You might be able to deduct the depreciation and get a tax loss, but you must have credentials and show you tried. That’s the takeaway on William L. Weller, 2011 T.C. Mem. 224, filed 9/20/11.

Bill was a Boeing build-up mechanic until he got laid off. Using inherited money, he bought a high-priced glider. He’d formerly instructed with the Boeing Employees Soaring Club, and held the FAA Certified Flight Instructor Airplane, Certified Flight Instructor Instruments, and Certified Flight Instructor Glider qualifications.

While grounded from Boeing, Bill set up a disregarded LLC and started a flying school. He kept the FAA mandated flying logs but no other books and records. He did advertise on the Web and in flying publications, handed out leaflets at flying locations, and worked week-ends during good weather (Bill was based in Washington State). Even when he got another job with a homebuilder, and after he got rehired by Boeing, he kept ‘em flying on weekends, but made no profit once he depreciated the glider. He also flew under the FAA 100-hour radar, which would have required more extensive inspections of his aircraft.

IRS claimed the flying school was a hobby. Flying is fun, Bill never kept business books and records, consulted with experts or formulated a business plan.

Judge Cohen finds for Flyin’ Bill. True, he didn’t have a business plan or business books and records, and he did fly under the 100-hour radar. But he did advertise, he cut out insurance for his glider when business didn’t justify the expense, and his efforts to attract pupils were more than sporadic. It’s true Bill has all the necessary FAA paperwork and did teach flying at the Boeing employees club, so maybe that counterweighs the facts that Bill never spoke to lawyers, accountants or business advisers about how to make money.

True, flying is fun, and Bill flew most weekends in good weather. But full-time employment is not required to show a profit motive, one can have more than one trade or business, and no one is required to prove suffering to show a profit motive.

There’s no evidence that any income was expected from asset appreciation (Bill never claimed his glider would get more valuable), nor had Bill ever conducted a similar business before.

Bill claimed that, without the paper depreciation write-off, he would have made money, but Judge Cohen says you cannot ignore depreciation in figuring profit.

Bill did have full-time employment with the homebuilder after the first year he ran the flying school, and then was rehired by Boeing in his old job title. Said Judge Cohen: “While substantial income from sources other than the activity may indicate that the activity is not engaged in for profit, a taxpayer’s lack of substantial income from sources other than the activity tends to indicate that an activity is engaged in for profit. Sec. 1.183-2(b)(8), Income Tax Regs. The legislative history of the Tax Reform Act of 1969, Pub. L. 91-172, 83 Stat. 487, discloses a particular concern about wealthy individuals attempting to generate paper losses for the purpose of sheltering unrelated income. See H. Rept. 91-413 (1969), 1969-3 C.B. 200, 244-245. We have no such concerns with respect to petitioner.” 2011 T.C. Mem. 224, at p. 13. Bill was no high-flying millionaire.

Finally, IRS did not contest that most of Bill’s flying hours were spent instructing students for pay, or for mandatory continuing FAA qualification.

Bill ultimately comes a cropper on unreimbursed business expenses, but those are unrelated to his flying business, and it’s the usual indocumentado story, no substantiation.

So there’s a Rule 155 computation on those, with penalties if Bill flunks the five-and-ten rule (greater of $5000 or 10% of tax required to be shown). But Bill’s flying business is a business.

No decisions from Tax Court for the last three days, barring one 7463 concerning the tax home of a tugboat captain, and I’d covered that issue in my post “Home Is Where the Heart Is”, 7/21/11.

But take heart; there is news. On August 19, 2011, IRS issued final regulations, effective August 23, 2011 on prima facie proof of mailing of time-critical documents to IRS. See TD 9543, effective for documents mailed after 9/21/04 (that’s no typo, the IRS means 2004). Certified or registered mail is still the only kind of mail that generates the prima facie proof. Even Priority Mail with Proof of Delivery isn’t good enough as prima facie proof, says IRS, because Congress never amended Section 7502(c). You can certainly mail that way, but, if IRS contests receipt, you’ll have to prove that you sent it and that IRS got it, and the printout from USPS isn’t prima facie proof.

