Or, Research Is Scientific

 So The Heritage Organization, LLC, finds out in The Heritage Organization, LLC, GMK Family Holdings, LLC, Tax Matters Partner, 2011 T.C. Mem. 246, filed 10/19/11.

Heritage was a tax planning promoter, originally a life insurance producer; a producer is a broker which solicits or negotiates insurance contracts on behalf of its customers. It claimed a Section 174 research and development deduction on its Form 1065 for the years at issue, courtesy of a decision by its CFO, a high-school graduate bookkeeper who had been working for Heritage for more than thirty years.

Heritage used a separate legal entity that “…conducted legal and tax research regarding corporate and trust structures that would allow individuals to minimize income and estate tax. It spent hundreds of thousands of dollars for legal advice from estate and tax planning attorneys from around the United States.” 2011 T.C. Mem. 246, at p. 5.

As a result of some of this research, Heritage set up trusts, in each of which Heritage placed corporations which ran a “son-of-BOSS” operation, in which short sales were mismatched with the unrecognized obligation to cover the short, thereby trying to create basis where none in fact existed.

In order to protect the trusts by covering their losses on the deals, Heritage’s CFO issued each a check for $550,000, an amount she derived based upon actual loss in covering the short, plus a gross-up for income taxes due and a rounding figure so the check would be in an even dollar amount. Heritage’s CFO booked the payments as “research and development”, and so deducted the payments on Heritage’s 1065.

No, said IRS.

No, said Judge Paris. “The term ‘research or developmental expenditures’ is defined as ‘expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.’ Sec. 1.174-2(a)(1), Income Tax Regs. The term generally includes all such costs incident to the development or improvement of a product. Id.”  2011 T.C. Mem. 246, at p. 15. Those are costs necessary to develop the concept or technique of the product, not the product itself.

Using the plain meanings of “experimental” or “laboratory”, Judge Paris finds “(T)he payoff amounts fail to meet the section 174 requirement that the expenditures be for research in the experimental or laboratory sense. The payments were not made for scientific activities. The payoff amounts consisted of the amount outstanding for each corporation on its loan from Heritage, a tax gross-up amount, and an arbitrary amount to make the payment a round number. While a portion of the loss may have been deductible as a short-term capital loss, the remainder would have been a nondeductible investment expense. Holdings relies on the fact that there were a number of employees of Heritage engaged in researching tax planning strategies and identifying high-net-worth individuals, even though these activities were performed by a different Heritage subsidiary. These activities are irrelevant to determining whether the payoff amounts are research and development expenses. The activities were unrelated to the payoff amounts, and further, any expenses associated with those activities were deducted through a different Heritage subsidiary.” 2011 T. C. Mem. 246, at p. 17.

In short, wrong church, wrong pew, and what you put in the collection plate isn’t deductible.

In the words of Ira Gershwin, from the 1935 American opera Porgy an’ Bess. Tax Court’s recent releases have been Section 7463 “Not for nuttin’” cases. None of them even explores interesting legal issues. And no, while they’re just as obvious as Christy & Swan Profit Sharing Plan, 2011 T.C. Mem. 62, filed 3/15/11, as discussed in my post “Maybe Not So Obvious”, 8/28/11, these truly are so obvious that no unwary person should be caught in their clutches.

By way of illustration of the foregoing, we have Robert David Wuerth & Cynthia Wuerth, 2011 T.C. Sum. Op. 121, filed 10/13/11. Bob and Cynthia’s Indiana homestead was hit by a tornado. Bob, a CPA who taught graduate courses in accountancy on-line, ascribed part of his loss to the business portion of the house (the home-office gambit). So far, so good, but the problem comes in with determining what the house was worth immediately pre-twister and immediately post-twister.

Bob put together some numbers and plugged them into his self-prepared returns (1040 for himself and Cynthia, and 1065 for his business partnership–incidentally, with Cynthia). IRS audited, and Judge Cohen takes up the story: “During the course of the examination, petitioner hired an appraiser to determine the value of the Indiana real property both before and after the tornado. The appraiser had not personally appraised the property before the damage occurred and relied on the statements petitioner made regarding its previous condition. The appraiser ultimately determined that the market value of the property before the tornado was $250,000 and after the tornado was $117,000. The appraisal report included numerous errors, including misstating the calculations for the pre-tornado value of the real property as totaling $220,000 and $240,000 at different points in the report.” 2011 T. C. Sum. Op. 121, at pp. 4-5.

