How could IRS trial counsel assert in the opening statement that all the deductions claimed were disallowed, without being able to prove a valid basis for each and every disallowance?

Moreover, Tax Court Rule 91(a)(1), applicable to all Tax Court cases, great or small, states: “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. Included in matters required to be stipulated are all facts, all documents and papers or contents or aspects thereof, and all evidence which fairly should not be in dispute.” Though the Court states that some facts were stipulated, apparently the most critical documents, namely, the attachment to the statement of claim, the 90-day statutory notice of deficiency, and any written statement of the basis for disallowance of any deductions claimed for either year, were not stipulated or introduced into evidence.

As petitioner and intervenor were both self-represented, it would be unfair for me to demand knowledge of them that they do not have. Petitioner was at time of filing the returns at issue a registered respiratory therapist, and intervenor was a firefighter. Neither could be expected to know how to try a tax court case.

But IRS trial counsel is another story altogether. I do not wish to disparage another lawyer; I know that there but for the grace of you-know-Who go any of us. So I will refrain from mentioning IRS trial counsel by name here. But I hope she learns from this experience to be better prepared for the next trial.

Or, Taxpayers Who Do Their Own Returns Get Done

So learned Yusufu Yerodin Anyika and Cecelia Francis-Anyika, in T.C. Memo 2011-69, released 3/24/11. They bought TurboTax at the local Costco, and set to work.

Yusufu owned and managed residential realty, while his day job was as an engineer. Yusufu had been an owner-operator for more than 15 years, but his problems only started with his losses reported for tax years 2005 and 2006. IRS disallowed the losses as passives not covered by the $25,000 safe harbor for passive rental losses, as the Anyikas’ combined AGI was in excess of $100,000, and phased out under Section 469(i)(1), and he failed the real estate professional tests.

Yusufu failed to turn over his trial evidence pre-trial, causing IRS to seek sanctions (denied). On the trial, he changed his testimony from his 4564 Document Information Request responses as to the hours he worked to try to qualify as a real estate professional (at least half of all hours worked devoted to real estate activity, but not less than 750). This flip-flop availed Yusufu not, and caused the Court to discredit his testimony generally.

Even worse, Yusufu’s account of his hours devoted to real estate was unsubstantiated. Once again, our old friend Temp Reg 1.469-5T(f)(4) sets forth the requirements necessary to establish the taxpayer’s hours of participation. I can’t do better than quote the regulation as the Court quoted it, T.C. Mem 2011-69 at p. 6: ‘The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.”

Once again this proves the old saying: That which is temporary becomes permanent, and that which is permanent becomes temporary. This regulation, temporary in name, is permanent in the Court’s memory.

Yusufu tries to avoid the Section 6662 negligence penalties by blaming TurboTax, as he did his own returns for those years with the ubiquitous software. The Court admonishes him thus: “Petitioners contend that they used TurboTax software to prepare their returns for both years and that the software program is to blame for any miscalculations in their income. However, petitioners have not provided any evidence showing the information that they entered into the software program, a preliminary showing that would be required to decide whether the software program is in any way at fault for petitioners’ underpayment. See Paradiso v. Commissioner, T.C. Memo. 2005-187. Such software is only as good as the information the taxpayer puts into it. See Bunney v. Commissioner, supra at 267. We have held that the misuse of tax preparation software, even if unintentional or accidental, is no defense to penalties under section 6662. See Lam v. Commissioner, T.C. Memo. 2010-82.” T.C. Mem. 2011-69, at p. 15.

In short, garbage in equals garbage out.

And, most warming to the heart of any tax professional, the Court recognizes us as the taxpayers’ first line of defense: “A reasonable person in Mr. Anyika’s position, understanding that the tax law governing the deductions he claimed was complex, would have consulted a tax professional instead of merely assuming that he qualified on the basis of his own conclusions.” T.C. Mem. 2011-69, at p. 13.

So, like the jolly testator who makes his own will, or the person who represents themselves and has you-know-what for a client, let us all fill our glasses and raise them high to the person who trusts the online guru or the shrink-wrapped expert to solve all their tax problems.

What is a lease? Most of us have a “seat of the pants” answer—a writing that permits a person we call tenant to occupy exclusively all or part of realty owned by someone else (who we call landlord or owner) on whatever terms and conditions the parties negotiate and the law requires be included or excluded.

But Judge Chiechi spends a lot of time parsing what a lease does or does not permit in Christina A. Alphonso, 136 T.C. 11, released 3/16/11.

Christina was a tenant-shareholder in a qualified cooperative housing corporation (see Section 216) known as Castle Village Owners Corp.(CV). Her stock ownership entitled her to occupy a certain residential apartment in an apartment building owned by CV. To memorialize the terms and conditions of Christina’s occupancy, she and CV entered into what is known as a “proprietary lease”, “proprietary” because of her (admittedly minimal) ownership interest in CV.

CV’s realty sits far above the waters of the lordly Hudson River, a city upon a hill, held in place by a massive retaining wall. In the tax year in question, the retaining wall gave way (whether as a result of natural wear, tear and deterioration occurring as the result of the passage of time and the elements, or as a sudden, unexpected and extraordinary event we need not decide, as Judge Chiechi didn’t have to decide that either), and great was the fall thereof.

