Tax Court’s back in full swing, with lots of new hints and kinks for the practitioner.

First, indirect partners please stand up. That’s the lesson from Judge Goeke in Gaughf Properties, L.P., Balazs Ventures, LLC, A Partner Other Than The Tax Matters Partner, 139 T. C., 7, filed 9/10/12. This case was another Jenkens & Gilchrist Section 754 basis-builder, matching a put-and-call in Japanese yen (the loss recognized, but not the offsetting gain). This, of course, buried the gain the Gaughfs got on their stock sale.

The deal used two LLCs, an L.P., and a sub S with the fetching name of Bodacious, Inc., thrown in. It takes IRS six years to unscramble the omelet, and I’ll spare you the story. IRS got lots of paper from the Gaughfs, none of which directly told IRS that they were behind the deals, but the Gaughfs claim IRS could have known their identities using the “other information” provision in Section 301.6223(c)-1T(f), and so the one-year statute of limitations when the NFPAA was issued had run before they got their deficiency notices.

Judge Goeke: “In its entirety, section 301.6223(c)-1T(f), Temporary Proced. & Admin. Regs., supra, provides–

“’Service may use other information. In addition to the information on the partnership return and that supplied on statements filed under this section, the Service may use other information in its possession (for example, a change in address reflected on a partner’s return) in administering subchapter C of chapter 63 of the Code. However, the Service is not obligated to search its records for information not expressly furnished under this section.’

“We believe that the permissive language of the regulation does not impose any obligations upon the Commissioner, see Murphy v. Commissioner, 129 T.C. 82, 86-87 (2007), and find that the Commissioner’s use of identifying information does not trigger the running of the one-year period described in section 6229(e).

“Before applying section 6229(e) to extend the statutory period for assessing tax attributable to partnership items, the Commissioner must often perform an extensive investigation of a partnership in order to determine whether the partnership properly reported profits and losses. The Commissioner must also engage in further investigation to discover the identity of partners who were not identified on the partnership return. During such an investigation involving an unidentified partner, we believe it quite common that the Commissioner will at some point come into possession of and use information identifying that partner, either to further the investigation or else to contact the unidentified partner (as occurred in this case after respondent received the J&G documents). Ruling that use of such information triggers the running of the one-year period described in section 6229(e) would hamper investigations of partnerships and partners, some of which go to great lengths to disguise their incomes, losses, and identities. We do not believe such a trigger to be the intended purpose of the permissive language of section 301.6223(c)-1T(f), Temporary Proced. & Admin. Regs., supra, as it relates to section 6229(e).” 139 T. C. 7, at pp. 44-46 (footnote omitted).

There’s a lot more about what partnerships have to tell IRS about their partners, direct and indirect (holders of interests in passthrough or disregarded entities) but the takeaway is simple. Name them all–or else.

Then there’s the sad story of Marcius J. Scaggs and Andrea L. Scaggs, T. C. Memo. 2012-258, filed 9/10/12. STJ Armen, the Judge with a Heart, delivers the bad news.

“Respondent mailed a notice of deficiency to petitioners’ last known address on April 8, 2011. The 90th day after respondent mailed the notice was Thursday, July 7, 2011, which was not a legal holiday in the District of Columbia. The petition was received by the Court and filed on July 12, 2011. The envelope in which the petition was received bears a Federal Express (FedEx) U.S. Airbill with handwritten entries dated July 7, 2011 (FedEx Airbill). The delivery service selected on the FedEx Airbill is ‘Express Saver Third business day’.” T. C. Memo. 2012-258, at p. 2 (footnote omitted).

Alas, Express Saver third business day is not on the approved list. As we know, Section 7502(f) permits IRS to designate the approved private delivery services, to supplement USPS registered or certified mail. Notice 2004-83, 2004-2 C.B. 1030 has the list. So even though Marc and Andy sent the package, it was sent by the wrong means, so no “deemed filed when sent” per Section 7502, and therefore no jurisdiction.

See my blogpost “Pay the Postman”, 8/21/12. But wouldn’t it be nice if IRS included the approved list in the notice telling taxpayers where, where and how to file a Tax Court petition? Maybe we should add a category to “Don’t Ambush the Indians”, 4/7/11, “Don’t Ambush the Accountants, Either”, 8/7/11 and “Don’t Ambush the IRS”, like “Don’t Ambush the Taxpayers”.

Sharon K. Hudgins had a shot at innocent spouse Section 6015(f) relief in T. C. Memo. 2012-260, filed 9/10/12, until it turned out that she had fraudulently conveyed some rental properties to her kinfolk, and hadn’t bothered to put that fact on her Form 433-A.

