Or, Little Pigs, Big Pigs

I gratefully acknowledge the assistance of Stuart D. Gibson, Esq., Senior Litigation Counsel, Tax Division, DOJ, who brilliantly shredded taxpayer’s experts in Stobie (see my posting of 1/10/11), and who provided the raw materials for this column. Of course, all the interpretations, errors and omissions herein are mine alone.

He and I must agree to disagree about the result in Appleton (see my posting of 12/28/10). In any event, still waiting for Third Circuit to tell us all.

However, the assault on the Virgin Islands non-virgins goes on apace, and Mr. Gibson kindly sent me Judge Sanchez’s memorandum decision in VI District Court in VI Derivatives v. Com’r, Civil 06-12, decided 2/18/10.

The background is the usual. Mr. Vento made fortune from an IT start-up in which he had minimal basis, but sold for millions in 2000, just before that bubble burst. Mr. Vento faced an astronomical taxable capital gain. Now comes the usual consultant with the tax dodge du jour: save millions by residing in the VI as of 12/31/01, as a result of Congress’ unguided largesse toward our broke but beautiful Islands in the Sun. Move there, invest in some business, and your tax bill shrinks like cheap boiled blue jeans. (Section 932, the dispenser of largesse, was since amended to require a full year residency.)

Mr Vento thither bends his joyful footsteps, buys a dilapidated compound that cannot be rendered fit for human habitation for two years, and celebrates Christmas 2001 en famille with his daughters and their families, significant others, and such hangers-on as he needs to restore his not exactly island paradise.

Having gifted pieces of his IT empire to the daughters aforesaid, Mr Vento decides that they too shall be beneficiaries of Congress’ unguided largesse. The daughters claim VI residency as well on the magic date, notwithstanding their sworn statements before and since, and actions speaking far louder in Judge Sanchez’s ears than the arguments of their counsel.

The residency arguments evaporated. It isn’t that one can’t have a residence, or even residences, different to one’s domicile, and the test for residency is clearly less precise than that for domicile. A recent Presidential candidate took flak because his spouse owned and maintained seven different residences, but on emotional grounds, for there is nothing illegal in having more than one residence. But Mr Vento and family fail the ultimate test–good faith.

Judge Sanchez lists the eleven factors of Sochurek v. Com’r, 300 F.2d 34 (CA 7, 1962). He individually weighs Mr Vento and spouse, and each daughter, in the Sochurek balance and finds each one wanting. Especially significant is the dilapidated condition of the “residence”; no air conditioning, no running water, abundant physical hazards. Mr Vento left his art collection behind in Nevada. The entire family did not move any possessions except some clothing to the “residence”. And they spent virtually no time at this “residence”.

It may be the Judge Sanchez imposed a tougher test, akin to a domicile rather than residence test, even though giving lip service to Sochurek, because Mr Vento had created a dubious charitable foundation, whose main function seemed to be to afford Mr Vento a charitable deduction for contributing his old house in Nevada, while his new house, costing double what he paid for the VI “residence”, was a-building.

And the move to the VI was so clearly tax-driven.

The takeaway for tax advisers is that it isn’t enough to give clients a good idea. You have to follow up and build the record–tell them to get the drivers’ licenses, get a library card, join the local social scene (deadly dull though it may be), open a bank account, hang out, hang around–and remember: little pigs go back to the trough, but big pigs get slaughtered.

Another in a Long Line of Phony Foreign Currency Tax Scams

Tax evasion is a growth industry. Yet another example is found in Mark and Lucy Kerman, 2011 T.C. Memo. 54, released 3/8/11.

Mark Kerman founded Kenmark, a successful eyeglass frame importing business. He built it up to a multimillion dollar S Corp. He sold part of his stock for a huge capital gain. Not wishing to pay tax, he turned to his old friend Bruce Cohen, who attended a seminar sponsored by Chenery, marketer of tax avoidance deals. Intrigued by the complex series of offshore intermediaries, counterparties and sleight of hand, Bruce passed the Chenery specialty, the Custom Adjustable Rate Debt Structure (CARDS) on to his friend Mark.

