Well, Just One

 There isn’t much to say about L.A. and Rayani Samarasinghe, 2012 T. C. Mem. 23, filed 1/19/12, and Judge Marvel says it as well as I can. It’s the evidence aliunde that’s the hook for me here.

As for the case, footnote 2 on page 2 of 2012 T.C. Mem 23 says it all: “The parties stipulated that if the self-rental rule of sec. 1.469-2(f)(6), Income Tax Regs., is applicable, then petitioners are liable for the deficiency. If the self-rental rule is not applicable, then petitioners are not liable for the deficiency. The parties also stipulated that the Westwood property ‘was rented for use in a business activity in which petitioner-husband materially participates.’”

The self-rental rule is a major exception to the “all rental activity is passive and all rental income is passive” rule. If you, or an entity which you control and whereby you carry on an active TOB,  rent from yourself,  the rental income isn’t passive and cannot be offset with passive losses, e.g., depreciation.

L.A. (hereinafter “Lala”) and Mrs. Lala, the Sweet Rayani, bought a building and leased the office space therein to Lala’s professional services corporation, pursuant to written lease made and entered into prior to February 19, 1988.

The magic of the 2/19/1988 date? “Section 1.469-11(c)(1)(ii), Income Tax Regs., provides that, in applying section 1.469-2(f)(6), Income Tax Regs., a taxpayer’s rental income is passive if it is attributable to the rental of property ‘pursuant to a written binding contract entered into before February 19, 1988.’ To qualify for transitional relief under the regulation, a taxpayer must prove that the rental income in question was paid pursuant to a written lease that was entered into before February 19, 1988, and was still in effect; i.e., was binding and enforceable for the year at issue.” 2102 T.C. Mem. 23, at pp. 12-13.

Whether the document proffered is a binding written contract (lease) is a question of State law. Judge Marvel canvasses New Jersey, the relevant State, law, and finds there is a binding written contract entered into before February 19, 1988 (lease).

But Lala comes unglued because neither he, his corporation, nor his trusty accountant Ramesh Sarva, CPA, ever bothered to follow the terms of said lease, at least during the years at issue. The periodic rent payments were never made, increases in base rent were never calculated or collected per the lease terms, but tenant leasehold improvements were made without lessors’ consent. Lessors didn’t recognize income in some years, even when the lessee was deducting rental payments. Mr. Sarva “determined the rent after the fact on the basis of his analysis of petitioner’s financial situation at the time. On these facts, we conclude that petitioners have not proved that the 1980 lease was a binding contract during 2005 and 2007.” 2012 T. C. Mem. 23, at p. 19.

Mr Sarva was the sole witness on the trial, neither Lala nor the Sweet Rayani appearing. Mr. Sarva’s testimony and records spoke loud and clear. The lease, though facially satisfactory, was a dead letter during the years at issue.

However, Judge Marvel gives Lala and the Sweet Rayani a bye on the Section 6662 penalties. “Respondent contends that petitioners are liable for the accuracy-related penalties because the underpayments of tax are attributable to either negligence or disregard of rules or regulations (2005 and 2007) or to a substantial understatement of income tax (2007). Respondent’s contentions necessarily reflect alternative grounds for imposing the section 6662 penalty because only one section 6662 accuracy-related penalty may be imposed with respect to any given portion of any underpayment, even if the underpayment is attributable to more than one of the types of listed conduct. New Phoenix Sunrise Corp. v. Commissioner, 132 T.C. 161, 187 (2009), affd. 408 Fed. Appx. 908 (6th Cir. 2010); sec. 1.6662-2(c), Income Tax Regs.” 2012 T. C. Mem. 23, at p. 20.

Judge Marvel finds negligence, so no substantial understatement penalty need apply. However, reliance on professionals can trump negligence. “Mr. Sarva has been a practicing C.P.A. for over 30 years. He has extensive experience in tax planning and return preparation and has advised clients with respect to real estate transactions. Petitioners relied on Mr. Sarva’s judgment in purchasing the Woodside property in 1979, in setting up the leasing transaction, and in preparing their and the medical corporation’s tax returns each year. Given Mr. Sarva’s credentials and the longstanding professional relationship between petitioners and Mr. Sarva, we find that petitioners were justified in relying on Mr. Sarva.” 2012 T.C. Mem. 23, at p. 23.

And even though neither Lala nor the Sweet Rayani bothered to testify on the trial, Judge Marvel still finds they were justified. So no penalty.

Now I said I was not going to say much about this case. But when I read footnote 13 at page 23 of 2012 T.C. Mem. 23, the lightbulb went on: “Mr. Sarva also has real estate investment experience.” Sure he does. It took me half an hour of online research, but I proved I still have a working memory bank. I represented an entity he controlled as sponsor of a cooperative housing conversion in New York City in 1989. Both our signatures are on the recorded deed. But I don’t remember giving him any tax advice, then or thereafter.