“Petitioner had the burden of proof as to persuasion, and if this were a matter of simply counting factors for and against relief, she would lose. In section 6015(f) cases, however, we do not simply count factors. We evaluate all of the relevant facts and circumstances to reach a conclusion. See Pullins v. Commissioner, 136 T.C. at 448; Rev. Proc. 2003-61, sec. 4.03(2). Some of the most compelling facts in our analysis are the findings that petitioner fraudulently conveyed the Linwood and Second Street properties and failed to disclose her interest in the Lincoln County property. These weigh heavily against relief in our view because a spouse requesting equitable relief under section 6015(f) should come to the table with clean hands. Petitioner took affirmative steps to minimize her asset ownership in order to distort the economic analysis conducted with respect to her section 6015(f) request for relief. Accordingly, we conclude that petitioner is not entitled to relief from joint and several liability under Rev. Proc. 2003-61, sec. 4.03.” T. C. Memo 2012-260, at pp. 39-40 (footnote omitted).

Takeaway- Tell the truth.

This was the title of the fictional rogue General Flashman’s memoirs, as discovered in a saleroom by the late G. M. Fraser. It suits well the departure of RPO chief David Williams, who implemented the current tax preparer registration regime, and the arrival at that Office of Ms. Carol Campbell, whose “vast understanding of tax law and of tax preparation issues” (to quote Mr. Williams’ farewell address) will doubtless be put to good use in the ongoing enrollment of all the world’s tax preparers.

Mr. Williams did indeed move the football. While giving heed to the stakeholders, he furthered Doug Shulman’s initiative with all due deliberate speed, and then some. He did get the Registered Tax Return Preparer initiative out of the starting gate and down the backstretch.

See my blogpost “An Important Town Meeting”, 11/12/11, about the Great Registration. “Just sayin’, this year the decree went out from Douglas Augustus that all preparers must be registered; this is the first registration, when Douglas was Commissioner of Internal Revenue and Timothy was Secretary of the Treasury.  Of  course, all the world was to be taxed long before this.”

Mr. Williams’ parting exhortation to the untested and unregistered: get tested, get registered and come over to the right side.

It remains to be seen, of course, how many Forms 14157 (a/k/a snitch and bitch) will wind up at Mail Stop 58 at Town & Country Commons, turning out the unregistered and unCirculared.

But I wish Mr. Williams all the best. And extend fraternal greetings to Ms. Campbell.

Means the start of the tax

Sharon F. Schilling finds herself without the help and support of three of her five children to avoid taxation on her alimony in T. C. Memo. 2012-256, filed 9/5/12, Judge Swift delivering the bad news.

This is yet another in a series I’ve posted on taxable alimony, but the first as to the recipient’s tax liability.

For the payor’s tax posture, see my blogposts: “Oh Death, Where Is Thy Sting?”, 7/2/12; “Same Again?”, 8/11/11; “Essmiss Essmoore, Esmiss Essmore”, 8/16/11; and “The Magic Paper Saves the Deduction”, 4/7/11.

Sharon split with husband (unnamed), 24 years and five children after they promised to love, honor, cherish and all that jazz. Their separation agreement carefully crafted reductions in alimony as each of the five offspring reached the age of 18 years. But the alimony entirely terminates on a date certain six years after it commenced.

Three of the five had so aged out as the year at issue (three years before the automatic termination) progressed.

The general rule, of course, is that alimony is taxable to the recipient unless it is either expressly designated as child support, or doesn’t terminate with recipient’s death (either explicitly or by operation of State law). While the agreement didn’t speak of termination at death, a critical feature in deductible alimony, relevant State law (Ohio) so provided.

Since no child aged out during the year at issue, IRS credited Sharon with whatever per-child amount was left for the remaining two kids who had not aged out, and declared the rest to be taxable.

Sharon first claimed the pre-1986 law controlled, relying on the lack of an express statement in the agreement (the divorce decree incorporated the agreement) that payment terminated at death, but the 1986 amendment to Section 71, putting State law into play, rendered that a non-starter.

Then she claimed that the automatic six-year termination was a reduction in alimony related to a child or a contingency referable to a child (see Section 71(c)(2)), thereby rendering the entire payment non-taxable to Sharon for the remaining years, including, but without in any way limiting the generality thereof (as the high-priced lawyers say), the year at issue.

Nope, says Judge Swift.

While Reg. 1.71-1T Q&A 18 seems to give Sharon some comfort, the favorable presumptions raised therein are conclusively rebutted by an automatic termination after six-years provision. The termination does not relate to a child, even though child C does turn 21 within 6 months of the termination date, because the termination is automatic. And child C aged out already, so there would need to be a child D to help out.