TD 9543 says: “Section 7502 does not authorize the Treasury Department or the IRS to adopt a rule that would permit USPS services in addition to certified and registered mail to establish prima facie evidence of delivery. Congress has been clear when it intended to change section 7502 to allow proof of delivery by other means. In 1958, Congress amended section 7502 to provide the IRS with the authority to treat certified mail the same as registered mail. See Technical Amendments Act of 1958, Public Law No. 85-866 (72 Stat. 1606 (1958)). Congress also amended section 7502 to authorize the IRS to publish rules providing the extent to which a PDS is the equivalent of certified mail. See Taxpayer Bill of Rights 2, Public Law No. 104-168 (110 Stat. 1452 (1996)); Internal Revenue Service Restructuring and Reform Act of 1998, Public Law No. 105-206 (112 Stat. 685 (1998)). Similar legislation would be necessary to authorize the IRS to treat additional USPS services as prima facie evidence of delivery.”

Good luck with getting Congress to enact such legislation.

Private delivery services (PDS) are still includable as providing a means of prima facie proof of mailing, if Doug Shulman blesses the service in question.

For the other side of the coin, see my post “The IRS Loses a Double-Header”, 7/12/11, where the IRS couldn’t prove mailing of a determination in a 7623 whistleblower case.

And now, as Monty Python used to say, for something completely different.

Maybe a rant does help sometimes. I see the 2012 Nationwide Tax Forum is coming back to New York City in 2012, on August 28 through August 30. See you there, guys.

That’s what Judge Swift Tells IRS’ Lawyers

 The takeaway from Ada R. Santos, 2011 T.C. Sum. Op. 108, filed 9/12/11, is that lawyers, even IRS lawyers, should really read the law before writing their trial briefs.

The issues in Santos are the dependency deduction, EITC and HOH filing status. Ada supported her 100% disabled son Walter, who got Social Security (SSI) and Medicaid benefits for the year at issue.

Ada wins on all three, because tax law changes effective for the tax year at issue (2005) eliminated the half-of-support requirement. IRS argued that Ada had to show she provided one-half of Walter’s support. No, says Judge Swift, the 2004 amendments did away with that.

“A qualifying child means an individual who:  (1) Bears a qualifying relationship to the taxpayer (e.g., a child of the taxpayer); (2) has the same principal place of abode as the taxpayer for more than one-half of the taxable year; (3) meets the age requirement of section 152(c)(3); (4) has not provided over one-half of his or her own support for the taxable year; and (5) has not filed a joint return with his or her spouse, if any. Sec. 152(c)(1). There is no longer a requirement that a parent claiming a dependency exemption for a qualifying child have provided over one-half of the total support for the child.” 2011 T.C. Sum. Op. 108, at p. 4.

In deciding whether Walter supplied more than one-half of his own support, IRS wanted to include Walter’s Social Security benefits (SSI). OK, says Judge Swift: “The value of government benefits normally excludable from income (e.g., Social Security benefits) may be included in the term “support”. See Turecamo v. Commissioner, 554 F.2d 564,569 (2d Cir. 1977), affg. 64 T.C. 720 (1975); sec. 1.152-1(a)(2)(ii), Income Tax Regs.” 2011 T.C. Sum. Op. 108, at pp. 4-5.

Now the SSI was a known figure, but Walter’s Medicaid benefits weren’t, so IRS argued that Ada couldn’t show how much of Walter’s support Ada, as opposed to Walter via Medicaid, provided for himself.

No fair, says Judge Swift:  “We, however, have acknowledged that payments received under Medicaid are not necessarily included in determining the support of a claimed dependent. In Archer v. Commissioner, 73 T.C. 963 (1980), Medicaid payments received were held not to involve ordinary support for the mother of the taxpayer. The Court noted:

‘To require that Medicaid payments be included inthe support equation * * * means that those individuals whose parents are the neediest will be the least likely to get a dependency exemption for supporting * * *[their parents]. This * * * seems exceedingly unfair and contrary to the basic thrust of the Medicaid program itself. Id. at 971.’

“On the limited record before us, we find it appropriate to exclude Medicaid benefits Walter received in calculating the total amount of Walter’s 2009 support. ” 2011 T.C. Sum. Op. 108, at pp. 5-6.