We take up the story in the words of Judge Goeke’s decision. “Mr. Cohen, a longtime friend of Mr. Kerman and one of his financial advisers, introduced him to Mr. Hahn and Mr. Stone of Chenery, the CARDS promoters. Mr. Cohen learned about the CARDS transaction while attending a meeting discussing ways to avoid paying taxes and knew that Mr. Kerman was interested in a way to eliminate his large income tax liability from selling his Kenmark stock. Mr. Cohen’s gross fee from Chenery for Mr. Kerman’s CARDS transaction was 10 percent of Chenery’s fee, or $50,000. Mr. Cohen testified that before the CARDS transaction, Mr. Kerman had considered another tax shelter called the “basis boost” to mitigate petitioners’ tax liability. He also testified that Mr. Kerman’s interest in the CARDS transaction had nothing to do with Kenmark or its operating needs but was based solely on reducing petitioners’ tax liability from their sale of the Kenmark stock.” 2011 T.C. Memo 54, at pp. 3-4.

The scheme itself is a purported loan, fully collateralized by top-class collateral, initially made to an offshore entity (a Delaware LLC with offshore members) by another offshore entity (in this case Bayerische Hypo-und Vereinsbank AG). Mark buys into this arrangement as a minority partner, becoming jointly and severally liable to repay the entire loan. The loan is so structured as to be without economic effect. In fact, the lender bails out of the loan in year one, collecting some interest and some fees, but leaving Mark with a tax loss in excess of $4,000,000, offsetting his gain from the sale of the Kenmark stock.

Not even analyzing the Code and Regulations, Judge Goeke finds the deal to be a sham. The loan proceeds were so tied up that the lender ran no risk, and the borrower merely paid some fees and interest. No economic benefit from the loan proceeds ever got to Mark.

His tax loss evaporates, leaving Mark facing the 20 and 20 penalty, 20% substantial underreporting and the second 20% for gross overvaluation of an asset to increase basis.

Mark turns to friend Bruce, whose valuable assistance netted Bruce $50,000, while hanging Mark out to dry. Mark claims reasonable reliance. Judge Goeke puts the brakes on that one: “Reliance on the professional advice of a tax shelter promoter is unreasonable when the advice would seem to a reasonable person to be ‘too good to be true’.” 2011 T.C. Memo. 54, at p. 41.

The three-legged stool of reasonable reliance requires taxpayer to show that: (1) The adviser was a competent professional who had sufficient expertise to justify the taxpayer’s reliance on him; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment.

Chenery provided Mark with an off-the-rack tax opinion from Brown & Wood, a well-known New York City law firm. Judge Goeke shreds this opinion. “The Brown & Wood tax opinion contains several misstatements, and petitioners admitted that the representations in the tax opinion are false and fraudulent. It states that the assets were released to petitioners when they purchased them and that they provided substitute collateral. … [P]etitioners never received any of the loan proceeds and never substituted collateral. Additionally, the tax opinion states that petitioners sold the assets on December 28, 2000, even though they actually exchanged portions of the euro on December 22 and 27, 2000. The tax opinion states that petitioners represented that they had reviewed the transaction summary in the tax opinion and that it was ‘accurate and complete’. However, Mr. Kerman testified that he never reviewed the transaction summary.” 2011 T.C. Memo. 54, at pp. 46-47.

Bottom line? Mark gets thoroughly nailed, and friend Bruce walks away with his $50,000. With friends like him….

I reiterate my aversion to posting 7463 “don’t quote me” decisions, which have no precedential value. But, given the paucity of exciting Tax Court quotables (if  “exciting Tax Court quotables” isn’t an oxymoron), I fall back on the gleanings.

In this case, Chief Special Trial Judge Panuthos gives a review of the rules  regarding active-passive-real estate professionals losses. The case is Todd D. Bailey, Jr. and Pamela J. Bailey, T.C. Summary Opinion 2011-22, filed March 2, 2011.

Todd was a doctor with an AGI to match his prominence. Pamela ran their  rental real estate operations. I won’t paraphrase Judge Panuthos’ exhaustive review of Pamela’s working life, or the extensive review of the statute and regulations, which I recommend to all tax professionals as non-credit CPE. The takeaway is that rentals averaging less than one week throw off business income that should be reported on Schedule C, along with the relevant deductions. This income is not passive, and taxpayer’s involvement therein doesn’t count toward the magic 750 annual hours to permit deduction of rental losses.

Thus hard-working Pamela defers her losses in accordance with the passive activity rules and loses her current years’ deductions.  And the $25,000 active participation loss is phased out because of the couple’s heavy duty AGI north of $150,000.

Nothing like hard work and success for ruining one’s tax posture.

Too Good to be True Might Even Be Good Enough

My Exhibit A for this seemingly oxymoronic headline is Jeffrey S. and Mary F. Charlton, T.C. Memo. 2011-51, filed 3/1/11.  Jeffrey, a perpetual seeker of pots of gold at the ends of dubious rainbows, finally found his way to Aegis Co., marketer of tax-evasive business trusts (it was subsequently shut down, and its principals convicted of fraud). This Jeffrey achieved after voyaging through a Sargasso Sea of multi-level marketing schemes (reminiscent of my early days as an apprentice thief-catcher in our State’s Attorney General’s office),  get-rich-quick bookselling, and another phony tax dodge.