No, Nor Your Cash Neither

Not in Judge Wherry’s courtroom, as he teaches John P. Owen and Laura L. Haskell Owen, et al., 2012 T.C. Mem. 21, filed 1/19/12, a famous date that happens to be the birthday of a certain Director in a major accounting firm, stationed in Houston, TX; though neither she nor her firm is involved in this case, I wish her a happy birthday.

There’s a lot going on here: personal service corporations, income assignments, employment agreements and Section 1244 stock sales followed by an attempted Section 1045 rollover.  I’m just going to focus on two of the goings-on: the Section 1045 small business corporation rollover, and the “cursory glance” requirement for good-faith reliance on your tax professional.

John P., who is a high school dropout, and his friend Nick Michaels (education unstated), with John P.’s spouse Lovely Laura L.,who stayed in school and graduated, and Nick’s girlfriend Chris Larson, started an insurance business that employed 150 people, and that they sold within five years for $7.5 million, with performance-based sweeteners, employment and non-compete agreements and other goodies if the business prospered under new management. It did. So did John P.

Relying on the advice of Robert Hall, EA, his first tax consultant, John P. and Nick incorporated and elected Section 1244 treatment for their corporation. Of course, their basis in their stock was a few thousand, and their capital gain enormous. Realizing Robert Hall, EA, was out of his depth, John P. sought out Greg Mogab, CPA, who sports a Masters’ in Taxation.

Says Greg, start a new Section 1244, throw in all the proceeds from the sale of the old Section 1244 within 60 days, elect Section 1045 treatment by due date of return for year of sale, and run the new Section 1244 as an active trade or business using 80% of the proceeds in the active trade or business. John P. claims at the trial he doesn’t remember the 80% bit, and only used 8% for the very little business the new corporation did. Greg says on the stand he darn sure did tell John P. 80% for first two years.

In any event, the $1.916 million John P. says he put into the new business generated gross receipts of $12K after two years, from six sales, of which four were to John P., his companies or his pal Nick. Judge Wherry says that’s not an active trade or business, and John P. can’t sell Judge Wherry the claim he was going slow to learn the business before plunging in, and kept a big cash reserve. Judge Wherry doesn’t buy whatever John P. is selling: “…we leave for another day what amount of cash on hand can be considered actively used in a trade or business under section 1045 that has been in existence for less than 2 years. We hold that under the surrounding facts here the fact that 92 percent of  . . .  assets were held in cash causes it to fail the active business requirement.” 2012 T.C. Mem. 21, at p. 45 (footnote and name omitted). So no deferral, and inclusion in income in year of sale.

By the way, the 80% use-in-business requirement falls to 50% after two years, but that doesn’t help John P. You can’t bury your cash.

Nor can you bury your mistakes. Among the miscommunications between John P. and Greg the Master of Taxation was a little matter of $1.5 million performance enhancement that John P. got in Year Two when the business he sold made the new owners rich.

Judge Wherry tells the story: “In January 2003 Mr. Owen called Mr. Mogab and informed him that the … Companies had met the target operating earnings and that he would be receiving an additional $1,500,000 for the sale of the … Companies. However, because Mr. Mogab did not yet have a 2003 tax return file for the Owens, he did not make a written record of this fact for future use.

“At trial Mr. Mogab explained that by mistake the accounting firm did not report the $1,500,000 capital gain on the Owens’ personal tax return for 2003. He explained that ‘A year and a half later when we prepared the ‘03 return honestly it was not recalled by me. There was not a 1099 issued by the company. If there were a 1099 they would have given me the 1099 and I would have had that document and it darn well would have been picked up’.” 2012 T.C. Mem. 21, at pp. 11-12.

Darn well it should have been memorialized somewhere when you got the phonecall, Greg, and then found its way into the 2003 tax file, especially when the money showed up as paid-in capital on the 2003 return of the new Section 1244 you told John P. to form. 2012 T.C. Mem. 21, at p. 12, footnote 10.

Howbeit, John P. and Laura L. want to get out of the Section 6662 (a) penalty because they told Greg, and his team blew the hand-off.

Judge Wherry blows the play dead. “The Owens argue that they are not liable for the section 6662(a) penalty because they relied on . . . [Greg’s] staff to accurately prepare their return. We conclude that the Owens did not rely in good faith on their accountants’ advice because their reporting of this payment was oral and was long before the return was prepared. Further, they did not carefully examine their return before it was submitted to the IRS, and this standing alone, given the material amount involved, would trigger the penalty under these facts. See Woodsum v. Commissioner, 136 T.C. 584, 595 (2011) (‘In signing the return thus erroneously prepared, petitioners were not deliberately following substantive professional advice; they were instead unwittingly (they contend) perpetuating a clerical mistake. The defense of reliance on professional advice has no application here.’); Neonatology Associates v. Commissioner, 115 T.C. at 99. Although the Owens attempted to convince the Court at trial that they were simply unsophisticated taxpayers at the mercy of their accountants, we find this extremely hard to accept given that Mr. Owen with Mr. Michaels built a company from four people into one that garnered over $7,500,000 when it was sold. A cursory glance at the return would have shown that the amount reported was less than half of the amount required.” 2012 T.C. Mem. 21, at pp. 54-55.