As a last straw, IRS argued that the value of the support, not the dollar amount alleged or proven actually to have been spent, should govern. No again, says Judge Swift: “In determining whether a qualifying child has provided more than half of his or her own support, the amount of support provided by the child is compared to the total amount of support available to the child. However, we have explained that ‘a taxpayer is not precluded from being entitled to a dependency exemption simply because he is not able to prove conclusively the total cost of the child’s support’. Stafford v. Commissioner, 46 T.C. 515, 517 (1966).” 2011 T.C. Sum. Op. 108, at p. 6.

Judge Swift finds Ada proved her living expenses, that only she and Walter lived in her residence, and that the dollar amount of her expenses allocable to Walter exceeded his SSI by a sufficient margin to establish that Walter did not provide more than one-half of his own support.

Since Walter is a qualifying child, Ada gets the dependency deduction, the EITC and HOH filing status.

Note that Ada tried this case pro se. She did a lot better than IRS counsel.

Or, It’s Still the Same Old Story

Remember poor Murray S. Friedland, who has an unbroken record of disastrous failures in getting his whistleblowing paid for. See 2011 T.C. Mem 90, filed 4/25/11, where he was told by an IRS representative to file with U.S. Court of Federal Claims; that the advice was wrong didn’t help Murray when he filed with Tax Court 217 days after the “determination”, which took the form of the usual “laundry list letter” (see also Cooper, 136 T.C. 30, filed 6/20/11, and my blog “The Whistleblower Blows It” of the same date). Tax Court’s jurisdiction is limited by statute; a rejected whistleblower must knock on Tax Court’s door within thirty days after issuance of the determination. Jurisdiction comes from Congress. Jurisdiction cannot be created by estoppel.

But Murray, nothing deterred, tries again, this time in Murray S. Friedland, 2011 T.C. Mem. 217, filed 9/17/11. Once again, Murray drops a Form 211, Application for Award for Original Information on Ogden, UT. Once again, the laundry list goes forth, which Tax Court knows Murray receives because he starts telephoning IRS asking for reconsideration, objecting to the denial, and doing everything but immediately filing a petition with Tax Court. The last contact Murray has with IRS is March 11. He sends in his petition April 12.

Too late, says Tax Court. Even though IRS again futilely argued that their laundry list letter (“we have the info, it was public record, and we didn’t get any money”), dated in this case March 3, wasn’t a determination within the meaning of Section 7623, IRS still won, even though, as in Cooper, they couldn’t prove mailing to Murray’s last known address. Murray alleged his March 11 phone call and his protests therein, and that’s enough to prove he got the letter.

Moreover, even if Tax Court takes March 11 as the start date for Murray’s thirty days, he doesn’t file until April 12. Too late.

Moral: If you blow the whistle, don’t blow the 30-day filing period. Send in your petition on day one. If necessary, amend as of right or seek leave to amend (see Rule 41(a)). But don’t waste time with telephone calls, prayer or fasting. Get on your bike to 400 Second Street, N.W., Washington, DC 20217.

Or, You Can’t Use It If You Can’t Lose It

Aside from bringing the law up to speed with the technology of the cellular telephone business (and incidentally deciding that holding a license to operate a cellular phone system is not a trade or business, unless you actually are operating the system), Judge Kroupa breaks new ground in the at-risk rules of Section 465 in deciding Robert and Kimberly Broz, 137 T.C. 5, filed 9/1/11.

Bob was a banker who got into the cellphone business in a big way when the FCC ran a lottery for cell license to RSAs (Rural Statistical Areas, areas underserved or unserved by the big cell operators). Bob set up a series of Sub S Corps, some of which would buy and hold the licenses, and another would build out the infrastructure and operate the system.

Bob borrowed money through his operating Sub S to pay for some of his build-out work, and pledged the stock of one of his license-holding sub Ss to secure repayment. The issue for Tax Court was whether the license holder was related, and if so, whether that disqualified the taxpayer from using the loan secured by the pledge of that stock as part of the amount for which he was at risk (and thus could use as basis and take losses currently).

Here’s Judge Kroupa: “We must decide for the first time whether stock in a related S corporation is property used in the business to preclude petitioners from being at risk for any pledge of property used in the business.