Jeffrey’s accountant Mr. Moore went with Jeffrey to meet with the Aegis promoters, and they came away converts to the legality of the Aegis offshore trust shellgame. As soon as IRS showed up at his door, Mr Moore of course rolled on Jeffrey, and, testifying for the IRS at trial, gave what Judge Foley (a jurist of superhuman patience) called “convincing testimony regarding the perceived legitimacy of the techniques and accuracy of the returns. His testimony relating to his advice to Jeffrey…, however, was inconsistent, incoherent, and at times incomprehensible.” T.C. Memo. 2011-51, at p. 11. Remind you of any tax advisers you know?

It was Mr. Moore who saved Jeffrey and Mary from deficiencies, interest, and the dreaded 75% fraud penalty. The three-year statute had run when IRS descended on the hapless Jeffrey, but frauds, like diamonds, are forever. So IRS asserted fraud, and trundled in the incoherent, incomprehensible Mr. Moore to prove it. With friendly witnesses like him, who needs adversaries?

Mr. Moore’s naïveté, coupled with his ineffable incomprehensibility, gave Jeffrey the wiggle room he needed. IRS has the burden of proof in a fraud case, and “clear and convincing” is there the standard, not just “tip the scales.” See Beaver v. Commissioner, 55 T.C. 85, 92 (1970).

Judge Foley said it best: “Simply put, respondent [IRS] has failed to meet his burden. See Petzoldt v. Commissioner, 92 T.C. 661, 700 (1989) (providing that the existence of fraud may not be found under ‘circumstances which at the most create only suspicion.’).’’ T.C. Memo. 2011-51, at p. 11.

While Henry David Thoreau was right when he said, “Some circumstantial evidence is very strong, as when you find a trout in the milk,” even the best circumstantial evidence fails to win the day when you put an incoherent accountant on the stand.

But Keep Good Records

Such is the takeaway from Bengt N. and Judy H. Bengtson, T.C. Mem. 2011-50, filed 3/1/11.

The Bengtsons invested with Mrs. Bengtson’s sister, who, using her own brokerage account in which the Bengtsons had no interest, selected and paid for shares in various public companies with her own and the Bengtsons’ money. Sis made money on her stock picks in 1999, and the Bengtsons gave her money to pay the taxes. Came the 2000 stock market debacle (can anyone remember back that far?), some of Sis’ hot picks went south, and the Bengtsons took capital losses in 2005, within the seven-year worthless securities window.

Bengt was diligent, pursuing Sis for cost bases, dates of purchases and sales and other necessary data, but Sis stonewalled him. The Bengtsons had no records showing bases, dates of purchases and sales, or anything but checks to Sis.

When the dates when the shares became worthless were disputed on examination, the Bengtsons filed amended returns for the years the IRS maintained were the proper years. It didn’t help; Judge Foley was sympathetic, but no records, no deduction.

The Bengtsons did get a bye, though. He eliminated the accuracy penalty, invoking Regulation Section 1.-6664(b)(1), holding that the Bengtsons tried to get information from Sis, read the IRS publications, and acted in good faith.

So trust me, trust me, by all means. But before you invest or send money, as the brokers say, make sure you’ll be getting the requisite records.

or,  Never Suborn, But Consider to Subordinate

We all know that unless taxpayer is current with present taxes, IRS need not consider an installment agreement or other collection alternative as to past-due taxes. But when IRS, through its own mistake of law, creates the default in current payments, Tax Court’s abuse-of-discretion review puts taxpayer’s proposed collection agreement back on track.

That’s the moral of AlessioAzzari, Inc., 136 T.C. 9, 2/24/11.

Taxpayer was a New Jersey homebuilder torpedoed by the credit crunch of 2008. Taxpayer was behind on its quarterlies even before 2008, but caught up by factoring its receivables to raise cash. Then the tsunami hit, and IRS filed a lien.

Taxpayer had more factoring cash lined up, laid off half its employees and entered other lines of business, trying to stay in business. But the factor refused to lend with the tax lien in place. Taxpayer sought release of lien, but IRS denied it, saying the factor’s  filed lien (UCC financing statement) predated the tax lien filing,  and was therefore senior, so there was no reason to subordinate that which was already subordinated as a matter of law—“first in time is first in right.”