Not only can’t you bury your own mistakes, you can’t bury your tax professional’s mistakes either.

Takeaway for tax professionals–There are no casual conversations with clients. The electron is your best friend; type it on your Smartphone or iPad and send an e-mail confirming it to the client, then and there. That will keep the client on the straight-and-narrow (hopefully), and you from under the wheels of the bus.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

OPIS finis.

Or, What You Call It Matters

Preparing an asset purchase-and-sale agreement often involves negotiating what you call the assets, and that can be just as important as what you pay for them. That’s what Judge Laro teaches in Peco Foods, Inc., and Subsidiaries, 2012 T.C. Mem. 18, filed 1/17/12.

Peco bought two poultry processing plants. Peco and the sellers itemized the assets “for all purposes (including financial accounting and tax purposes)” in their agreements. Most of the assets were stated to be real property, and initially Peco depreciated those assets using a 39-year, nonresidential realty, straight-line method.

Then Peco woke up, and hired two appraisers to appraise the property by components, with a view to preparing revised depreciation schedules. Both the experts were dead when this case came on for trial. Then Peco retained another expert to prepare a cost segregation study, based on those appraisals, in order to buttress an application to change its accounting method to pick up about $5.3 million of depreciation on the components. Oh yes, the preparer of the cost segregation study was also dead when the case came on for trial.

Ya gotta watch those poultry processing deals–they could be hazardous to your health.

Based on the component approach, Peco took double declining balance treatment over 15-year and seven-year lives on the components, claiming they were Section 481(a) adjustments, and depreciated them accordingly.

IRS disallowed the adjustments, claiming that Section 1060(a) mandates that what the parties say in the contract binds them, unless IRS decides the contract allocation is inappropriate. Peco claims it can use Section 338(b)(5) residual methodology.

Nope, says Judge Laro. “Peco, insofar as it seeks to elevate the residual method of section 338(b)(5) over the written allocations, misinterprets the law.

“Where the parties to an applicable asset acquisition agree in writing as to the allocation of the consideration or as to the fair market value of any of the assets, that agreement ‘shall be binding’ on both the transferee and the transferor unless the Commissioner determines that the allocation is not appropriate. Sec. 1060(a). However, where the parties to an applicable asset acquisition do not agree in writing to allocate any part of the consideration of the acquired assets, the residual method of section 338(b)(5) applies to determine the transferee’s basis in, and the transferor’s gain or loss from, each of the assets transferred. See West Covina Motors, Inc. v. Commissioner, T.C. Memo. 2009-291. Congress’ use of the phrase ‘shall be binding’, when viewed in the light of section 1060(a) as a whole, directs that the written agreement supersedes the residual method of purchase price allocation.” 2012 T.C. Mem. 18, at p. 14.

IRS’ interpretation of an agreement between seller and buyer can be set aside “only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.” 2012 T.C. Mem. 18, at pp. 12-13.

The agreements are clear and unambiguous: “for all purposes including financial reporting and tax purposes” means what it says.

IRS wins.

Takeaway- Have tax counsel on board when you negotiate that purchase-and-sale agreement. It might seem more expensive, but you’ll find it’s much less expensive than the alternative.

This well-known lament comes not from the streets of Laredo, but from the Office of the National Taxpayer Advocate Nina (“The Big O”) Olson, in ONTA’s 2011 report to Congress. It’s on their website; you could look it up, as the late great C. D. Stengel was wont to say.

The Big O laments that Congress has starved IRS for funds; tweaked, tinkered, tortured and generally mucked IRC about so that IRS spends too much time explaining and generating forms and instructions, and trying to stop the fraudsters and gameplayers who are looking for the seams in IRS’ zone defense among these continual outbursts of unguided Congressional largesse. And not enough time talking to taxpayers. And too much time figuring out ways to make an audit not be an audit, so as to do end-runs around taxpayers’ rights.

IRS is trying to automate its way out of the dilemma of how to do more with less. But that means auto-rejects, one-size-fits-all letters, and errors multiply. I’ve commented more than once that form letters don’t solve problems, and ONTA agrees. So does Tax Court; see my blogpost “You’ve Got to Be More Specific”, 4/19/11.

The Big O has it right: Congress gets $200 for every $1 it gives the IRS. The “phantom economy” is the fastest-growing segment of the economy. Honest taxpayers are paying an extra $2700 per year per head to cover the revenue lost to the fraudsters and the off-the-bookies.