The Regulations require that pre-casualty and post-casualty valuations “shall generally be ascertained by competent appraisal.” Sec. 1.165-7(a)(2)(I). Bob’s hastily-prepared “appraisal” doesn’t satisfy the competency test. Even though Wuerth assisted in its preparation, the appraisal is found to be Wuerthless (sorry, guys).

Next is “what’s in a name?” Shakespeare’s rose by any other name helps out, but does not rescue, Tawana L. Bradley, 2011 T.C. Sum. Op. 120, filed 10/12/11.

Tawana was a cheerleader for the cheerleaders who encouraged the Muhammad Ali Youth Football and Cheerleaders League. Claiming it was a 501(c)(3) exempt organization, she took a charitable deduction when she chartered a bus and paid for it, to transport said cheerleaders and athletes to various competitions. At trial, she got the name of the organization wrong.

Fortunately, the receipt from the bus company was close enough. Judge Ruwe: “Petitioner testified that she volunteered as a cheerleading coach for the Muhammad Ali Youth Football and Cheerleaders League, which is not listed in Publication 78 as an organization that is eligible to receive tax deductible charitable contributions. However, the Muhammad Ali Youth Football and Cheerleaders League is not the group named on the charter bus confirmation that petitioner submitted in support of her claimed deduction. Instead, the charter confirmation form names the Yellow Jackets Cheerleaders as the group. According to Publication 78, the Muhammad Ali Yellowjackets, Inc., is a qualified organization that was formed in Kentucky. Given the similarities of the group names and the location of the groups within the Commonwealth of Kentucky, it appears that petitioner confused the organization’s name while testifying. Given that her testimony was reasonable and that she has provided reliable evidence of the group’s actual name, we find that petitioner’s activities were services to the Muhammad Ali Yellowjackets, Inc.” 2011 T.C. Sum. Op. 120, at p. 6.

All would be well, but for Tawana’s lack of a Section 170(f)(8)(A) statement from the Yellowjackets. Since the bus charter was more than $250, the receipt from the bus company doesn’t affirm the requisites that only the Yellowjackets could provide, namely, that Tawana got nothing back from the Yellowjackets, or described the goods or services Tawana donated, or gave an approximate fair value for the goods or services. See my post “The $250 Misunderstanding”, 6/3/11, and Jan Elizabeth Van Dusen 136 T.C. 25, released 6/2/11. So no deduction.

Nothing new here.

Some of us have been on a LinkedIn message board discussing the new Form 8938, and its interface with Treasury 90-22.1. That’s the foreign financial account reporting stuff. For a little background, see my post “Frequently Asked Questions”, 7/22/11.

The issue is whether certain holdings in offshore private equity funds and hedge funds are or are not reportable on the Form 8938, but not on the Treasury 90-22.1, or vice versa. Why there should be any difference between what is reported on the two forms, or even why there should be two forms, filed in different places and with different rules, is another story.

And since the $10,000-at-any-time threshold is not so high as to preclude ordinary people from being enmeshed in the foreign financial account spiderweb, it is germane to the in-the-trenches preparer.

And if the experts aren’t sure what to include or exclude, what is that in-the-trenches preparer to do, but throw in everything, required or not?

One can but hope that preparing a single form, with one set of rules and penalties, filed in one place at one time, is not beyond the combined resources of Messrs. Geithner and Shulman.

There is an old story of Lord Melbourne, Prime Minister under Queen Victoria in the mid-Nineteenth Century, at the end of a Cabinet Council, putting his back against the door and saying to his colleagues before they separated—”Now, gentlemen, are we agreed that a sliding scale lowers or raises the price of corn? I do not care myself twopence which it is, but let us all have the same story.”

So may I presume to address Lord Melbourne’s old suggestion to our esteemed Secretary of the Treasury and equally esteemed Commissioner of Internal Revenue: “I do not care myself tuppence which it is, but let us all have the same story.”

It’s another Section 7463 “just sayin’”, but the reasoning is interesting. What does “construction” mean, when the taxpayer wants to deduct mortgage interest for  “qualified residence indebtedness”, and the qualified residence hasn’t yet been built? That’s the question in Thomas G. Rose, Sr., and Cheryl G. Rose, 2011 T.C. Sum. Op. 117, released 10/4/11.

Tom and Cher wanted to build their dream house on the Florida coast. They bought land, on which stood an existing house they didn’t want. They entered into a contract to buy the land, but before they took title and pursuant to their contract of sale, the existing owner let them demolish the house. They then borrowed land acquisition mortgage money, closed title, and started the permitting process.