But there is no child D whose 18th birthday is within 6 months of the automatic termination date (poor timing, Sharon; but you can blame that on your ex). So termination is not clearly connected to a child or a contingency related to a child. Once all the child-related reductions are off the table, whatever’s left is taxable.

Of course, as the remaining two children age out (if they age out before the six-year cutoff), that’s another story, but those years aren’t in issue.

Moreover, “(B)ecause neither the separation agreement, the divorce decree, nor the shared parenting plan specifically designated any portion of the spousal support payments for the support of the children, the entire amount of such payments is includible in petitioner’s income as alimony….” T. C. Memo. 2012-256, at p. 12.

Apparently IRS didn’t seek penalties, because none are discussed in Judge Swift’s decision.

I’ve commented before about the preparation software trap. See my blogposts “Real Estate Professional Revisited”, 3/24/11, and “Basis for Dummies”, 11/24/11, in the latter post specifically my discussion of Kurt C. Olsen, T. C. Sum. Op. 2011-131.

Now the shrink-wrap gurus may not claim to be foolproof guides, philosophers and friends, taking the innocent and inexperienced through the impenetrable thicket, unintelligible alike to laypeople and lawyers, that is the Internal Revenue Code, and its pendant Regulations, Revenue Rulings, Revenue Procedures and Notices. And I’m sure the software developers’ counsel have festooned box and contents with disclaimers and exculpatory exhortations worthy of the medieval indulgence mongers.

But I’d argue that the prevalence of the software, the public’s apparently inexhaustible appetite for same, and IRS’ increasing, and well-publicized, reliance thereon for e-filing and free-filing, causes taxpayers to think that the digital wizard behind the cellophane will solve all their problems. And, incidentally, computers give Congress the impetus to complicate the IRC even further, as no taxpayer needs to understand what they’ve done, because Doug Shulman’s guys and the geeks at TurboTax and others of that ilk will solve it all.

Of course, reliance on the CD-ROM enshrined in the fetching cardboard box, which promises fast fast fast relief from the annual income tax headache, and frees one from entanglement with paid preparers now registered and charging appropriately, avails the taxpayer naught when enmeshed like Laocoön in the aforesaid thicket.

Today’s post-Labor Day blues is brought to you by Judge Cohen, as she unpacks the sad tale of Brenda Frances Bartlett, T. C. Memo., 2012-254, filed 9/4/12.

Brenda Frances retired from Qwest Communications at the youthful age of 50. As she strode for the last time from her cubicle, she was handed the $221K accumulated in her pension account.

Brenda Frances reported only half that amount on her 1040, and failed to report $2K in other income and a couple of hundred bucks in wages.

When IRS nailed Brenda Frances for $44K in unpaid tax, plus penalties (10% Section 72(t) early withdrawal plus Section 6662(d) accuracy for over $5K or 10% understatement of tax due), she blamed TurboTax, with which she claimed she was unfamiliar.

Brenda Frances admitted she understated her tax.

No go, says hard-hearted Judge Cohen. Brenda Frances typed in the wrong information. “It is apparent that a portion of the information petitioner entered into the TurboTax program was incorrect; hence the mistakes made (which resulted in the underpayment) were made by petitioner, not TurboTax. TurboTax is only as good as the information entered into its software program. See Bunney v.Commissioner, 114 T.C. 259, 267 (2000). Simply put: garbage in, garbage out.

“Petitioner’s errors were not merely isolated computational or transcription errors. See sec. 1.6664-4(b)(1), Income Tax Regs. Petitioner systematically underreported her income and this resulted in an underpayment of tax on her Federal tax return. Petitioner did not have reasonable cause for any portion of the resulting underpayment. Respondent’s determinations as to both the tax deficiency and penalty are sustained.” T. C. Memo. 2012-254, at pp. 4-5.

So if, like Kurt, you put one item on the wrong line, you might get away without penalties, but Brenda Frances went a little too far.

Maybe the shrink-wrapped gurus might carry a warning: RELYING ON THIS SOFTWARE COULD BE HAZARDOUS TO YOUR TAX HEALTH.

Maybe not, if your partner really isn’t your partner. See Historic Boardwalk Hall, LLC, et. al. v. Com’r., Docket No. 11-1832, 3d Cir., 8/27/12, a little Labor Day light reading overturning Tax Court’s decision released 1/3/11, 136 T. C. 1. See my blogpost “Social Engineering Trumps the Code”, 1/3/11.

This case arose from a Section 47 Historic Rehabilitation Tax Credit (HRTC). The New Jersey Sports and Exhibition Authority (not to be confused with a sneaker retailer of similar name) wanted to make the old Atlantic City landmark into a sports and exhibition venue, but needed to raise money. So Pitney Bowes, the postage meter company, came into the deal through a broker who was selling tax credits.