And we, who have to advise taxpayers, and deal with a broken and demoralized IRS, should be speaking up. Congress, ya gotta spend some money to make some money. You can’t spend trillions you haven’t got, or have borrowed without any sensible plan to pay those trillions back. And to get those trillions, you need  a tax system that lets the taxpayer who actually pays what he or she owes, know she or he isn’t some kind of fool. Give IRS the tools and let them do the job.

Oh yeah, and while you’re at it, Congress, how about a new Taxpayers’ Bill of Rights, one that has teeth in it? And a Taxpayers’ Bill of Responsibilities, too.

If You Want a Deduction

 Dear to the hearts of the oil and gas industry is the ability to expense intangible drilling costs (IDCs). These are all the make-readies and put-togethers before the drill touches the ground. As Judge Gustafson explains in Caltex Oil Venture, Caltex Management Corporation, Tax Matters Partner, 138 T.C. 2, filed 1/12/12, these IDCs include “clearing of ground, draining, road-making, and surveying work to all amounts paid for labor, fuel, repairs, hauling, and supplies (e.g., drilling muds, chemicals and cement) incident to and necessary in the drilling and preparation of wells for the production of oil and gas.” 138 T. C. 2, at p. 3, footnote 2.

While ordinarily these costs would be capitalized, they get special tax treatment, so that they can be deducted as expenses. Caltex Oil Venture (Caltex) is a typical oil and gas shelter. Caltex enters into a contract with a drilling services company, whereby the services company does all the work to get the well pumping (a two year process), but Caltex incurs the IDCs and deducts them up front, around $5 million worth. Caltex pays 10% down and the rest by a note (that never gets into evidence, but Judge Gustafson assumes for Rule 121 benefit-of-the-doubt purposes that the note was executed and delivered).

Caltex is an accrual basis taxpayer. Caltex tried to write off its entire investment in Year One, claiming all events had occurred to create its liability to pay, and that the sum due was reasonably ascertainable. Fine, says IRS, but Section 461(h) economic performance hadn’t occurred because, as both Caltex and IRS stipulated, “[n]o drill penetrated the ground for purposes of drilling a well by or on behalf of Caltex Oil Venture” during the years at issue. 138 T. C. 2, at p. 6.

Caltex responds that they have 90 days after the end of their tax year, because Section 461(i)(2)(A) says they can deduct in the previous year if drilling of the well commences within said 90 days. Except it didn’t, says IRS, because you or your servicer didn’t put a drill bit in the ground in either year.

But we did some work, says Caltex; we got permits and did site preparation. And even if we didn’t drill within 90 days, we have the Regulation Section 1.461-4(d)(6)(ii), the 3-1/2 month rule, which says if we reasonably expected performance from the servicer in 3-1/2 months, we can deduct the IDCs.

No good either way, says Judge Gustafson.

As to the 90-day push, the Section 461(i)(2)(A) language is plain: drilling must commence within said 90 days. “According to Webster’s Third New International Dictionary 690 (2002), to ‘drill’ means ‘to make (a rounded hole or cavity in a solid) by removing bits with a rotating drill’, while to ‘commence’ means ‘to begin’.  Id. at 456. Giving effect to the plain meaning of these words, we find it unambiguous that ‘drilling of the well commences’ when the boring of a hole for the well begins. Therefore, we find that the plain language of section 461(i)(2)(A) dictates that, as a matter of law, ‘drilling of the well commences’ when the drill bit penetrates the ground to start the hole for the well.” 138 T.C. 2, at p. 17.

As to the 3-1/2 month rule, IRS says this applies only if all of the work could reasonably be anticipated to be completed within 3-1/2 months after end of tax year, and everyone agrees that’s a “nevah hoppen”. Caltex replies that some work got done in the 3-1/2 months. Judge Gustafson says that, where the contract is divisible or severable, that is, where it calls for work in stages or phases with payment made or due proportionately, economic performance occurs as each stage or phase is completed and the 3-1/2 month rule helps. But here there was a single-shot payment up front, so economic performance of the entire contract must be reasonably anticipated within the 3-1/2 month window before deduction of IDCs allowed.

Caltex says that makes it impossible for the 3-1/2 month window to do any good for investors in what a certain Director in a major accounting firm, stationed in Houston, calls the “owl bidniz”. That’s  “oil business” to you Yankees. Wells just can’t be drilled in less than two years.

Judge Gustafson says so sad, too bad, but the Internal Revenue Code was not written solely for the benefit of the “owl bidniz,” and maybe the 3-1/2 month rule helps somebody else. Besides, the point of the rule was to make it easier for taxpayers to figure out when services or property was provided, and economic performance occurred. With commendable restraint, Judge Gustafson says: “It would be somewhat at odds with such a regime–engineered to avoid difficulties in determining when services have been provided–to allow a taxpayer to accelerate deductions for just the portion of services expected to be provided within 3-1/2 months of payment and, in order to do so, to make ex post facto valuations of those services–valuations that would require fact-intensive analyses by both the taxpayer and the IRS. This is the very difficulty that the regulation sought to avoid.” 138 T.C. 2, at p. 30.