The permitting process proceeded for two years at a turtle’s pace, because the turtles were holding up the deal. Florida Department of Environmental Protection (FDEP) wanted to make sure that light from Tom and Cher’s putative palazzo wouldn’t disturb the nesting habits of the local sea turtles. While FDEP was checking out the turtle races, the Florida real estate market went south, and Tom and Cher couldn’t get their construction financing.

They sold the beachfront for whopping loss (which IRS didn’t question), and had deducted the mortgage interest for the two years while FDEP was checking out the turtles’ nightlife, claiming the house was “under construction” and therefore Section 163 qualified.

IRS said “No, it’s turtles all the way down. You had no residence, it was a hole in the sand, you weren’t building and you didn’t even own the property when the old house was demolished. Paper pushing and turtle-watching isn’t construction.”

Judge Ruwe to the rescue. “The issues we must decide are: (1) Whether the residence was ‘under construction’ during the taxable years at issue, and, if so, (2) whether the fact that events occurred after the taxable years in issue that prevented the completion of construction of a qualified residence should disqualify the interest deduction for prior years.” 2011 T.C. Sum. Op. 117, at p. 11.

Judge Ruwe answers question number one: “In order to determine the proper meaning attributable to the term ‘under construction’ it is useful to consult the meanings ordinarily given to those words. See Asgrow Seed Co. v. Winterboer, 513 U.S. 179, 187 (1995). ‘Construction’ is defined as ‘the act or process of constructing’. Webster’s New World College Dictionary 313 (4th ed. 2009) (emphasis added); The American Heritage Dictionary 315 (2d College ed. 1985). Furthermore, the applicable definition of ‘under’ defines the word as ‘in the process of’. (In fact, one of the examples given following the definition is ‘under construction’.) Webster’s Third New International Dictionary 2487 (1986); see also The American Heritage Dictionary (2d College ed. 1985). The definitions commonly attributed to both ‘under’ and ‘construction’ acknowledge that the terms can be read as being broad enough to encompass the entire process of construction and not simply the physical assembly of building materials. Therefore, the question becomes whether petitioners’ activities during 2006 and 2007 amounted to the commencement of the process of construction rather than merely preparatory activities.” 2011 T.C. Sum. Op. 177, at p. 13.

Yes, Tom and Cher were constructing: “Although the house was leveled and the lot was cleared before petitioners received legal title to the property in March, 2006, the work would not have occurred had petitioners not bargained for it in the purchase and sale agreement. For all practical purposes, petitioners were responsible for the demolition work, and it came about as a direct result of their purchasing the property. The fact that petitioners did not hold legal title to the property at the time that the work occurred does not negate its relevance to our inquiry, especially given the real property laws of the State of Florida. At the time the actual demolition and cleanup work took place with respect to the property, petitioners were possessors of equitable title. As such, petitioners were the beneficial owners of the property when the demolition of the existing house took place. Therefore, we find that by causing an entire house to be demolished and by clearing the lot so that it would be suitable for a new residence, petitioners undertook significant steps in the process of constructing their vacation house, as early as January 2006.” 2011 T.C. Sum. Op. 117, at p. 14 [Footnote omitted.]

And as to the permitting process, Judge Ruwe said : “Petitioners undertook significant work in preparing to obtain a construction permit, and that work was a necessary component of the overall process of construction. We hold that the property was ‘under construction’ as a residence during 2006 and 2007.” 2011 T.C. Sum. Op. 177, at p. 15.

As for the later frustration of Tom and Cher’s plan to build their dream house, each tax year stands on its own. Regulation Section 1.163-10T(p)(5)(i) and (ii) permits deduction of interest for 24 months while a qualified residence is a-building. After month 24, no deduction until the residence is finished. The deduction must be taken in the appropriate tax year. No way could Tom and Cher have known in 2006 or 2007 that the credit market would crater in 2008.

Or more elegantly, as Judge Ruwe says: “If petitioners intended to claim the deduction for qualified residence interest during the construction period, they had to claim it on their returns for the years immediately following the commencement of construction in January 2006. It is a well-known principle that each taxable year stands alone and is evaluated separately. In evaluating each year on its own, it would be impossible for petitioners or the Internal Revenue Service to have known that the proposed residence would never become ready for occupancy. The appropriateness of the deductions petitioners claimed should be evaluated on the basis of the facts and circumstances as they existed in 2006 and 2007. Events beyond petitioners’ control occurred in subsequent years and prevented petitioners from completing a residence.” 2011 T.C. Sum Op. 117, at pp. 16-17. [Citations and footnote omitted.]

So Tom and Cher win, and even better, IRS can’t appeal.