You’ll remember Tax Court said, essentially, that to disregard the effects of the tax credits would be to disregard Congress’ will–to encourage the rehabilitation of historic structures and that Congress knew that the majority of such rehabilitation projects could not succeed without tax incentives. So the Tax Court ran roughshod over any conflicting provision of Code or Regulations that IRS could muster.

Third Circuit wasn’t having any of this. Although paying lip service to Tax Court’s notion that “…the HRTC statute is a deliberate decision to skew the neutrality of the tax system to encourage taxable entities to invest, both in form and substance, in historic rehabilitation projects,” (Decision at p. 15), Third Circuit reverses Tax Court and torpedoes Pitney’s credit.

While the rehab project was supposedly a partnership between New Jersey Sports and Pitney, Pitney had virtually zero economic risk; no real share in profits and losses; and could be taken out with its tax credit intact. And New Jersey Sports guaranteed Pitney against any tax loss.

Now economic substance was argued, but did not play a role in the outcome. “Accordingly, we focus our analysis on whether PB is as a bona fide partner in HBH [Historic Boardwalk Hall, the partnership], and in doing so, we assume, without deciding, that this transaction had economic substance. Specifically, we do not opine on the parties’ dispute as to whether, under Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), we can consider the HRTCs in evaluating whether a transaction has economic substance.” Decision, at p. 54, continuation of footnote 50.

So the issue is whether Pitney had any interest in the success or failure of HBH as an ongoing enterprise. If not, there was simply a prohibited sale of a tax credit. In short, did Pitney have any skin in the game?

Now there’s a lengthy discussion of the difference between economic substance and form-over-substance, and the famous codification of economic substance in the 2010 Health Care Act, but here none of this is relevant. Likewise there’s no suggestion that partners cannot limit their risk in an enterprise. But here Pitney had no meaningful risk to the downside, and no realistic prospect of gain to the upside, barring the HRTC.

So, as I said in my blogpost “Social Engineering Trumps the Code”, 1/3/11, “(T)he Third Circuit will no doubt have something to say about this. Follow.”

Did they ever!

It’s a 213-page spectacular, with Judge Marvel unwinding the tangled trail of phony corporate reorganizations, and put-and-take with carefully manufactured but imaginary losses, in 139 T. C. 5, filed 8/30/2012, and bearing the improbable but delightful name Gerdau Macsteel, Inc. & Affiliated Subsidiaries.

Gerdau Macsteel’s street name is Quanex, which runs a lot of specialty steelmakers. Quanex unloaded two of its dozen subsidiaries for a ferocious gain, part of which was capital gains but part of which was big-time recapture. Now, loath to pay taxes, Quanex turned to its hotshot accountants, Deloitte, to jury-rig some short-term capital losses to sop up the gains, provided it didn’t cost Quanex any real money.

Quanex had had a health insurance plan for its employees for years. Quanex was trying to reduce the costs thereof, like every other employer.

Deloitte’s hotshot Mr. Singer, relying on Rev. Rul. 95-74, 1995-2 C. B. 36, which allowed a corporation to transfer environmental liabilities (or liabilities for future medical costs) to a liability management corporation in a joint venture, figures out a way to use the joint venture to create a capital loss. Judge Marvel takes up the story: “In the revenue ruling the IRS ruled that certain contingent environmental liabilities that a transferee assumed in a section 351 exchange were not liabilities for purposes of sections 357(c)(1) and 358(d) and that the transferee, in accordance with its method of accounting, could, as appropriate, either deduct the liabilities as business expenses under section 162 or capitalize the liabilities as capital expenditures under section 263.” 139 T. C. 5, at pp. 25-26.

So Quanex would use a dormant subsidiary, which is carrying on its books a reserve for liabilities that has not been deducted from income, to act as liability manager, assign it the job of managing the liabilities, do an intra-company mix-and-match with notes and stock, have the preferred stock bought by a shill and take a huge short-term capital loss, which it would take on its consolidated return (after first deconsolidating and then  reconsolidating) against the capital gain and recapture generated by the sale of the two live subsidiaries.

Of course, the accountant/architect of the scheme insisted the engagement letter provide “…as a condition of the engagement that Quanex agree in the engagement letter that it would indemnify … from any liability, cost, or expense (including attorney’s fees and expenses) stemming from the engagement, absent … bad faith or willful misconduct.” 139 T. C. 5, at p. 37.

The accountant set up the joint venture with Quanex’s existing healthcare benefits consultant. Of course, the liability manager corporation was ignored throughout.

IRS called a halt to the charade. “Respondent explained that he disallowed the loss because petitioners failed to establish that Quanex’s basis in the stock exceeded $11,000; the loss arose from transactions ‘that have no economic substance or business purpose, were entered into solely for tax avoidance, and were prearranged and predetermined’; and petitioners failed to establish that the loss otherwise met the deduction requirements under the Code.” 139 T. C. 5, at pp. 138-139.