Besides, Caltex, draft your contracts to be divisible, and you’ve solved your problem, at least in part.

By the way, Regulation section 1.461-4(g)(1)(ii)(A), provides that “payment includes the furnishing of cash or cash equivalents and the netting of offsetting accounts. Payment does not include the furnishing of a note or other evidence of indebtedness of the taxpayer, whether or not the evidence is guaranteed by any other instrument (including a standby letter of credit) or by any third party (including a government agency).” 138 T. C. 2, at p. 34. So Caltex would be limited to work actually performed to the extent paid for in cash in Year One plus 90 days, or around $7K, says IRS.

Judge Gustafson leaves that for trial, because Caltex disputes the amount. But Judge Gustafson gives IRS summary judgment knocking out the $5 million deduction.

Takeaway–Drill, baby, drill.

Judge Gustafson gets an oddball, in Ann Marie Minihan, Petitioner, and John J. Minihan, Jr., Intervenor, 138 T.C. 1, filed 1/12/12.

Mrs. Minihan claims she’s a Section 6015 innocent spouse, but IRS already levied on a joint account she held with John J., her former spouse, for the full amount of tax, interest, and penalties (note the Harvard comma, because this is a Massachusetts case where Massachusetts law plays a big part).

So IRS says “Even if Mrs Minihan is an injured innocent (which we don’t agree), no tax is due, so no collection action will follow. But in case Mrs. Minihan is seeking a refund, we’ll move for Rule 121 partial summary judgment that she isn’t entitled to a refund even if she can prove innocent spousehood, because we levied on a joint account, and by Mass law either joint account holder can withdraw 100% of the money, irrespective of who put it there or what deals they had between themselves.”

Judge Gustafson puts it this way: “The question whether a section 6015(f) petitioner is eligible for any relief is logically prior to the question whether she is entitled to a particular form of relief (i.e., a refund); and in a sense the Court’s holding a partial trial on the latter question first puts the cart before the horse. However, because here the entire joint liability has been satisfied, petitioner’s request for relief is moot (since the IRS will engage in no more collection activity) unless a refund is possible. The IRS sensibly moved for partial summary judgment on this issue, since if the motion succeeded, the parties and the Court could avoid a trial on the fact-intensive and sometimes vexing question of entitlement to equitable relief under section 6015(f).” 138 T.C. 1, at p. 2, footnote 2.

Note that the new proposed innocent spouse Rev. Proc. in IRS Notice 2012-8, 2012-4 I.R.B. 1 (see my blogpost “Innocence is Bliss,” 1/6/12) is mentioned in the decision, but plays no part in the outcome. 138 T.C. 1, at p. 12, footnote 7.

The only question is whose money is it,  anyway.  After trial,  Mrs. Minihan’s pro bono counsel moved to reopen the record to submit documentation showing the bank account IRS levied upon was one from which neither Mrs. Minihan nor John J. could unilaterally withdraw money. Judge Gustafson allows this over IRS and John J. objections, because it won’t change the result. While the bank’s paperwork isn’t of the best, Mrs. Minihan prevails.

Before IRS levied, Mrs. Minihan filed her Section 6015 petition, which stopped IRS from pursuing collection against her. So IRS went after the joint account. IRS set up what are called “mirror” accounts, his-and-hers, to go after John J.’s money, wheresoever it might be. IRS says “because joint money belongs to whoever grabs it first, we can seize the joint account.”

No, says Judge Gustafson. You can levy, all right, but that doesn’t decide whose money it is. As between depositors and the bank, either party can take out all the money, and the bank is off the hook. See Section 7426; if someone who doesn’t owe tax has their property levied upon to pay the tax of someone who does, they can sue to get it back.  See also US v. Rodgers, 461 US 677 (1983).

But Mrs. Minihan missed the statute of limitations to go under Section 7426. No problem, says Judge Gustafson; there’s wonderful “notwithstanding any other provision of law” language in Section 6015(g)(1) that saves the day, allowing the injured spouse to challenge the levy when all other recourse is gone. So Section 6015 is the innocent spouse’s cure-all.

Presuming without deciding that Mrs. Minihan is entitled to innocent spouse relief under Section 6015(f) equitable principles,  and a refund if she overpaid notwithstanding any other provision of law (except some specifically enumerated ones), Judge Gustafson looks at Massachusetts’ take on joint accounts and what went into the account.

Mass law, says Judge Gustafson, citing several cases, is that as between the depositors, it’s a question of intent, and a question of fact, as to whose money it is, anyway.