That’s what Healthpoint wound up with when they settled an infringement suit against Ethex, in Healthpoint, Ltd., DFB Pharmaceuticals, Inc., Tax Matters Partner, 2011 T.C. Mem 241, released 10/3/11.

Healthpoint sued Ethex for ripping off Healthpoint’s great debrider (which is a drug that removes necrotic tissue), adulterating the formula and thereby trashing Healthpoint’s sales and goodwill. Healthpoint won a great jury verdict, sued Ethex for more of the same, Ethex appealed lawsuit one, and after much legal whammer-jammer, Ethex settled both cases and paid Healthpoint big bucks.

Now for the tax issue: what part of the settlement money is for damage to goodwill, and what for lost profits? The former is long-term capital gain, the latter is ordinary income. So guess where 90% of the money was allocated in the settlement agreement? Of course tax counsel wasn’t consulted.

Healthpoint argues that, as the parties are adversaries and at arms’-length, and as Ethex fought vigorously against admitting guilt or paying punitives, their allocation should be respected. Nope, says Judge Cohen: “Healthpoint did not maintain any business documentation relating to goodwill or make any calculations during the settlement negotiations to justify the allocations in the agreement. Healthpoint was aware that allocating money to items of ordinary income rather than capital gain would generate a higher tax burden. Healthpoint’s tax counsel was not involved in any discussion of the total amount of the settlement or the amount of each individual allocation.” 2011 T.C. Mem. 241, at p.9.

The point is, what claims did the parties really settle, not what did they say they settled? Judge Cohen again: “…general adversity between the parties to a lawsuit is to be expected. The requirement that parties involved in settlement negotiations be adverse is a factor in determining whether the final agreement reflected the true intentions of the parties involved. If the parties were generally adverse but ultimately allocated the funds in a way that did not represent the claims they actually intended to settle, then we need not respect the allocations made in the settlement agreement.” 2011 T.C. Mem. 241, at p. 13.

Ethex didn’t care how Healthpoint characterized the money Ethex paid, as long as the characterization didn’t inculpate Ethex. Judge Cohen: “We agree with respondent [IRS] that, in the light of the circumstances of the settlement and the verdict in Ethex I, the allocations made by the jury should be applied to the settlement of Ethex I for tax purposes. However, we must still address the allocations with respect to Ethex II. ‘When assessing the tax implications of a settlement agreement, courts should * * *[not] engage in speculation’, but should discern ‘the claim the parties, in good faith, intended to settle for.’. [Citations omitted.] 2011 T.C. Mem 241, at p. 16.

Remember, Healthpoint won a jury verdict in the first lawsuit, but settled both before the second went to trial.

Treat ‘em alike, says Judge Cohen: “Although Healthpoint’s complaint in Ethex II alleged misdeeds by Ethex slightly different from those alleged in Ethex I, the cases were very similar. In fact, the settlement agreement allocated the damages in Ethex I in similar proportions to Ethex II.

“Petitioner has not met its burden to show that the allocations according to the settlement agreement in Ethex II should be respected. The amounts paid to settle Ethex II should be allocated in the same proportions and classifications as those in Ethex I, on the basis of the jury verdict, the above analysis, and respondent’s concession.” 2011 T.C. Mem 241, at pp. 16-17.

Takeaway for trial counsel: Talk to tax counsel when you craft your settlements. Don’t get carried away by the joy of victory, lest you later suffer the agony of defeat.

That’s part of the lesson from Barry S. Friedberg and Charlotte Moss, 2011 T.C. Mem. 238, released 10/3/11. Barry and Charlie come a cropper on the appraisal, which doesn’t fill the bill for their Section 170(h) façade easement. They might survive on the transferable development rights surrender (if that’s worth anything), but that will await trial (if any). But when IRS tries to dump their $3,886,000 deduction and hit them for penalties because they didn’t complete their Form 8283, Judge Wells calls a halt.

Barry and Charlie are involved another one of those National Architectural Trust deals (see my post “A Joy Forever”, 4/4/11). It’s the usual story. Barry and Charlie bought and refurbished a townhouse in New York City’s historic silk stocking district, for which they paid telephone numbers. Along comes the National Architectural Trust and offers them a huge write-off. But Barry and Charlie don’t get the big deduction.

Their supporting appraisal comes unglued on technical grounds. Judge Wells devotes 67 pages to unscrambling this omelet in copious detail, the vast majority of which I refer to specialists. Of interest to New York City practitioners, of which I am one, is a very clear explanation of transferable development rights (“air rights”). However, valuing the same is very much like Omar Khayyam: “Myself when young did eagerly frequent/Doctor and saint, and heard great argument/ About it and about, but evermore/Came out by the same door as in I went”.