“We begin with an overview of the at-risk rules. The at-risk rules ensure that a taxpayer deducts losses only to the extent he or she is economically or actually at risk for the investment. The amount at risk includes cash contributions and certain amounts borrowed with respect to the activity for which the taxpayer is personally liable for repayment. Pledges of personal property as security for borrowed amounts are also included in the at-risk amount. The taxpayer is not at risk, however, for any pledge of property used in the business.” 137 T.C. 5, at pp. 28-29.

The magic words, of course, are “used in the business.”

After disposing of Bob’s assertion that stock in a business is not “used in the business”, because it can be sold without affecting the business’ balance sheet, and therefore is separate from the business, by saying that such an argument is too narrow a view because of the close interrelationship between the two Sub Ss at issue, Judge Kroupa went on: “Pledged property must be ‘unrelated to the business’ if it is to be included in the taxpayer’s at-risk amount.” 137 T.C. 5, at pp. 29-30.[citations and footnote omitted]

The stock is related apparently because the corporations are related. But the ultimate argument is the smell test.

Judge Kroupa again:” Moreover, even if the … stock is unrelated to the cellular phone business, petitioners were not economically or actually at risk with respect to their involvement with the … entities. Petitioners contend that petitioner was the obligor of last resort on the … loan. Petitioners were not actually at risk because they never personally guaranteed the … loan, nor were they ever personally liable on the purported loans to the … entities. Additionally, petitioners were not economically at risk. We have held that where the transaction has been structured so as to remove any realistic possibility of loss, the taxpayer is not at risk for the borrowed amounts. We have already determined that the structured transaction made it highly unlikely that petitioners would experience a loss.” 137 T.C. 5, at pp. 30-31.[citations omitted]

Footnote 12 at p. 30, which I omitted above, adds another wrinkle. Bob pledged the stock that he claimed put him at risk to borrow the money he claimed he lent to his other Sub S. The footnote: “Furthermore, the flush language of sec. 465(b)(2) provides that no property shall be taken into account as security for borrowed amounts if such property is directly or indirectly financed by indebtedness which is secured by the property. The … stock qualifies as “property * * * directly or indirectly financed by indebtedness” because … borrowed the funds from CoBank. Petitioners’ pledge of … stock therefore cannot be taken into account to determine whether petitioners were at risk.”

So be careful before you pledge your stock in one of your Sub Ss to secure a loan for another one of your Sub Ss. Make sure they’re different activities, trades or businesses.

And remember, whether related or not, you can’t use it if you can’t lose it.

I said often enough that this blog is for the in-the trenches practitioner, not the writer of law review articles or newsletters for the two-yacht preparer. But Tax Court has an interesting take that has a good deal of general application.

This was Superior Trading, LLC, Jetstream Business Limited, Tax Matters Partner, et al., 137 T.C. 6, filed 9/1/11.

Judge Wherry was tasked with unraveling this son-of-DAD deal, where, like so many similar schemes, a pseudo but recognized loss is married to a real gain, and immediately afterward the parties unwind the deal, right after the real gain is shielded from tax. Like the currency trade shenanigans (see my blogpost of 4/14/11, “An Option Isn’t a Contract”), the DADs (distressed asset/debt) take distressed debt, which supposedly generates a massive loss, and ties it in to a real gain (the packager of the deal making a fee from selling the scam to the gainer, which is split with the distressed assetholder/debtor).

Take it away, Judge Wherry! “Instead of a claimed permanent tax loss manufactured out of whole cloth, a DAD deal synthesizes an evanescent one. The loss is proclaimed under authority of sections 723 and 704(c) from an alleged contribution of a built-in loss asset by a ‘tax indifferent’ party to a purported partnership with a ‘tax sensitive’ one. However, this loss is preordained to be nullified by a matching gain upon the dissolution of the venture. Consequently, the tax benefits sought by the tax sensitive party are, absent other factors, confined to timing gains. Moreover, claiming these benefits requires sufficient “outside basis”, which, in turn, entails an investment of real assets.” 137 T.C. 6, at pp. 4-5.

So here, a bankrupt Brazilian equivalent of Circuit City, which provided purchase-money financing to its customers who promptly defaulted, contributes all its allegedly worthless consumer paper to a partnership. The Brazilian partner, of course, has no effective connection with, substantial presence in, ever done business of any kind in or with, or even can find the USA on a map. Various characters sell partnership interests to US parties who need a quick write-off. The Brazilians claim their customers’ paper is worthless and take a huge write-off.