“The money in the joint account came from the sale of the couple’s long- time marital house, in which they had made a home together during almost two decades of marriage. Although the money to pay the mortgage had come from the earnings of Mr. Minihan, his earning potential depended on Ms. Minihan’s making her contribution to the household by keeping house, raising the children, and fulfilling the other responsibilities of the stay-at-home spouse.

“Most telling, however, is Mr. Minihan’s testimony at trial: When asked why, on one occasion when he unilaterally withdrew from the account $5,000 for himself, he also withdrew $5,000 for Ms. Minihan, Mr. Minihan testified: “I did so because it was equitable. That was–if one was going to take out $10,000, the other one would take out $10,000”. Mr. Minihan had every incentive in this case to minimize Ms. Minihan’s claim on the funds in the joint account, but even his testimony suggests that the parties intended that Mr. and Ms. Minihan each had a 50-percent interest in the account, notwithstanding that the initial source of the funds might be traced to Mr. Minihan’s paycheck.” 138 T.C. 1, at pp. 26-27.

The money, incidentally, was supposed to pay for their three children’s education and living expenses, according to the evidence Mrs. Minihan brought in, and John J. and IRS couldn’t rebut.

In short: “The propriety of the creditor’s levy is one thing; the right of a third party to assert a claim against the creditor for the property it seized is another thing.” 138 T. C. 1, at p. 28.

So Mrs. Minihan can get back her 50%, assuming she can prove she’s an innocent spouse.

Takeaway- The either-depositor-can-take-all rule is there to protect the bank, not the depositors, so the bank hasn’t to decide a jump-ball between joint account holders. But if IRS levies on a joint account, it’s not “game over.” Ask the question: “Whose money is it anyway?”

In deciding whether litigating fiduciaries should be reimbursed legal fees and disbursements from the estate for which they are acting, Judge Goeke reminds us that the key question is, ‘Is the estate a player or a spectator?’ Is the fiduciary fighting for the estate, or is the estate a mere stakeholder while the fiduciaries fight with one another or with someone else? To see an in-depth analysis, look at Estate of Raymond J. Gill, Deceased, Sabal Trust Company, Personal Representative, 2012 T.C. Mem. 7, filed 1/9/12.

Famous Ray was a man of means. He and his wife Joan had an elaborate estate plan, with credit shelter trusts, marital trusts, living trusts, and springing trusts for the children and grandchildren of the said Famous Ray and Joan.

Joan dies first, and that’s the problem, because Famous Ray takes a business trip to Germany, and brings back a souvenir costing ten years of litigation and $830K in legal fees and disbursements, namely, the Beautiful Valerie, who becomes Mrs Famous Ray II (hereinafter “MFR”). MFR causes Famous Ray to restructure the estate plan, oust his children (Mark and Mrs. Alabaster) as fiduciaries, and install MFR and SunTrust in their place and stead, and give MFR all kinds of goodies.

Mrs. Alabaster, on getting the news, gleams, but not, as Katherine Lee Bates suggests in her immortal hymn “America, the Beautiful”, “undimm’d by human tears.” No, Mrs. A springs to the attack as soon as Famous Ray is in the cold, cold ground and she gets wind of MFR’s shenanigans.

Enter the lawyers. Lawsuit follows, then mediation follows, then comes a stipulation that MFR immediately breaches. More lawsuits, more mediation, and a new stipulation. Mrs. A ousts MFR and recoups some cash (which goes to her and Mark). Finally, Sabal Trust Company succeeds SunTrust, who aided and abetted MFR throughout their ten-year odyssey through the Florida courts.

Emerging bloodied but victorious, and installed as fiduciary, Mrs A seeks, inter alia as my high-priced colleagues say, to get paid back for the $830K she and Mark ponied up for the legal talent.

Now Judge Goeke gets down to business. But first, “(W)e have corrected minor mathematical errors made by the parties in their calculations. Those corrections have reduced the total administration expense deductions sought by $6.” 2012 T. C. Mem. 7, at p. 15, footnote 3. Ya gotta love a court that, faced with a claim for $830K, has time to do the arithmetic and find $6, which is less than one minute of a white shoe second-year associate’s billable time.

Next, IRS left off disbursements in reckoning the $2.8 million deficiency slapped on Famous Ray’s estate. Judge Goeke: “In his calculations, respondent [IRS] took only attorney’s fees into account and failed to include related court costs (such as those for transcripts and depositions) incurred by the estate’s lawyers. Such costs are deductible under section 20.2053-3(d), Estate Tax Regs.” 2012 T. C. Mem. 7, at p. 16.

But whether fees or disbursements, these must be chargeable to the estate under local law. Canvassing Florida law, Judge Goeke finds some part of the legal fees claimed to be allowable as charges to the estate.