One thing is clear, though. If you attach your appraisal to your Form 8283, even if the Form 8283 is incompletely filled in, you’re still in the ballpark.

Judge Wells: “Section 1.170A-13(c)(4)(ii), Income Tax Regs., lays out the required contents of the appraisal summary, which include:

(B) A description of the property in sufficient detailfor a person who is not generally familiar with the type of property to ascertain that the property that was appraised is the property that was contributed;

(C) In the case of tangible property, a brief summary of the overall physical condition of the property at the time of the contribution;

(D) The manner of acquisition (e.g., purchase, exchange, gift, or bequest) and the date of acquisition of the property by the donor * * *

(E) The cost or other basis of the property * * *

“Respondent contends that petitioners’ Form 8283 complied with none of those requirements. Respondent contends that because of those omissions, the entire contribution should be disallowed.” 2011 T.C. Mem. 238, at pp. 54-55.

Petitioners argue substantial compliance. “The Form 8283 attached to petitioners’ return described the subject property by providing its street address, described its condition as ‘Historic Facade Conservation Easement’, and provided no information about Mr. Friedberg’s acquisition of the subject property. The Form 8283 does not, by itself, describe the subject property in sufficient detail for respondent to determine the nature of the contribution. Indeed, it does not even mention the contribution of the unused development rights. However, petitioners also attached to their tax return the appraisal report completed by Mr. …, which describes the contributions of a facade easement and unused development rights in sufficient detail. Petitioners contend that it is not necessary that the appraisal summary reprise everything in the appraisal; they contend it is sufficient if the appraisal summary enables respondent to identify the subject property in the appraisal report, which it does.” 2011 T.C. Mem. 238, at pp. 55-56.

Judge Wells lets the Form 8283 survive the challenge: “In Bond v. Commissioner, 100 T.C. at 41-42, we held that because the Form 8283 the taxpayers attached to their return provided all of the important facts except for the qualifications of the appraiser, the taxpayers substantially complied with the regulations despite their failure to attach an appraisal report to their return. In the instant case, petitioners attached to their return an appraisal report that contained all of the required information, but they failed to fully complete the Form 8283 summarizing the contents of the appraisal report. If, as we held in Bond, a fully completed Form 8283 can excuse the failure to attach an appraisal report under the doctrine of substantial compliance, then, a fortiori, attaching a completed appraisal report may excuse the failure to fully complete a Form 8283 under the doctrine of substantial compliance. Consequently, we conclude that petitioners substantially complied with the requirements of section 1.170A-13(c)(4)(ii), Income Tax Regs. Their minor omissions on the Form 8283 are not enough, by themselves, to disqualify the contribution.” 2011 T.C. Mem. 238, at p. 57.

Takeaway: If you put the bare facts on the Form 8283, but attach the appraisal, you’re OK.

Maybe not, in the case of Thomas and Monica L. Kleber, 2011 T.C. Mem. 233, filed 9/28/11. The issue is when was Farmer Monica relieved of her obligations for past due rent, interest and administrative fee she owed to the U. S. Navy.

Farmer Monica leased land at the NAS Lemoore, CA for agricultural purposes. The lease term was four calendar years, but during Year Two Farmer Monica quit paying rent and at year-end told the Navy she was giving up the farm.

Manning battle stations, the Navy sent Farmer Monica notices of default, lease cancellation notice, demands for payment, and, when these availed not, sent the matter to the Defense Finance and Accounting Services (DFAS), the bill collector, to get the Navy its money. DFAS sent a collection letter and then did nothing for almost a year-and-a-half, then bucked the problem to Treasury Cross-Service Program, who might have been cross but performed no service, and took three years to send the file back to DFAS, stating the bill was uncollectable. A year later, DFAS writes off the debt, and still another year later Farmer Monica gets a 1099-C, Cancellation of Debt, showing $263K of cancelled debt.

Farmer Monica and Husband Tom file their return timely but don’t mention the $263K. Surprise, surprise, 90-day letter follows.

Farmer Monica and Husband Tom petition, saying “Wrong year, amount claimed is wrong, anyway debt cancelled years ago, statute has run, anchors aweigh.”

Take it away, Judge Haines:  “If an information return, such as a Form 1099-C, serves as the basis for the determination of a deficiency, section 6201(d) may apply to shift the burden of production to the Commissioner. Section 6201(d) provides that in any court proceeding, if a taxpayer asserts a reasonable dispute with respect to the income reported on an information return and the taxpayer has fully cooperated with the Commissioner, then the Commissioner has the burden of producing reasonable and probative information in addition to the information return.” 2011 T.C. Mem. 233, at p. 5.