In short, an elaborate, multistep transaction was orchestrated to create a paper loss.

But if corporate wheeling and dealing floats your boat, read the decision.

On an unrelated topic, I withdraw my bright idea in my blogpost “The Unanswered Question”, 6/13/12. Section 296 won’t work with a Sub S because the losses attach to the shareholder and cannot be transferred by any means. I was awake at the IRS Nationwide Tax Forum this week, really I was.

Very often lawyers get carried away with their own brilliance. Such is the case in the roll-out of a split-dollar life insurance arrangement (or SDLIA; I’ll explain what that means presently). The case is G. Steven Neff and Carrie J. Neff, T. C. Memo. 2012-244, filed 8/27/12, Judge Swift rolling it all out for us.

The explanation, cribbed from google.com, of course, is as follows. The split-dollar concept is simple. It is a funding arrangement that helps one individual obtain life insurance at a cost lower than would otherwise be possible. This is achieved by sharing (splitting) the premium with another individual or entity, such as a business. The arrangement, provided by a written agreement, generally calls for the sharing of premiums in exchange for the sharing of death benefits and, in some cases, cash value. In the last-named instance, it provides a means whereby descendants can buy out ancestors.

Steve and Carrie, and business partners Bradley T. Jensen and Terri Jensen, set up a split-dollar life insurance deal to provide liquidity to buy out Steve or Brad, when they die. Steve and Brad were master builders, and needed to secure succession when each of them dies.

Steve and Brad had their business pay the premiums, but, by written agreement, should one die, or their business be sold, or if their agreement with the business be terminated for any reason, Steve and Brad must reimburse the business for the premiums paid, out of death benefit at death or out of cash surrender value if living.

Termination of a split-dollar deal is known as a roll-out. In this case, the total premiums amounted to more than $800K. Steve and Brad paid the business about $131K.

“Nothing in the SDLIA agreements and the collateral assignment agreements suggests that–upon termination of the SDLIAs for reasons other than the deaths of petitioners–reimbursement to N & J Management [the business] of the premiums it paid on the policies would be put off until the deaths of petitioners and receipt of the life insurance proceeds.” T. C. Memo. 2012-244, at p. 8.

Because of regulatory changes in 2002, Steve’s and Brad’s lawyers told them to end the SDLIAs effective at year end 2003, and they did.  But the story doesn’t end there.

“At the request of petitioners’ counsel, individuals at petitioners’ accounting firm calculated what they regarded as the ‘December 2003’ fair market value of N & J Management’s rights to be reimbursed the $842,345 premiums paid. However, apparently on advice of petitioners’ counsel, the individuals at petitioners’ accounting firm treated N & J Management’s reimbursement rights as the right to be reimbursed the $842,345 only upon the deaths of petitioners. The accounting firm applied a present value discount for the $842,345–using an assumed life expectancy for each petitioner of 85 and an interest rate of 6%. Petitioners’ advisers calculated the December 2003 present value of N & J Management’s $842,345 reimbursement rights at $131,969.” T. C. Memo. 2012-244, at pp. 10-11 (Footnote omitted).

So the business relinquished its right to be reimbursed the full $842K in exchange for the $131K payment, Brad and Steve of course being on both sides of the deal.

The lawyers either never papered the roll-out, or, if they did, the paper never got into evidence on the trial. “Apparently, no contemporaneous documentation exists (or was offered into evidence) relating to the December 2003 agreement between petitioners and N & J Management that ended or terminated the SDLIA arrangements. No written termination letter or agreement between petitioners and N & J Management with regard to the SDLIAs was offered into evidence. No written contract of any kind was offered into evidence relating to the above December 2003 agreement to end the SDLIAs. Further, no contemporaneous documentation refers to a sale by N & J Management to petitioners of ‘contract rights’. T. C. Memo. 2012-244, at p. 12.

Brad and Steve never picked up $710K of income for the remainder of the premiums paid by the business. Or the cash surrender value of the SDLIAs they got at the roll-out.

At trial, Steve’s and Brad’s lawyers tried to argue for the first time that the roll-out really happened in 2004, because that was when the checks were cashed, and that was a closed year. But Judge Swift isn’t buying: “No explanation is provided as to why petitioners’ counsel was not able to obtain and review the 2004 bank records and canceled checks before September 2011.” T. C. Memo. 2012-244, at p. 16.

You can’t ambush the IRS.