This loss winds up on the 1040s of the US investors who bought these partnership interests. Of course, TEFRA administrative partnership adjustments rain down on the heads of the US investors, who Judge Wherry styles as inhabitants of “Mr. Rogers’ Neighborhood.” Only this Mr. Rogers is not a Presbyterian minister, like the eponymous television personality; rather, this dude is Mr. John E. Rogers, who  “has a B.A. in mathematics and physics from the University of Notre Dame, a J.D. from Harvard Law School, and an M.B.A. from the University of Chicago, with a concentration in international finance and econometrics.” 137 T.C. 6, at p. 9. Clearly, Mr. Rogers’ credentials wow even the unflappable Judge Wherry, as he devoted a three-quarter-page footnote to Mr. Rogers’ glowing resume.

But Mr. Rogers’ tiered partnerships and swapping around of distressed debt was only a timing gain. Eventually, the gains would overtake the losses, but the timing benefit could be substantial, resulting in deferral of gain. In any event, Congress slammed the door on such shell games by the American Jobs Creation Act of 2004; distressed debt cannot be allocated among partners–the contributing partner keeps it all.

Ultimately, these pre-Act deals fall apart because the Brazilians and Americans never intended to go into business together. There was no real partnership; the Brazilians carried on their collection activities independently from the Americans, who played their own games on their own playgrounds. There was no common business. Tax Court concludes that the Brazilians sold their distressed assets to the partnership, and bought them back, a process known to some by the arcane technical term as “selling the chumetz”. And it doesn’t fly.

While it’s true that tax benefits can exceed true economic gain without denuding a transaction of economic substance, here there was no substantial business purpose to these partnerships. IRS wins.

At the IRS Nationwide Tax Forum in National Harbor, MD, I was soaking up knowledge and learning, and trying to find something to blog, when two Enrolled Agents from Washington State, Gene Bell and Kathy Hettick, put on quite a show. Aside from blasting through the hot topics on Subchapter S corporations, they dropped a bomb.

IRS is going after preparers, not for the few grand in preparer penalties (remember the poor lady who messed up the late Lawrence Wickersham’s and Dancehall Mary’s return?). No, because by auditing one dud return from a preparer, they can blaze a trail to dozens, if not hundreds, of dud returns perpetrated by said preparer; put the fear of the Righteous Jehovah and the Continental Congress in the hearts, minds and wallets of dozens, if not hundreds, of taxpayers, the erstwhile clients of said preparer; and hand out slam-dunk assessments to said taxpayers at all points of the compass.

Another bonanza, of course, is the Sub S corp, whose one and only shareholder, officer and director is actively engaged in a personal service trade or business, and whose Form 1120-S shows distributions to said one and only shareholder of hundreds of thousands of dollars, but reports no payroll, salary or wages. The S Corp files no Forms 941 and makes no payments of employment taxes withheld. Trust fund violation penalties follow, as well as recharacterization of distributions, assessment of interest, negligence penalties and other sleep-disturbing matters.

In short, beware.

I looked at the day’s Tax Court decisions, seeking diversion. Only one case looked vaguely interesting, Charles R. and Shanda G. Douglas, 2011 T.C. Mem. 214, released 8/31/11, and that not because of Ms. Douglas’ unique given name. No, not because IRS conceded the Section 6662(c) negligence penalty, or that Judge Goeke found that Charley and Shanda relied on their CPA and thus weren’t liable for the Section 6662(a) substantial understatement penalty either, although they did substantially understate their tax due.

The case involves a Sub S Corp, Bantam Leasing, Inc., but Sub S concepts don’t determine the outcome.

No, Judge Goeke unpacks the concept of the idle asset. Here’s Judge Goeke’s take: “…Shanda Douglas was the sole owner and officer of Bantam. Charles Douglas was an employee of Bantam, which operates an over-the-road trucking business.

“Roughly 75 percent of Bantam’s business is classified as ‘critical timing’ delivery services. In this line of work, punctual dispatch of cargo is important as Bantam’s accounts could be placed in jeopardy should Bantam fail to deliver on time. Mr. Douglas believed an aircraft would minimize the risk of losing customers on account of tardy delivery, not by moving freight but by potentially replacing drivers who become ill or who are unable to continue. Mr. Douglas consulted his certified public accountant … about the tax aspects of purchasing an aircraft.” 2011 T.C. Mem. 214, at p. 3.