IRS puts in all the dunning letters from the Navy and DFAS, and a timeline showing everything that happened. Judge Haines says that’s good enough to meet the Section 6201(d) burden of production.

OK, but when was the debt actually canceled or discharged? Judge Haines again: “The moment it becomes clear that a debt will never be repaid, that debt must be viewed as having been discharged. The determination of whether discharge of indebtedness has occurred is fact specific and often turns on the subjective intent of the creditor as manifested by an objectively identifiable event.” 2011 T. C. Mem 233, at pp. 6-7. [citation omitted.]

Judge Haines goes on: “There is a rebuttable presumption that an identifiable event has occurred during a calendar year if a creditor has not received a payment on an indebtedness at any time during a testing period ending at the close of the year. Sec. 1.6050P-1(b)(2)(iv), Income Tax Regs. The testing period is a 36-month period increased by the number of calendar months during all or part of which the creditor was precluded from engaging in collection activity by a stay in bankruptcy or similar bar under State or local law.” 2011 T. C. Mem. 233, at pp. 7-8.

Of course presumptions were made to be rebutted, and this the Navy can do if it showed it “…engaged in significant, bona fide collection activity at any time during the 12-month period ending at the close of the calendar year, or if facts and circumstances existing as of January 31 of the calendar year following expiration of the 36-month period indicate that the indebtedness has not been discharged. Significant, bona fide collection activity does not include nominal or ministerial collection action, such as automated mailing.” 2011 T. C. Mem 233, at p. 8.

The documents IRS proffered show no significant collection activity–no lien, no sale of the debt, or anything that an active creditor would do. Letters aren’t enough.

The Navy was asleep on watch.  The debt was canceled long before the year for which the 1099-C was issued, the statute has run, and the ship has left. Oh, by the way, no penalty for Farmer Monica.

Takeaway: Creditors, on deck! Stand to your guns!

Or, Your Dues Include the Magazine

The National Education Association (NEA) publishes two magazines, both of which contain paid-for advertising. The costs of the magazines are included in the annual dues paid by members, and members can opt out of receiving the magazines (but with no reduction in their annual dues). NEA deducted the magazine costs from the advertising revenue, attributed no part of the members’ dues as income to offset the magazine costs (circulation income), and claimed to owe no Unrelated Business Income Tax (UBIT).

Wrong, says Judge Gustafson, in National Education Association, 137 T.C. 8, filed 9/28/11. The key regulation is section 1.512(a)-1(f)(3)(iii).

Judge Gustafson: “The issue for decision is whether NEA must allocate a portion of its members’ dues to the circulation income of those magazines. The parties agree that the outcome of this dispute depends on whether, for purposes of 26 C.F.R. section 1.512(a)-1(f)(3)(iii), Income Tax Regs., membership in NEA gave members ‘the right to receive’ NEA periodicals. If the members had a ‘right to receive’ the magazines, then: (a) a portion of the members’ dues was circulation income; (b) as a result of that income, NEA did not have a loss from circulation activity; (c) NEA’s income from advertising (an ‘unrelated’ activity subject to UBIT) was therefore not offset by any circulation losses; and (d) NEA owes tax on the advertising income. NEA concedes that if the IRS prevails on this issue, then the IRS’s computations are correct with respect to the amounts of membership dues allocable to circulation income for the years at issue.” 137 T.C. 8, at p. 3

Of course, the aim is to prevent otherwise exempt organizations (as NEA would be pursuant to Section 501(c)(5)) from making a profit on selling advertising in their publications to offset their non-publishing operating expenses, giving them an unfair advantage over taxpaying periodical publishers. The Regulations “fragment” taxable advertising income from exempt-function income.

NEA’s key claim was that their members had no “right to receive” the periodicals in exchange for their dues payments. First, NEA could stop publishing at any time, and the members had no legally enforceable right to receive the magazines. Second, NEA put the magazines on-line and not restricted to “members only”.

After much fencing between NEA and IRS, and after parsing of the term “right to receive”; with Judge Gustafson wading through law dictionaries, a U. S. Supreme Court First Amendment decision, Treasury Regulations, IRS Announcements, PLRs and unpublished Technical Advice Memoranda, Judge Gustafson concludes that the member did have the requisite “right to receive” the magazines, and NEA owes the UBIT.