Now the rules regarding SDLIAs were confusing, and for the years that Steve and Brad had their SDLIAs, they had to pick up as income whatever premiums the business paid on account of the policies. This they never did. So they had to bail, and claim they were paying the business for its right to receive the premiums the business paid at the deaths of Steve and Brad, and really didn’t terminate the SDLIAs.

Wrong, says Judge Swift: “To the contrary, we believe it obvious that a cancellation, an unwinding, a release, or a roll-out of N & J Management’s interests in the SDLIAs occurred. The formal SDLIA agreements may not have been technically or formally terminated by a written document, but as of the end of December 2003, the SDLIA arrangements were unwound, and N & J Management was released from its obligation as employer to provide further funding on the life insurance policies. Petitioners have stipulated that after and as a result of the transaction at issue in these cases, N & J Management had no continuing interest or reimbursement rights with regard to the underlying life insurance policies.

“We find that the transaction before us constituted an effective roll-out of the SDLIAs and that the equity split-dollar life insurance arrangements were terminated during December 2003, even in the absence of a formal written termination of the SDLIA agreements.” T. C. Memo. 2012-244, at p. 19.

Paying at roll-out for the right to receive reimbursement of premiums at death doesn’t cut it.

And the income is payment for services under Section 83. It’s not cancellation of debt, which is only the medium (and not the message) for paying for Steve’s and Brad’s services.

By the way, even if Steve’s and Brad’s lawyers are right about the deal being done in 2004, a supposedly closed year, the doctrine of mitigation would still open the year for adjustment of income. See my blogpost “Mitigation and Inventory”, 4/20/11.

But since Steve and Brad relied in good faith on their lawyers, the Court denied IRS the Section 6662 penalties.

This is so vexed a question that Patricia A. Flood and Donald J. Flood escape penalties for understating tax in the eponymous T.C. Memo. 2012-243, filed 8/27/12, Judge Morrison doing the vexing.

Don’s a day trader, and claims his real estate operation, which consists of buying and selling vacant lots, is just a sideline. But Don only makes from day trading, during the two years at issue, “$25,901 of gains in 2004 and $24,153 of gains in 2005.” T. C. Memo. 2012-243, at p. 10.

On the other hand, Don and Pat made from their land-grabbing well over $1.75 million. Don claims capital gains; IRS says “No, you’re a dealer, one who sells something in the ordinary course of a trade or business.”

Of course, Don and Pat are self-represented, although they are confronting nearly $600K in deficiency and over $100K in penalty. Pat defaults in Tax Court, neither showing up herself nor giving Don POA, and has judgment entered against her for whatever Don gets. Is Pat going to try for innocent spouse? Stay tuned.

Don fails to respond to IRS’ demand that a 75-paragraph stipulation be deemed admitted, so it is.

That sound you hear is Don’s case going down the drain.

So what is a dealer? That is, one who must report profits from the enterprise as ordinary income, as opposed to capital gains, which carries a preferential rate of tax. Judge Morrison: “The answer depends on whether the Floods held the property primarily for sale to customers in the ordinary course of business or held it, alternatively, as a capital asset.” T. C. Memo. 2012-243, at p. 7.

So here’s how we unpack to which category the lots belong: “Typically, the factors in making this determination include: (1) the taxpayer’s purpose in acquiring the property; (2) the purpose for which the property was subsequently held; (3) the taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income; (4) the frequency, continuity, and substantiality of sales of property; (5) the extent of developing and improving the property to increase the sales revenue; (6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales; (7) the use of a business office for sale of property; (8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property; and (9) the time and effort the taxpayer habitually devoted to sales of property. The frequency and substantiality of sales is especially probative.” T. C. Memo. 2012-243, at pp. 8-9 (Citations omitted).

Judge Morrison starts well here, but ends up with something that, if Don had a lawyer or a Tax Court admitted person, might have turned out differently: “Mr. Flood testified that the Floods bought the land for investment purposes. He asserts that the Floods sold lots only to pay real-estate taxes and that they sold only a few of the lots in 2004 and 2005. Although it appears that the Floods sold only some of the lots they owned during the two years at issue, the gains from these sales were spectacular. Even according to the Floods’ tax return for 2005, they sold properties in 2005 for $1,754,135 that they had originally purchased for $631,044. This is a gain of over $1 million. As we explain in parts 3 and 5 below, the actual gain was even greater than that. Furthermore, we surmise that the values of the remaining lots not sold by the Floods in 2004 and 2005 were relatively low compared to the values of the lots that were sold.” T. C. Memo. 2012-243, at p. 9. The parts 3 and 5 referred to are based on the 75-paragraph torpedo.

“Surmise”, Judge? Based on what? The only issue is the nature of the gain on the sale of the lots that were actually sold, not what lots might have been, or could have been, sold. If one accumulated 100 shares of APPL for five years, held all of them at least a year and a day, and yesterday sold 50, could one “surmise” that the value of the remaining 50 shares was “relatively low”?