But are they reasonable? Whether allowable or not by State law, to pass muster for deductibility for Federal estate tax purposes these fees must be reasonable. Judge Geoke finds they are: “Because Fla. Stat. Ann. sec. 733.106(3) allows attorneys to be awarded reasonable attorney’s fees only for services to an estate, and the legal fees comprised mostly attorney’s fees, we find this is strong evidence of the reasonableness of the fees. In addition, the estate introduced into evidence voluminous records of legal fees incurred by the Gill children over the years in which litigation was ongoing. Considering these records as a whole, we see nothing unreasonable about those fees. We also consider the fact that the Gill children were reimbursed less than their actual legal fees. Respondent offered no evidence of his own that the legal fees were unreasonable.” 2012 T.C. Mem. 7, at p. 21. No evidence from IRS? On what then did IRS base its deficiency?

Final fence before the finish line: were the legal fees in question “essential to the proper settlement of the estate”? If not, no deduction. And State law is not dispositive on this point. See Reg. 20.2053-3(c)(3).

Here comes the test: is this a dispute between beneficiaries as to who gets what, with the estate uninvolved as it only has to pay one or the other; or is this a question of who is a fiduciary and are they acting as such? If the former, in the immortal words of Humphrey Bogart in the 1948 classic “Treasure of the Sierra Madre”, “why don’t everybody smoke their own?” But if acting as a fiduciary, even with a personal interest in the outcome, and even if the end result of the legal process puts money in the fiduciary’s own pocket, the legal fees and disbursements are proper deductions. Judge Goeke canvasses the caselaw, and finds that, as to some of the fees, Mrs A was acting as fiduciary, so she gets some of the fees, even though the outcome of the litigation enriched her personally.

Some deductions the estate doesn’t get, largely because of poor recordkeeping.  Each litigation stands on its own, and Judge Goeke goes through the who, what, where and when of each, and if the paperwork isn’t clear, Mrs A loses, as she has the burden of proof. And even MFR’s and SunTrust’s legal fees, for which they were reimbursed by the estate for the time they were fiduciaries, are deductible, to the extent allowable, reasonable and essential.

The accountants’ fees are disallowed, again for poor recordkeeping. Shame on the accountants. But the lawyers weren’t all that much better, either.

Takeaway–Document, document, document. Have the lawyers do their bills to show exactly which clients they represented, in what capacity (individual or fiduciary), and what they did and when they did it. And the accountants likewise.

Or, Less Work for Us Tax Court Bloggers?

Though no new Tax Court cases came down on January 6, IRS kindly filled the gap by issuing IRS Notice 2012-8 on January 5, setting out a proposed replacement to Rev. Proc. 2003-61, 2003-2 C.B. 296, the Section 6015(f) equity relief for the innocent spouse.

Apparently the spate of Tax Court cases over the last few years has caused IRS to re-engineer its approach where the requestor makes out a case for spousal abuse by, or financial control exercised by, the non-requestor. And the proposed Rev. Proc. also cleans up the process generally.

A couple of points follow, but read the whole Notice, there’s a lot more.

IRS will “streamline” its treatment of innocent spousery when: “… the requesting spouse establishes that the requesting spouse:

(1) Is no longer married to the nonrequesting spouse…;

(2) Would suffer economic hardship if relief were not granted…; and

(3) Did not know or have reason to know that there was an understatement or deficiency on the joint return…, or did not know or have reason to know that the nonrequesting spouse would not or could not pay the underpayment of tax reported on the joint income tax return …. If the nonrequesting spouse abused the requesting spouse or maintained control over the household finances by restricting the requesting spouse’s access to financial information, and therefore, because of the abuse or financial control the requesting spouse was not able to challenge the treatment of any items on the joint return, or to question the payment of the taxes reported as due on the joint return or challenge the nonrequesting spouse’s assurance regarding payment of the taxes, for fear of the nonrequesting spouse’s retaliation, then the abuse or financial control will result in this factor being satisfied even if the requesting spouse had knowledge or reason to know of the items giving rise to the understatement or deficiency or had knowledge or reason to know that the nonrequesting spouse would not pay the tax liability.” Notice 2012-8, at pp. 14-15.

The proposed Rev. Proc. also defines “economic hardship”, a useful step when what we usually see is a dissection of a spouse’s income and expenses, a time-wasting exercise that cannot be applied in any case but the one at bar. Here’s IRS’ new answer: “If the requesting spouse’s income is below 250% of the Federal poverty guidelines, or if the requesting spouse’s monthly income exceeds the requesting spouse’s reasonable basic monthly living expenses by $300 or less, then this factor will weigh in favor of relief unless the requesting spouse has assets out of which the requesting spouse can make payments towards the tax liability and still adequately meet the requesting spouse’s reasonable basic living expenses. If the requesting spouse’s income exceeds these standards, the Service will consider all facts and circumstances in determining whether the requesting spouse would suffer economic hardship if relief is not granted.” Notice 2012-8, at pp. 17-18.