Charley didn’t do things by halves. He bought one plane, sold it, bought another, wrote off the maximum expense permitted by Section 179, and wrote off operating expenses of the plane as well. Only one problem–Charley couldn’t fly a plane, and neither could Shanda. In fact, Bantam hadn’t a single employee, contractor or drinking buddy who could fly anything.

So Charley took to the skies, but by the time the year at issue arrived, all Charley had was a student license, the aerial equivalent of a learner’s permit. Neither Charley nor anyone else used the plane to deliver a spare driver, a spare tire or anything else. All Charley used the plane for was to take flying lessons.

IRS grounded Charley with a heavier-than-air deficiency. IRS argued that the Section 179 deduction only becomes available when the property is placed in service, that is, ready, willing and able to be used for a specified function. The plane was placed in service, right enough, but the purpose was personal use, not business use. Thus, no deduction.

Charley’s lawyers argued “idle asset”, that is, an asset ready, willing and able but awaiting the right moment for business use.

Judge Goeke shoots that one down (sorry, guys), thus: “Depreciation deductions may be available under the ‘idle asset’ rule in situations where an asset, while not in actual use, was nevertheless devoted to the business of the taxpayer and was ready for use should the occasion arise. See Piggy Wiggly S., Inc. v. Commissioner, 84 T.C. 739, 745-746 (1985), affd. 803 F.2d 1572 (11th Cir. 1986). In the context of the established facts, however, petitioners’ attempt to employ the ‘idle asset’ rule cannot succeed as their aircraft does not fit within the rule’s requirements. The Cessna 172 was not idle in that it was used for training by Mr. Douglas, and it was simply never available for its alleged business function of providing an expedited method of transporting drivers to retrieve disabled vehicles. An aircraft cannot be considered ready and available for business use without a suitable pilot to fly it. …no employees or officers of Bantam held a pilot’s license that would have enabled them to use the aircraft to transport a replacement driver. Petitioners’ vague assertion that there were ‘stand-by pilots’… is not credible. There is no evidence in the record, aside from Mr. Douglas’ statement, that there were any ‘stand-by’ pilots for the aircraft; and there is no evidence at all that would support a finding that Bantam had access to standby pilots on an expedited schedule, which was the alleged business reason for the aircraft. There is no evidence in the record of any agreement between a qualified pilot and Bantam that might suggest his or her availability for the purpose of flying drivers to disabled vehicles on short notice.” 2011 T.C. Mem 214, at pp. 5-6.

So the upkeep and maintenance deductions for the plane also crash, because they were not business expenses.

But, as aforesaid, Charley and Shanda are spared the Section 6662 (a) substantial underreporting penalty. Apparently Charley asked his trusted CPA about business use of aircraft, told her the full story, and relied in good faith on her expertise (presumably that was the last time he will so rely), so Charley and Shanda are off that hook.

I’ve taken the title of one of Hemingway’s lesser novels as the theme of this post, because it illustrates what is necessary both to have not (in the case of Kenneth Lay’s annuity sale) and to have (in the case of the late Clyde Turner, Sr.). And why it is sometimes better to have not than to have.

Clyde’s story is told in Clyde W. Turner, Sr.,  Deceased, 2011 T.C. Memo. 209, filed 8/30/11. Clyde was a self-made millionaire, a World War II vet who went into the lumber business. Judge Marvel tells the Turner story at length, but cutting to the proverbial, Clyde Sr.’s daddy Ollie was the first depositor and pioneer stockholder in a little crossroads Georgia bank that grew into Regions Bank, mutated by phonetic transcription into Regents Bank, 2011 T.C. Memo. 209, at p. 40. Clyde Sr. got the stock, however you spell, it, bought more and never sold nuthin’ never.

Senior set up a life insurance trust for the benefit of his children and grandbabies, but paid the premiums himself, not out of trust assets. These, Judge Marvel ruled, were gifts of present interests, as the trust instrument provided that the children and grandbabies could demand present distributions, thus qualifying them for the annual gift exclusions. Even if the children and grandbabies never even knew they could demand present distributions, if they had the legal right to demand and receive, they had. Therefore the payments Senior made were gifts to them, even though they had not known that they had, and qualified for the annual gift exclusion, therefore Senior had not gift tax liability.