But Don did sell 40 lots in the second of the two years at issue, although he sold only two in the first. Still, we have some more “surmise”: “(A)lthough many lots remained unsold, the record reveals little about the cost or value of the unsold lots. We surmise that the value was relatively insignificant.” T. C. Memo. 2012-243, at p. 10-11.

How the value of the unsold lots has anything to do with the nature of the lots is still unexplained. Perhaps that is the basis for the “surmise”.

True, Don devoted a lot of effort to his lottery (the selling of lots–sorry, guys), searching public records, sending out mass mailings, and scouring the byways and highways of the Sunshine State to find and harvest the low-hanging fruit. He used a lawyer to draft contracts and enforce them, used a broker whom he supervised to sell lots, advertised lots for sale, had a dedicated website to flog his lots and so is a dealer.

The 75-paragraph “deemed admitted” stipulation buries Don as regards basis in the lots, and torpedoes a number of his other claimed deductions. One can only “surmise” that Don didn’t bother to consult a lawyer or Tax Court admittee, or that he did, and was told that his case was DOA, so he saved the legal fee.

The good news: “We first find that the Floods had reasonable cause for reporting the lots in question as capital assets and that they did so in good faith. The lots are the types of assets that could conceivably be capital assets. Whether they are capital assets is close question.” T. C. Memo. 2012-243, at p. 19. But some of their other torpedoed tax positions are spurious, as Don produces no records, so it’s off to a Rule 155 to sort out the numbers.

I’m going to be a little slow in blogging the next few days, as I’m off to the IRS Nationwide Tax Forum, held this year in my hometown, to get those precious CPE hours. But I’ll be on board as fast as I can; I know all thirty of you are hanging on my every word. Yeah, right.

And, Dogged Persistence Doesn’t Always Win

Two for the price of one today, 8/23/12, from the hardworking Judges at 400 Second Street, N.W., in Our Nation’s Capital.

Leading off, a “not for nuthin’” from the pen of Judge Goeke, Ronald Webster Moore, T. C. Sum. Op. 2012-83, filed 8/23/12, and the taxpayer wins.

In his young days as a GI, Ron buys a whole life policy from The Company That’s On Your Side, Nationwide Insurance. Ron pays the twenty bucks a month premium for about two years, from 1975 to 1977, and stops. He reckons he’s surrendered whatever cash value accumulated (couldn’t have been much, he thought).

The policy says that if a premium isn’t paid for 31 days, policy is forfeited unless within 90 days the owner pays up with interest. Also, Ron elected the automatic premium loan; that means that cash surrender is used to pay premiums until exhausted. It’s a true loan, and if the payments are used to pay premiums, they are deemed distributed to the owner, and if not repaid by owner are income to owner at exhaustion of the cash surrender value. The excess of loan over premiums paid is taxable as ordinary income. Thus, IRS argues, the cash surrender value was enough to pay premiums through 2008, at which point Ron is deemed to get a distribution and to pay it back to Nationwide to satisfy the loan.

See my blogpost, “A Dangerous Thing,” 4/13/11.

But Ron says no, the policy is ambiguous, I cooperated with IRS, so IRS has burden of proof. Judge Goeke agrees.

Here’s Judge Goeke’s take: “The policy contract provides: (1) premium payments not paid on or before their due date ‘will be in default’; (2) after default, the policy will remain in effect for a 31-day grace period; and (3) the policy will terminate if premiums are unpaid by the end of the grace period. Furthermore, the policy contract goes on to explain that: (1) the policy may be reinstated within five years after the due date of the premium payment first in default upon Nationwide’s receipt of certain evidence from petitioner; (2) an automatic premium loan will automatically be granted to pay a premium in default when the policy has a net cash value; and (3) the policy will automatically be placed on extended term insurance if no payment is made by the end of the 31-day grace period.

“Several of the premium payments were made after the expiration of the grace period–the payments were not made in time to prevent the insurance policy from terminating.” T. C. Sum. Op. 2012, at p. 17.

Nationwide sent Ron letters about the premium loan, but he tossed them unread, thinking they were just sales pitches.

It gets better. “Moreover, all premium payments due beginning September 28, 1980 through 2007, were not made within the grace period. Automatic premium loans were issued to pay the premiums three months after their respective due dates. The automatic premium loan provision functions to pay premiums in default. If a premium was not paid by the end of the grace period, the policy terminated. After termination the policy had to be reinstated by certain affirmative actions by petitioner–the automatic premium loan provision could not reinstate the policy after it had terminated.