Oh yes, IRS will apply all these new procedures at once, without waiting for the Rev. Proc. to issue in final form. “Because the provisions in the proposed revenue procedure expand the equitable relief analysis by providing additional considerations for taxpayers seeking relief, until the revenue procedure is finalized, the Service will apply the provisions in the proposed revenue procedure instead of Rev. Proc. 2003-61 in evaluating claims for equitable relief under section 6015(f). If taxpayers conclude that they would receive more favorable treatment under one or more of the factors provided in Rev. Proc. 2003-61 they should advise the Service in their application for relief or supplement an already existing application. Then the Service will apply those factors from Rev. Proc. 2003-61, until a new revenue procedure is finalized.” Notice 2012-8, at p. 3. So until the new Rev. Proc. is issued, it’s gambler’s choice.

Hopefully, the new procedures will supply speedy relief to the innocent without the need for Tax Court intervention, and discourage the undeserving. Of course, for a $60 petition fee, the undeserving can still waste Tax Court’s time.

Maybe there will be less in the innocent spouse sphere for us bloggers to blog about, as well.

But That Doesn‘t Mean You Get a Deduction

Budding authors, before you sing Richard Rodgers’ and Lorenz Hart’s 1940 classic song from “Pal Joey”, read and heed the lesson Judge Vasquez gives you would-be best-sellers in Michael S. Oros, 2012 T. C. Mem. 4, filed 1/4/12.

Mike worked full-time for Intel (ba-bing, ba-bing), but he hankered for far horizons and, he claimed, for the fame and fortune of professional authordom. So he wrote up a business plan (he had an MBA), and took off on a four-month trip spanning two tax years, during which he visited South America, Australia, Asia and Africa. He collected vacation pay and sabbatical pay from Intel while doing so. He said he was going to write a book, self-publish it and make money therefrom.

Mike took 4542 photographs (though not professionally-trained, he claimed he was an accomplished amateur photog), kept a detailed diary of his travels, and arranged his travels around events he wanted to see and photograph. He produced credit card receipts and statements from his trip at trial, but didn’t itemize what was business and what wasn’t.

But four years after his trip, all Mike had was a 100 to 150 page first draft of his book, which didn’t make it into the record at trial. And Mike had never written anything before.

Mike seeks about $19K in Schedule C deductions, against no income. Mike didn’t give up the day job at Intel.

Now Judge Vasquez agrees that just because someone hasn’t published before, that doesn’t mean they’re not in the trade or business of writing for profit. Every for-profit author had a first story that didn’t make money, or where the author lost money. And just because they have a day job doesn’t mean they’re not a for-profit author, either. Moreover, IRS never claimed Mike wasn’t in it for profit.

But the newbie Shakespeare has to show continuous effort, or, as Judge Vasquez puts it, “(P)etitioner failed to produce evidence to show some intent or effect on his part to engage in and continue in the writing field with substantial regularity and with the purpose of producing income and a livelihood. In Hawkins v. Commissioner, supra, we noted that the taxpayer’s published book of poetry “could just as easily be an isolated venture for the personal satisfaction of * * * [the taxpayer] seeing * * * [her] poetry in print as it could be a product of trade or business.” Id. The same could be said of petitioner; his planned travel book could just as easily be an isolated venture for the personal satisfaction of taking a worldwide trip and seeing his travel adventures in print as it could be a product of a trade or business.” 2012 T. C. Mem. 4, at p. 7.

And you can satisfy your intellectual curiosity about the Hawkins case at Hawkins v. Commissioner, T.C. Memo. 1979-101, affd. without published opinion 652 F.2d 62 (9th Cir. 1981).

Anyway, even if Mike was in it for the money, he falls foul of the strict substantiation of Section 274(d), IRS’ big torpedo for eager taxpayers. To deduct travel and meals, you have to show who, what, when, where, how and why for each and every expense as you make the payment, and tie it in to the business.

So Mike’s literary venture, while personally rewarding and possibly artistically meritorious, fails of taxpayer subsidy.

IRS says “Time for the five-and-ten, the Section 6662(a) negligence with substantial understatement (the greater of $5000 or ten percent of tax properly due) penalty on top”. But Mike says he went to his friendly neighborhood tax preparer, who had more than 36 years of experience, and told the preparer the whole story. And said preparer told Mike to go for it.

So Mike acted in good faith and with reasonable cause, and, as Judge Vasquez puts it, “(B)ecause the reasonable cause and good faith exception is a defense to both negligence and a substantial understatement of income tax, the section 6662 penalty does not apply.” 2012 T. C. Mem. 4, at p. 11.

Takeaway–Just because you could write a book doesn’t mean you’re in it for the gold. Write and keep writing, substantiate and keep substantiating, even if you don’t give up the day job.