Except it isn’t. Reviewing tax lien learning for the last sixty years, Tax Court distinguishes, as the law does, between “choate” and “inchoate” liens (pronounced “ko-ate”; not to be confused, as one of my colleagues did, with Choate, pronounced “Chote”, a private school). The factor’s lien attached only to receivables existing at filing date of tax lien and those acquired by factor during 45 days following (“choate”). So the factor was subordinate to the tax lien from day 46 onward (“inchoate”).

IRS’ appeals officer first misapplied the law, then refused to consider an installment agreement because his refusal to consider subordination provoked taxpayer to fall further behind. Tax Court treats this conduct as it deserves (I cannot do better than quote Judge Wells’ decision):

“Respondent urges us to hold that the issue of subordination of the tax lien is irrelevant because even if the tax lien had been subordinated, petitioner still would have been ineligible for a collection alternative because it was not in compliance with its employment tax deposits. In his briefs respondent did not even address the relevant law governing the priority of tax liens, nor did he bother to respond to petitioner’s arguments that Mr. Lee [IRS appeals officer] erred in his interpretation of that law.

“Instead, respondent rests his entire argument on a previous case in which we upheld the Commissioner’s policy of rejecting collection alternatives when taxpayers have failed to pay their current taxes. See Giamelli v. Commissioner, 129 T.C. 107, 111 (2007). However, respondent’s reliance on Giamelli is misplaced.

“In Giamelli and other previous cases in which we have upheld the Commissioner’s rejection of collection alternatives because the taxpayers had failed to satisfy current tax obligations, the Commissioner had done nothing to contribute to the taxpayers’ failures to remain current with their tax liabilities.  In contrast, respondent’s abuse of discretion contributed to petitioner’s failure to make timely tax deposits.” 136 T.C. 9, at pp. 23-24.

Judge Wells went on to say:

“We do not accept respondent’s argument that Mr. Lee’s  decision regarding subordination of the tax lien is irrelevant.

“Indeed, accepting respondent’s contention would be tantamount to granting respondent the power to abuse his discretion at will as long as petitioner eventually misses a deposit on its employment taxes. In situations similar to the instant case, where petitioner’s business is in a dire position largely due to industry conditions beyond its control, the Commissioner’s decision not to subordinate an NFTL could exacerbate taxpayers’ cashflow problems and make it difficult, if not impossible, for taxpayers to remain current with their tax deposits while continuing to run their businesses. The Commissioner could hold off issuing a notice of determination indefinitely until the taxpayer missed a deposit, and the Commissioner could then refuse to grant an installment agreement on the basis of the taxpayer’s failure to remain current with its tax deposits. Because the taxpayer would have already fallen behind on current tax liabilities, we would be unable to meaningfully review the Commissioner’s decision not to subordinate the NFTL. We find such a scenario unacceptable.” 136 T.C. 9, at pp. 25-26.

In short, while IRS must never suborn, if they caused the problem they must at least consider to subordinate.

From the Tax Court website:  “The Tax Court’s Web site will be unavailable from 4:00 p.m. Friday, February 18 through 9:00 a.m. Tuesday, February 22 due to system upgrades. No documents may be eFiled during this time.” So no postings from me over Presidents’ Day weekend.

I recently discussed  WB Acquisitions, Inc. and Subsidiaries as an example of following the forms, and the penalties for not doing so. Now we have another example of form not followed, with grave consequences for the taxpayer. Again, while I don’t usually comment on 7463’s, this case is a good example of why taxpayers need competent advisers to help them follow the rules.

In Crandall and Dulin, T.C. Sum. Op. 2011-14, 2/15/11, taxpayers wanted to sell one piece of unimproved realty held for investment (on which they had a substantial gain) for another closer to home. They tried the usual forward-deferred 1031—sell the old, escrow the proceeds of sale with a Qualified Intermediary, locate and identify the new, and close, all within the 45-180 day timeframe of Section 1031. All this the taxpayers did–except the paperwork was defective.

The taxpayers took a few thousand dollars worth of proceeds out of escrow, but that in itself didn’t torpedo the 1031. Tax Court went off on the proposition that “(T)he … escrow agreements did not reference a like-kind exchange under section 1031, nor did they expressly limit petitioners’ right to receive, pledge, borrow, or otherwise obtain the benefits of the funds.” Crandall, at p. 4.

Tax Court went on to say “(T)he taxpayer’s own limitation of use of the funds does not convert the escrow account into a qualified escrow account. Klein v. Commissioner, T.C. Memo. 1993-491.” Crandall, at p. 7.