Unhappily for Senior’s heirs, son Marc hired some good ol’ boy lawyers from down the road to help Senior and Miss Jewell, his wife of nearly 60 years, plan for the inevitable. The lawyers put together an off-the-rack limited partnership, using a business agreement they drafted for someone else and adding the word “family” in places. The assets with which Senior and Miss Jewell funded the trust were all bank deposits and long-term buy-and-hold stock positions; though Senior had engaged in some real estate buying and selling, no such assets wound up in the LP.

Judge Marvel found that there was no non-tax business purpose to the creation of the LP. There was no need to centralize management of assets at risk of dissipation or which required special attention. There were no real risks of interfamilial litigation. All that the LP did was create a new bucket into which to drop whatever passive investments Senior had.

Thus, there was no bona fide sale of the assets Senior transferred to the LP, even though the heirs and IRS stipulated that Senior did receive full and adequate compensation in the form of the trust beneficial interests he got in exchange for the assets he contributed.

Moreover, Senior used the trust as an alternate bank account, paying himself a management fee though he did no work, and using the trust to make gifts to his children and commingled personal funds with trust corpus. And as sole general partner, he could amend the partnership agreement without consent of the limited partners.

Thus Senior had the trust corpus at date of death, and after paying estate taxes, his heirs had not as much as they thought they had.

Ken Lay, of Enron fame (or infamy), on the other hand, had not, during his lifetime, so no income tax due. This is the result Judge Goeke reaches in Estate of Kenneth L. Lay, Deceased, Linda P. Lay, Independent Executrix and Linda P. Lay, 2011 T.C. Mem. 208, filed 8/29/11.

While Ken was riding high at Enron, he made retirement noises. The Board, which Judge Goeke deemed independent, wanted to keep him, but Ken wanted spot cash free of tax. So the Board let Ken sell Enron an annuity he had bought from Manulife for a price within 5% of FMV, after much corporate formality, appraisals and complying with State law and the requirements of Manulife, and for no gain above his basis in the annuity contract. So Ken reported no gain in year of transfer.

IRS tried to make much of the fact that Manulife claimed it didn’t receive the originals of the assignments and didn’t change title on their books. No matter, says Judge Goeke. Enron treated the annuity as its own, listed it on the asset matrix in its bankruptcy petition, and faxed copies of all the transfer documents to Manulife. Both Enron and Ken fully performed under their written contract of sale. That Enron sent Ken an amended W-2, showing the sale proceeds as wages, years later, as part of a deal Enron made with IRS during the Enron bankruptcy, didn’t change an already fully consummated transaction.

Equitable title, benefits and burdens, is the test. Enron had, Ken had not. To prove this, Lovely Linda approached Manulife saying she wanted some cash, and asked for it. Manulife told her “no, nacho money.”

IRS tried the Section 83 gambit, that the “sale” was disguised payment of wages, as the annuity supposedly “sold” was not subject to substantial risk of forfeiture. By the terms of sale, if Ken wasn’t fired or quit before 4.25 years, he could get the annuity back from Enron. The sale was golden handcuffs, to keep Ken working for Enron and on the straight and narrow. If he didn’t stay, he wouldn’t get the annuity back. Nor was the annuity segregated or placed in trust, to prevent Enron’s creditors from seizing. So there was substantial risk of forfeiture.

Thus, no non-qualified deferred compensation plan.

So although Ken had $5 million from Enron, he had not a taxable gain.

Back on 3/15/11, in my post “A Good Day for Taxpayers”, I gave scant space to the decision in Christy & Swan Profit Sharing Plan, 2011 T.C. Mem. 62, filed 3/15/11, largely because of my erroneous conclusion that the point was obvious–for a retirement plan to be qualified, it must comply with the Code, as amended, to the letter, whether the plan will actually do any of the acts to which the Code, as amended, pertains. Salvatore Bochicchio, CPA, however, brings me up short. Thanks, Mr. B.