NEA told its members what part of their dues was allocated to the magazines. The magazines were the vehicle by which NEA conveyed essential information mandated by NEA’s constitution and by-laws. Although NEA argued they could have stopped publishing at any time, they didn’t during the years at issue. Moreover, NEA stated in writing that their publication schedule was fixed a year in advance, and NEA had contracts with its advertisers. Result: NEA couldn’t establish that it could stop publication at any time. Thus, the members had enough of a “right to receive” the magazines to satisfy the Regulation at issue.

Finally, the on-line argument falls. NEA argued that anyone can read the magazines on-line, members and non-members alike, at no charge, so it cannot be fairly said that the members received the magazines in exchange for the payment of their dues, and thus had the right to receive them.

Judge Gustafson again, a jurist of great patience: “This contention is contradicted, however, by two facts:

“First, the Internet versions of the periodicals do not include all of the content of the paper editions. The paid advertising and the letters to the editor are available only in the print edition. The record includes no evidence that these features are of no value to members.

“Second, that NEA goes to significant expense and trouble to produce the paper editions shows that paper copies of the periodicals have value even in the Internet era. We take judicial notice of the fact that many periodicals have both online editions that one may access without cost and paper editions for which subscriptions must be paid. Evidently, a market still exists for paper publications. A user who has on-line access to a publication may still value receiving a paper copy. NEA put on no evidence that its members do not value the paper periodicals.” 137 T.C. 8, at p.35.

I can’t write a takeaway any better than Judge Gustafson did: “26 C.F.R. section 1.512(a)-1(f)(3)(iii), Income Tax Regs., requires an allocation of membership dues to circulation income if the exempt organization’s members have a legal right to receive the publications. For the years at issue, NEA members had such a legal right to receive the periodicals. The fact that NEA also made most of the content of the periodicals available on the Internet does not change this conclusion. Consequently, the IRS was correct in requiring NEA to allocate a portion of its membership dues to circulation income.” 137 T.C. 8, at p. 39.

501(c)s and your tax advisers, read and heed. And stand by for the inevitable appeal, as every 501(c) in the country with a magazine will be filing amicus briefs.

I may be preaching to the choir here, as the people who need this advice are the self-represented, the taxpayers who go to Tax Court pro se, because they can’t afford, or don’t want to pay, a tax professional admitted to Tax Court. But maybe the pros who read this can forewarn their “go-it-alone” clients– “don’t ever concede anything you want to dispute at trial anywhere”.

Case in point: Bernard J. Williams and Martha Williams, 2011 T.C. Mem. 227, filed 9/22/11. The fight is over nearly $60K in Schedule C expenses. Bernie was a mortgage broker in the “low dishonest decade” just ended. He claimed he split commissions with other brokers, but had a problem of proof. SNOD and petition both followed.

The tax year was calendar 2006. In November, 2009, Tax Court ordered Bernie and IRS to file a status report by February, 2010, stating “in particular, the progress made towards resolution, by settlement or otherwise, of the issues raised in this matter.” 2011 T.C. Mem. 227, at p. 6.

To paraphrase the late great John Lennon, you say that you want resolution? Judge Morrison takes up the story: “Pursuant to that order, the Williamses and the IRS filed a joint status report on February 5, 2010. The report stated that the Williamses conceded that the IRS’s adjustment to the Schedule C business-expense deductions was correct, which meant that they agreed that the allowable Schedule C business expense deductions were only $6,790. The status report was signed by counsel for the IRS and by both of the Williamses. The IRS pretrial memorandum stated that the parties had settled the adjustments in the notice of deficiency that related to the Schedule C business-expense deductions, a statement which is consistent with what the parties said in the status report. The Williamses did not prepare a pretrial memorandum. When the case was tried on December 8, 2010, Bernard Williams asserted that the Williamses were entitled to Schedule C business-expense deductions for $59,719.92 of commission expenses, an amount in addition to the $6,790.” 2011 T.C. Mem. 227, at p. 6.  [Footnote omitted.]

Maybe Bernie didn’t think the status report was binding on him, or he didn’t understand what he signed, or he forgot about what he signed, and the decision doesn’t say, but he was stuck.

Judge Morrison again:  “The status report bars Bernard Williams from contending that the deductible Schedule C business expenses are greater than $6,790. Whether the statement in the status report is considered a settlement or a stipulation, Bernard Williams is precluded from repudiating it. There is no evidence that it was based on fraud or mutual mistake. Allowing Bernard Williams to contend that the deductible Schedule C business expenses are greater than $6,790 would likely prejudice the IRS, which reasonably thought the issue had been resolved before trial. See Rule 91(e), Tax Court Rules of Practice and Procedure (stipulations are binding, although the Court may permit a party to contradict a stipulation if justice so requires).” 2011 T.C. Mem. 227, at pp. 6-7 [Citations omitted.]

