Or, The Whistleblower Gets Supremely Blown

I am in favor of whistleblowers. If they didn’t exist, much skullduggery would go un-dug. Unhappily, many whistleblowers are also among the unrighteous, as it is rare for saints to be present when the skullduggers are plotting or doing the nasty.

Now I was at a CLE this morning at which representatives of our State Attorney General’s Taxpayer Protection Bureau lectured us on Section 194 of our State’s Finance Law. This is our version of the Federal Statute, and it differs from the Federal False Claims Act (“Lincoln Law”), in that taxes are part of the State Finance Law’s scope, unlike the Federal, where tax whistleblowing is found in IRC Section 7623 (and see my blogposts “The Whistleblower Blows It”, 6/20/11, “IRS Loses a Double-header”, 7/12/11, and “Whistleblowers, Beware!”, 9/7/11).

You’ll remember that one of the sharpest arrows in IRS’ quiver for shooting down whistleblowers is that the information tendered is public.  The Supremes said “Amen”, 5 to 3, with Justice Elena Kagan, daughter of my old friend and colleague the late Bob Kagan, Esq., sitting it out, on 5/16/12, in Schindler Elevator Corp. v. US ex rel. Kirk, 10-188.

Kirk spilled the beans on Schindler’s supposed hiring of veterans that never happened, he said, relying on his wife’s Freedom of Information Act request to US Department of Labor. He used the results to back-check Schindler’s list of hires, as he worked for Schindler and was himself a veteran.

The Supremes said that the DOL information was public, available through FOIA, therefore constituted a “report” as defined by FFCA, thus barring any recovery by Schindler.

Now the problem is obvious: it needs the whistleblower to connect the dots. Some dots may be public, some private, some hidden, some in plain sight. But in the immortal words of the late great Bill Klem, “Some is balls and some is strikes, but they ain’t nuthin’ till I calls ‘em.” Somebody has to call ‘em, or at least put it all together, so the party charged with “callin’ ‘em” can in fact call ‘em.

Does no one remember Edgar Allen Poe’s classic short story “The Purloined Letter”? The essential document was in plain sight all along, but disguised. It took an expert’s eye to find it, and an expert’s hand to recover it for the true owner.

If the public policy of the United States is to create a disincentive to the knowledgeable coming forward, who will connect the dots? The Supremes saved pennies, and threw away dollars.

Fortunately, New York State does not bar whistleblowers who use public disclosure in addition to their own knowledge to connect the dots.

But a word of caution. If the whistleblower needs to make a NYS Freedom of Information Law request, let them first craft a disclosure and check in with the Taxpayer Protection Bureau at the Attorney General’s Office, and apply for some “cold comfort” before proceeding.

And in any event beware of the Federal FOIA; here be dragons.

Judge Wherry, again unwhimsical (but see my blogpost “A Whimsical Judge”, 3/6/12), has a lesson for IRS lawyers (but not only IRS lawyers) in Peter Kuretski and Kathleen Kuretski, T. C. Memo. 2012-262, filed 9/11/12.

The tax itself is uncontested, and the levy is sustained based on lack of hardship and the lack of meeting of the minds between AO and taxpayer’s rep on a full-pay installment agreement. Liability was more than the Section 6159(c)(1), (4) limit of $10K and payout more than three years, so no automatic installment agreement, thus IRS has discretion and on the facts here discretion wasn’t abused.

Now for the lawyer issue. IRS wanted the 6654(a) underpayment of withholding addition to tax. As we all know, the rule is 90% of current year’s tax as shown on return (or 90% of tax due if no return filed), or 100% of tax shown on previous year’s return (unless previous year was less than twelve months or no return filed).

But IRS introduces nothing to show what the prior year’s return, if any, showed as tax due, if anything. IRS counsel could have proffered the Form 1040 itself, or Form 3050 Lack of Record, or Form 4340, Certificate of Assessments, Payments, and Other Specified Matters. Instead, “The parties submitted a stipulated exhibit, Form 656, Offer in Compromise, in which petitioners stated that they sought to compromise tax liabilities for the 2006, 2007, and 2008 taxable years. This exhibit suggests that petitioners had a tax liability for the 2006 year but sheds no light on whether it was an income tax liability. In any event, this cursory statement is insufficient for us to determine the tax shown on the return for the 2006 taxable year.” T. C. Memo. 2012-262, at p. 16, footnote 4.