“The policy contract provided that the frequency of premium payments could be altered only by a written request to Nationwide; however, there is no evidence in the record that such request was made. Accordingly, by the very terms of the contract, the policy should have terminated at the expiration of the grace period for any of the aforementioned premium payment due dates.” T. C. Sum. Op. 2012-82, at p. 18.

Now for the good news for Ron: “We are not persuaded that petitioner’s life insurance policy terminated in 2008 resulting in a taxable deemed distribution. Respondent’s (IRS’) argument would have us construct a multitude of inferences in his favor and simultaneously turn a blind eye to several unexplained discrepancies in the record. This we will not do. We believe a plain reading of the terms in the life insurance contract signifies that the policy should have terminated and been converted to extended term insurance on several occasions before 2008.” T. C. Sum. Op. 2012-83, at p. 18.

No distribution in 2008, no deficiency, Ron wins it.

Now for the “dogged determination” subheading. That’s Ralph Galyean and Laraine Galyean, T. C. Memo. 2012-242, filed 8/23/12. Judge Foley has this sad tale and it ends badly for the taxpayers.

Ralph loses his job on an oil rig, gets a shore-based consultancy, and when that goes south, takes Social Security. Laraine had a job as an administrative assistant, but between the two of them that wasn’t enough to stave off bankruptcy.

Ralph and Laraine lose their house, and rent an apartment for themselves and their two dogs (breed and names not stated, except dogs are styled as “large dogs”). But the rent is over the famous IRS local housing and utility standards. See my blogpost “A Home Is Not a House”, 8/16/12.

Ralph and Laraine filed returns for the years at issue, but didn’t pay the tax. They seek CDP, claiming they should be in “not currently collectible” status, because they have nothing left after paying living expenses. IRS says “you’re over the schedule on house and utilities, so pay up”.

True, say Ralph and Laraine, but if we rent a cheaper pad, it would be on a higher floor, and the dogs would have to go. Or, put more lawyerly, “Petitioners acknowledge the availability of apartments at or below the local standard but assert that first floor apartments, which would allow them to keep their dogs, are more expensive. Respondent reasonably determined that these preferences did not justify a deviation from the local standard in determining petitioners’ reasonable basic living expenses.” T. C. Memo. 2012-242, at p. 5.

Unfortunately, Ralph and Laraine had other arguments, but they weren’t raised at the CDP, so they’re non-starters in Tax Court. Again, put more lawyerly, “Petitioners make two contentions that were not raised at their CDP hearing. They contend that respondent failed to consider vehicle expenses and the impact of petitioners’ bankruptcy. We reject both contentions because they were not raised at the hearing. See Murphy v. Commissioner, 125 T.C. 301, 315 (2005) (holding that in reviewing the Commissioner’s determination the Court generally only considers evidence that was brought to the attention of the Appeals officer), aff’d, 469 F.3d 27 (1st Cir. 2006).” T. C. Memo. 2012-242, at p. 5, footnote 4.

Use it or lose it, guys. And too bad for the dogs. They’ve either got to climb or go.

            And Save the Trial Subpoenas for Non-Parties

Judge Gustafson lectures both IRS and taxpayers in William Cavallaro, et al., Docket No. 3300-11, 8/22/12, a Designated Order, so not precedent but a good quick refresher on Tax Court discovery.

First, ask politely. Informal discovery is the rule, the magic words being “informal communication or consultation”, or, in other words, play nice and have show-and-tell, before you start with motions to compel.

Second, follow Tax Court’s scheduling order. The scheduling order is not what the Pirates of the Caribbean call “guidelines or aspirational goals”. Failure to do so might provoke judicial ire, even with so genteel a Judge as Judge Gustafson.

Third, don’t try to use trial subpoenas duces tecum to circumvent Rules 70 and 72. Judge Gustafson: “The parties now attempt to use a trial subpoena duces tecum served on a party (or his agent) to accomplish discovery that should ordinarily be conducted under Rules 70 and 72 (which, among other things, provide for a 30-day response time and provide cut-offs sufficiently in advance of the trial to enable deliberate action by the parties and deliberate decision-making by the Court). Ordinarily, discovery from a party should be conducted under the discovery rules, and trial subpoenas duces tecum should be used to obtain information from non-parties. Ordinarily, the use of a trial subpoenas duces tecum to obtain information from a party would involve an evasion of the discovery procedures that the Rules intend for parties. If there is an exceptional circumstance in which a subpoena duces tecum served on a party is proper, that circumstance is evidently not present here. ” Order, p. 2 (emphasis by the Court).

So the parties’ motions to compel production of documents, of the existence of which the parties were well aware weeks before, on the “brink of trial”, are both denied. But the parties should bring the documents with them to the trial, so Judge Gustafson can rule on them if he has to.