In other words, if you can’t prove fraud or mutual mistake (presumably of fact), you’re stuck. Since you can’t ambush the Indians (see my post “Don’t Ambush the Indians, 4/7/11) or the accountants (see my post “Don’t Ambush the Accountants, Either”, 8/17/11), you can’t ambush the IRS by raising an issue at trial that they thought was disposed of  ten months before.

Nevertheless, Judge Morrison goes the extra mile and lets Bernie try to prove his Schedule C expenses case, notwithstanding that, as a matter of law, he is precluded.

Bernie strikes out. “Even if Bernard Williams is not precluded from contending that the correct commission-expense deductions totaled $59,719.92, he has failed to show by a preponderance of the evidence that he incurred any commission expenses. Although he testified that he paid commissions of $59,719.92, we disbelieve this testimony given the lack of documentary evidence and the lack of corroborating testimony.” 2011 T.C. Mem. 227, at p. 7, manifesting once more the leeway the Courts afford the pro se.

One wonders what the outcome would have been, had Bernie produced documentary evidence and corroborating testimony. Would the ambush have worked? Perhaps the excessive largesse Judge Morrison afforded Bernie was bottomed on the knowledge that his “evidence” would lack any probative value, and not change the resolution of the case .

Bottom line: anything in writing that concedes anything is binding and conclusive, even colloquies in Court that are transcribed. See my post “Mitigation and Inventory”, 4/20/11. Even if you agree to the settlement, your adversary (IRS) is not your friend.

Pro se taxpayer, beware!

Woody Guthrie’s Depression-era ballad comes to the rescue of hard-working Gary A. Lyseng in 2011 T.C. Mem. 226, filed 9/21/11. Gary’s case was tried March 31, 2010; we now get the decision.

Gary will get a 6662(a) accuracy penalty on his unsubstantiated deductions after the Rule 155 computation, but that’s not anything special. What’s of interest is the determination of Gary’s tax home.

Gary was born and raised in Bemidji, Minnesota, and lives with fiancée and Papa in the house he bought years before the year at issue. Like the narrator in Dion’s famous song, The Wanderer, he roamed around around around, working as a laborer in nuclear power plants at inspection time, in Minnesota and other States.

IRS claimed that, since all Gary’s gigs were temporary and in different places, he had no tax home and therefore no travel expenses from Bemidji to wherever. Bemidji might be his domicile and principal place of residence, but that was for his convenience.

But Gary was a staunch union man, and got all his gigs, both in and out of Minnesota, from the Laborer’s Union local in Bemidji.

Judge Swift follows Gary’s wanderings, and then deals with the key issue: “Section 162(a)(2) allows taxpayers to deduct travel expenses incurred while away from home in pursuit of a trade or business. In order to deduct travel expenses a taxpayer generally must show that he or she was away from home overnight when the expenses were incurred. The purpose of the deduction is to alleviate the burden on taxpayers whose business or employment require them to incur duplicate living expenses. For purposes of section 162(a)(2) the word ‘home’ generally means the vicinity of a taxpayer’s principal place of work or employment, not the taxpayer’s personal residence. A taxpayer may be treated as having no principal place of work when the location of his work is always temporary.

“However, when a taxpayer has no principal place of work, and when the taxpayer maintains a personal residence or family home remote from his temporary jobsite, the taxpayer’s home may be treated as his tax home if: (1) The taxpayer incurs duplicate living expenses while traveling and maintaining the home; (2) the taxpayer has personal and historical connections to the home; and (3) the taxpayer has a business justification for maintaining the home.”  2011 T. C. Mem. 226, at pp. 6-7.

Gary has duplicate living expenses (some at least substantiated), and a personal and historical connection to his Bemidji homestead, but what about business reasons?

Judge Swift answers the question: “Petitioner’s union has helped him find work in Minnesota, and it appears reasonable that he will continue to use his union and his address in Bemidji to obtain work in Minnesota…. Petitioner had an adequate business justification for maintaining a home in Bemidji.” 2011 T.C. Mem. 226, at p. 7-8. (Citation omitted)

So Gary prevails as to his tax home. Of course, he still has to substantiate his allowable expenses, where he finds difficulties. But he can join in, with full voice, in Woody Guthrie’s immortal words, “Oh you cain’t scare me, I’m stickin’ to th’ Union….”