Although the properties were like-kind, although the timeframes of Section 1031 were adhered to, although the taxpayers clearly intended to do a 1031 exchange, the defective paperwork resulted in a deficiency.

IRS kindly conceded the accuracy-related penalty in a rare moment of mercy.

The takeaway—don’t use a boilerplate escrow agreement. Carefully put in the magic language of Regulation Section 1.1031(k)-1(g)(3)(ii)(B): “The escrow agreement expressly limits the taxpayer’s right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account.”

Leave out that language and it can get expensive.

But if you put the form in writing, you must abide by it.

While relaxing on South Beach (if you wondered where my blog went to the last ten days, it was behind a mojito on Ocean Drive), my fingers idly strayed across the keyboard looking for something interesting. And I found WB Acquisition, Inc., and Subsidiary, et al., TC. Memo. 2011-36, 2/8/11.

Barone and Watkins were asbestos removers and specialty contractors. Their work involved high-risk, high-reward projects, requiring them to provide personal guarantees to bonding companies. Short-cutting a lengthy explanation (which Judge Haines gives at great length), Barone and Watkins hired an attorney to create a multi-layered ownership structure for WCI, the operating company, which would be undertaking an ultra-high-risk, ultra-high-reward project for the U. S. Naval Base at San Jose, CA.

The corporate structure was elaborately documented, with employment agreements between the entities and Barone and Watkins. But the Navy project was much larger than any project Barone and Watkins had done before. Concerned about shielding the rewards from past creditors, and desiring to minimize any personal liability, Barone and Watkins entered into a joint venture agreement between WCI and an entity two layers up the ownership chain (but still controlled by Barone and Watkins).

The joint venture agreement insulated the upstream partner from loss, but left all responsibility for the work, from initial permit to sign-off at completion, with WCI. The profits were to be split 70-30, the upstream entity getting the larger share, as it had no previous indebtedness or complications.

WCI was the only entity that could obtain permits for the work, or that was recognized by the bonding companies. The joint venture filed no income tax return, claiming that under GAAP they were not required to. That argument did not fly with Tax Court.

Barone and Watkins sold WCI after completion of the project, and the complications arising from that sale are dealt with in the decision, but I am concentrating here on the disregard of the joint venture agreement by Barone and Watkins.

They reallocated the share of the profits between the joint venture entities without amending the joint venture agreement or establishing any business purpose for the reallocation, except stating “the profits were too large”. Tax Court treated this as a prohibited income-shifting device, and proceeded to deconstruct the joint venture.

Using the “distilled” principles enunciated in Luna v. Commissioner, 42 T.C. 1067 (1964), the so-called “Luna factors”, Tax Court examined:

“The agreement of the parties and their conduct in executing its terms; the contributions, if any, which each party has made to the venture; the parties’ control over income and capital and the right of each to make withdrawals; whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; whether business was conducted in the joint names of the parties; whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers; whether separate books of account were maintained for the venture; and whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.” WB Acquisitions, Inc., at p. 24.

Of course, Barone and Watkins were found to have violated the greater part of the Luna factors, and run all the various entities as extensions of themselves. Despite the carefully constructed documents and the elaborate rationalizations of the legal team, the “joint venture” was found to be a smoke screen, and a rather transparent one.

Chiefest among Tax Court’s objections were shifting of profits after the fact and without any basis in the joint venture agreement, the joint venture’s failure to file its own income tax returns, and the lack of any substantial role played by the upstream entity.

In short, “build it–they will come” means not only build it, but play it like it was built.  And the takeaway for tax advisers– it isn’t enough to create a beautiful structure, you have to warn the users of the structure to play by the rules.

Seated in the “rabble” section at the New York State Bar Association Tax Section luncheon yesterday (1/25) and trying to assimilate yet another helping of the Hilton’s rubber chicken (Chick Fil-A, where art thou?), we awaited IRS Chief Counsel William J. Wilkins’ pronouncement on how IRS would deal with the penalties associated with the statutory embodiment of economic substance in the Code.

Chief Counsel’s office will study the matter and proceed cautiously. I await further enlightenment.

I do commend Chief Counsel’s caution, however. Whether the enactment merely codifies existing law, or boldly goes where no one has gone before, remains for the Courts to unravel. Whether one can determine whether the lion will bite, otherwise than by sticking one’s arm in the lion’s mouth, remains to be seen (I fervently hope in S.E.C.–Someone Else’s Case). But for a litigator to suppress the “off with his head!” approach, to which litigators are born, not made, takes real statesmanship.

Well done, sir.