That something is obvious to professionals doesn’t mean it’s obvious to everyone. The traps are set for the unwary, the “unwary” being the nonprofessional, like the unfortunate Mr. Swan, who ran a real estate business with an old-law qualified 401 (a) plan. For the years at issue, Mr Swan was the sole participant and trustee. He missed the amendments required by various subsequent Congressional tweaks, tried to cure them retroactively with a catch-all letter, and ended up with his plan being disallowed years later.

No matter that the amendments had nothing to do with the plan’s real-life operations. Judge Swift said Section 7476 tied his hands. “…(S)ection 7476 ‘does not provide a broad grant of authority to the Court to conduct a review of factual matters related to controversies over retirement plans and to fashion equitable remedies to resolve these controversies’.” 2011 T.C. Mem. 62, at p. 8. Abuse of discretion is the only standard of review. Since adherence to the letter of the law, whenever Congress tinkers with it, is what Congress required, IRS was right to disqualify the plan, and poor Mr. Swan does a swan-dive (sorry, guys).

Now we may worthily lament that the idea of an Internal Revenue Code, with year-to-year stability in place of annual Revenue Acts that left everything up in the air, such as was envisioned by the first Internal Revenue Code of 1939, has gone by the boards. We have instead annual tweaks, adjustments, revisions, automatic sunsets, cliffhanging extensions and non-extensions, and other agents of chaos that make tax planning more like gambling. But we’re stuck with this régime; so we must learn to stop worrying and love the annual Congressional bomb.

Note that IRS threw Swan a rope. Per Rev. Proc. 2008-50, 2008 I.R.B. 35-464, Swan could have made a deal with IRS, paid some money based upon the severity of his transgressions, and received plenary absolution. Swan chose to duke it out instead. Wrong!

Takeaway–Freedom is not free. If you want your plans to benefit from the largesse of Section 401 et. seq., have a professional review your plan. And if you blow it, make a Rev. Proc. 2008-50 deal with IRS. As Mr.Kipling said, “It ‘alves the gain, but safer you will find.”

Thanks again, Mr. Bochicchio.

Or, Six Out of Sixty-Four Isn’t Enough

While I ordinarily wouldn’t spend much time on a run-of-the-mill substantiation case, I couldn’t resist the petitioner’s name in light of the current hurricane brouhaha.

So here is the short story of Jeremiah and Addie Weatherly, 2011 T.C. Mem. 206, filed 8/25/11.

Jeremiah was a bailiff. He hired various casual laborers to help him evict tenants, serve process and move property. Jeremiah claimed he got names, addresses, and SSANs for all his workers.  IRS disallowed all his labor deductions.  On audit, he produced 64 1099-MISCs, but had never filed them with IRS. At the audit, IRS requested Jeremiah to provide Forms 4669, Statement of Payments Received, for all the casuals.

Jeremiah produced eight, but two got bounced for mismatched SSANs. The number of orphan SSANs must be in the millions; SSA was quoted years ago as saying that billions in FICA payments were not credited to individual workers due to mismatches. The reasons varied from illegal immigrants using stolen numbers to people changing their names when they got married and not telling SSA to identity thieves to simple keypunch errors.

IRS concedes the payments to the six as a deductible expense. Jeremiah wants an approximation for the rest.

No can do, says Judge Haines. “Petitioners have not provided contemporaneous books and records to substantiate their contract labor expense for 2005.  Further, Mr. Weatherly failed to testify at trial to the recordkeeping practices of his business. Petitioners merely produced 64 Forms 1099-MISC prepared for the audit without any supporting documentation. These Forms 1099-MISC were not filed with the IRS. Petitioners were able to produce only six valid Forms 4669 for six daily workers, for which respondent conceded a deduction of $25,115. As to the remainder of their claimed contract labor expense, petitioners have failed to substantiate that such an amount was paid. In fact, the evidence submitted does not provide us with a reasonable basis upon which an approximation of an allowed amount of contract labor expense could be made under the Cohan rule. Accordingly, we sustain respondent’s determination with respect to the contract labor expense.” 2011 T.C. Mem. 206, at pp. 4-5.

Moral–Six out of sixty-four is too few.

Footnote– Jeremiah and Addie represented themselves. Further, the amount of the deficiency was more than $67K. Why Jeremiah did not find an attorney to represent him baffles me. Bailiffs tend to have contacts in the legal profession. Nevertheless, Jeremiah and Addie went it alone, and encountered stormy weather.