Christina’s proprietary lease called for her to pay her share of whatever it took to operate, repair, maintain, fix up or improve CV’s property. And Chrstina did; she paid more than $25,000 to CV to put the property back. Now a qualified cooperative housing corporation is a C corp, not an S (and CV had far too many shareholders to elect S treatment), so the casualty loss, if casualty it was, cannot flow through to the shareholders.

But could Christina take a Section 165 deduction as a lessee of the property? No, says Judge Chiechi. All the lease does is let Christina use the area that collapsed, but doesn’t demise it to her or give her anything more than a revocable license, although the Judge didn’t use those words.

Judge Chiechi said “The model proprietary lease did not provide that Castle Village leased to petitioner any portion of the Castle Village grounds and did not provide that Castle Village granted to her any other property interest in those grounds. Although petitioner, like the other stockholders of Castle Village, had the right to use the Castle Village grounds subject to the Castle Village board house rules regarding the use of those grounds that were made part of the model proprietary lease by paragraph 13 thereof, we conclude that that lease and those rules did not grant to petitioner a leasehold interest, an easement, or any other property interest in the Castle Village grounds that entitles her to a deduction under section 165(a) and (c)(3) for damage to those grounds.” 136 T.C. 11, at p. 22.

Christina’s argument that the pass-though provisions of Section 216 should be judicially expanded from mortgage interest and real estate taxes to include the monies paid to fix the collapse fared no better.

Judge Chiechi said: “As the Supreme Court of the United States has held, ‘Where Congress explicitly enumerates certain exceptions to a general prohibition, additional exceptions are not to be implied, in the absence of evidence of a contrary legislative intent.’ Andrus v. Glover Constr. Co., 446 U.S. 608, 616-617 (1980). Petitioner does not cite any legislative history establishing that Congress intended section 216(a) to permit the stockholders of a cooperative housing corporation to deduct any of such corporation’s expenses that it paid or incurred except for the two deductions that Congress expressly allowed in that section.” 136 T.C. 11, at pp. 25-26.

So Christina’s case collapses like the retaining wall, and her deduction is disallowed.

Taxpayers 3, IRS 1

Two transferee liability cases yield wins for the transferees. The facts of both do not differ widely.

We once again have the successful businesspeople selling the corporations that carried them to exalted financial heights, with a basis in pennies. In both cases, sale of the corporation, whether by way of a stock sale or an asset sale, was followed by vendee shenanigans, of which the vendors were unaware, triggering astronomical tax liability in the sold corporation, and setting up the transferees of the sales proceeds for Section 6901 transferee liability.

The cases are Griffin, T.C. Mem. 2011-61, and Starnes, T.C.Mem.  2011-63, both released 3/15/11. In both cases, the guileless selling stockholders sold their profitable businesses to a subsidiary of Mid-Coast Financial, a strip-miner of worthless debt.  Mid-Coast, by reason of acquiring stock in a corporation with almost no basis in valuable assets, landed the corporation with an enormous tax liability by selling off the corporation’s assets.

Mid-Coast played the variation on the interest rate swap, foreign currency game, as in Stobie Creek (see my 1/2/11 post). They bought a Producers type “collar”, that either produced a lottery-size win (on lottery-sized odds) or a dead loss (that was worth an enormous tax savings), and married the loss on the swap to the gain on the assets. And of course there was no substantial business purpose for a corporation that operated warehouses (as in Starnes), or made swimming-pool heat pumps (as in Griffin), to play Las Vegas style options trades. Huge tax assessed on corporation, and selling shareholders as insider-transferees.

Tax Court went off the uniform fraudulent conveyance statutes. The transferees of the purchase price had no idea that Mid-Coast was playing games (in fact Griffin sued Mid-Coast, spent $125,000 in legal fees to get a judgment directing Mid-Coast to pay the taxes as they had agreed, and of course didn’t collect Dime One).

The taxpayers are injured innocents, said Tax Court. IRS should pursue Mid-Coast.

Winner number three is the Estate of Sylvia Riese T.C. Mem 2011-60, released 3/15/11.  The late Sylvia was the  widow of a co-owner of the largest franchisee of chain restaurants in New York City. The late Sylvia sets up a QPRT for her mansion (IRS says it’s worth $11 million). QPRT ends, but Sylvia never gets around to signing a lease or paying rent before she dies suddenly and unprepared, but before the end of her current tax year. Even the fair market rent had not then been determined, although her daughter and co-executor said she intended to get it done. And of course the trustees never deed the property to the trust beneficiaries.

What should have been a slam-dunk for IRS hit the rim and bounced out (sorry, it’s March), because the decedent died before tax year-end, and the Regulations don’t say when rent must commence or lease be signed. As decedent died before either act had to take place, the mansion is out of the taxable estate.

The fourth case was a run-of-the-mill unamended retirement plan case, Christy & Swan, Profit Sharing Plan, T.C. Mem. 2011-62, released 3/15/11. No amendment means disqualification, even if the plan never involved any of the matters required to be amended by the statutory enactments. Taxpayer loses, even though the result flies in the face of reason. So what else is new?