So no addition.

Takeaway- Determine each element of your prima facie case for each claim or defense. Determine what evidence you need to prove or establish each thereof. Obtain, collect and collate your evidence. Offer it.

Or, Portney’s Complaint

This is the sad story of Anthony Tesoriero, and his long-time (but probably by now his ex) accountant, Jack Portney, CPA. Read all about it in Anthony Tesoriero, T. C. Memo. 2012-261, filed 9/11/12, Judge Wherry the Whimsical Judge (see my blogpost “A Whimsical Judge”, 3/6/12) being anything but whimsical here.

Tony’s problem was that his withholding was way low for the year at issue. Jack, not a bit dismayed “…did not adjust the estimated tax liability for wage income and did not adjust the total …payments for withholding credits. Nor did he adjust any entries to reflect Ms. Tesoriero’s income despite the fact that he knew she was employed by petitioner’s corporation.” T. C. Memo. 2012-261, at pp. 3-4 (footnote omitted).

By the way, Tony never told Jack that Ms. Tesoriero was in the process of divorcing him and that she was going to file separately, using another preparer. But that wasn’t all.

Jack, relying on the old SALY principle (Same As Last Year), just toted up Tony’s estimateds, put that number ($69K) down on a 4868, and sent his secretary to post it off via first-class mail. Jack routinely put about half his clients on extension; not uncommon. And used first-class mail, not registered or certified. Also not uncommon.

You can guess the rest. The 4868 never got there, Tony’s actual tax liability was more like $280K, and Tony gets nailed for the Section 6651(a)(1) late-filing penalty.

Tony pleads that Jack mailed the 4868, albeit not registered or certified, nor by a sanctioned private delivery service. Judge Wherry: “This Court has allowed taxpayers to prove delivery through other extrinsic evidence, such as testimony that they mailed the document. Estate of Wood v. Commissioner, 92 T.C. 793, 799 (1989), aff’d, 909 F.2d 1155 (8th Cir. 1990). In certain circumstances, therefore, taxpayers may prove delivery, thus filing, through testimony. But, as we have cautioned taxpayers in the past, when a return is not sent by registered or certified mail, it is the taxpayer, not the Government, that bears the risk of nondelivery. Walden v. Commissioner, 90 T.C. 947, 951 (1988).”  T. C. Memo. 2012-261, at p. 7.

Tony being a New Yorker, Judge Wherry has to follow Second Circuit learning, and Second Circuit isn’t friendly to unorthodox mailers. Section 7502 is the exclusive remedy in New York, Connecticut and Vermont. And that means registered, certified or sanctioned private deliverers…nothing else.

And the new retroactive regulation concerning mailing doesn’t matter: “Respondent contends for the first time in his posttrial reply brief that sec. 301.7502-1(e)(2), Proced. & Admin. Regs, promulgated in 2011 and effective September 21 2004, controls. See 76 Fed. Reg. 52561 (Aug. 23, 2011). Because we are constrained by precedent of the Second Circuit that reaches the same conclusion, we need not address this argument.” T. C. Memo. 2012-261, at p. 8, footnote 4. See my blogpost “Mail Call”, 9/16/11.

Tony is out of luck, and he can’t claim he reasonably relied on Jack to get the 4868 to IRS on time. Reliance on an agent is not reasonable reliance, unless a question of law is involved, such as “no tax due”, but not “I’ll timely file”. Second Circuit is adamant on that point as well. Finally, “petitioner did not produce evidence of such reliance. Petitioner never requested that Mr. Portney file an extension request. Nor did petitioner present evidence that he followed up with Mr. Portney to ensure that the extension request was filed. Mr. Portney did not call petitioner to inform him that an extension request had been filed.” T. C. Memo. 2012-261, at p. 11, footnote 6.

Preparers, pay the two-and-a-half bucks and send it certified (nothing says return receipt requested is required).

And taxpayers, don’t grouse when your preparer charges you the two-and-change for certified mail. It’s truly cheap.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Takeaway- Tell the truth.

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

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

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

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

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

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

Means the start of the tax

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

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

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

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

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

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

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

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

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

Nope, says Judge Swift.

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

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

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

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

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

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

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

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

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

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

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

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

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

Brenda Frances admitted she understated her tax.

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

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

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

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

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

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

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

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

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

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

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

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

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

Did they ever!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

You can’t ambush the IRS.

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

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

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

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

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

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

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