Or, What Counts and What Doesn’t

Two Tax Court cases filed 6/9/11, and each is interesting.

As the old saying goes, a short horse is soon brushed, so let’s start with the number–zip code number. In Nahmi Lee, 136 T.C. Mem. 129, it’s all about the statutory notice of deficiency, the “90-day letter.” IRS sent a 90-day letter to Nahmi’s last known address, but with the wrong zip code, another to a former business address now occupied by an unrelated party (who subsequently sent the notice on to Nahmi’s mother, who, Tax Court finds, “is elderly, is not fluent in English, does not sort her own mail, and frequently is away from her residence at the 46th Street location, working in upstate New York. “ 136 T.C. Mem. 129, at p. 4), and still another to a New Jersey address, concededly not the last known address of Nahmi. Nahmi claims the notice was late, and her petition was timely filed.

No, says Judge Jacobs. The zipcode error is immaterial; if the notice is sent to the last known address, receipt by taxpayer is immaterial. Judge Jacobs puts it this way: “This Court has long held that an inconsequential error in the address used in mailing a notice of deficiency does not render the notice invalid. [citations omitted] An error in the address used in mailing a notice of deficiency is inconsequential where the error is so minor that it would not prevent delivery of the notice.[citations omitted].” 136 T.C. Mem. 129, at p. 6. And the Pickering case, Pickering v. Commissioner, T.C. Memo. 1998-142, disposed of the wrong zipcode issue once and for all.

So Nahmi loses, no jurisdiction under Section 6213(a) (90 days means 90 days from mailing, period), petition dismissed.

Takeaway: any mail from IRS gets top-shelf priority.

Now for the name: Retief Goosen, 136 T.C. 27. Goose is a pro golfer, non-resident alien (South African national residing in the UK for years in question), apparently a big enough noise in the pro golfing world to garner endorsements from the likes of Rolex, Acushnet, Izod and Upper Deck, among others. The issue is Goose’s allocation of endorsement revenue between personal services and royalty income, and secondarily between effectively connected US income and non-effectively connected US income.

Goose entered into employment deals with his management firm, who promo’d him while funneling his income from the pro tour and endorsements into Liechenstein and Channel Islands entities, to keep his non-UK earnings from the UK tax man. The UK tax man agreed.

Goose’s success on the course gained him endorsements of two kinds: wearing or using sponsor’s materials in tournaments (product placement) and non-tournament endorsements. In addition, Goose had to make some personal appearances, test equipment, and generally keep his name clean–no sex, drugs or rock ‘n’ roll.

The issue was the allocation of endorsement money. Goose allocated his tournament US earnings as a fraction of his total world-wide earnings. IRS allocated all US tournament earnings to the US, not just the fraction that represented the US share of Goose’s world-wide earnings. IRS and Goose agreed that non-tournament earnings were royalties, not personal service income, but IRS said 25% was US income and Goose said 10%.

No one disputed that Goose was in a trade or business (TOB) when he played golf for money in the US.

Tax Court looked at what Goose and his sponsors agreed to. In some sponsorship deals, Goose had to play in a certain number of tournaments, with bonuses if he won, and keep clean. He also allowed sponsors to use his name and likeness to advertise their wares. Advertisers testified that Goose’s cool, professional image and his upstanding citizen persona were valuable, aside from his substantial golfing prowess.

So the sponsors needed both Goose’s playing skills and his image. Tax Court agrees with Goose, and splits the US tournament money 50-50 between personal services and royalty income, stressing that this is our old pal facts-and-circumstances at work.

Turning to sourcing, royalty income for intangibles is sourced where the intangible is used. Goose tries the UK deal, 25% UK and 75% elsewhere. Tax Court rejects this. Tax Court looks at sales: trading cards and video games with Goose’s stamp on them are mostly sold in the US, so they’re sourced in the US.

On-course and Rolex present a different problem. Goose is a world-wide brand. While Goose’s US wins give him great creds, Goose musters enough evidence to convince Tax Court to refuse to source all Goose’s on-course and Rolex money to the US, and ends up splitting it 50-50.

Now for effective connection. Goose never had a fixed place of business in the US, so he is only taxed on his US-sourced income effectively connected to his US TOB.

Tax Court summarizes the basics: “In the case of U.S.-source income that is effectively connected with a U.S. trade or business, a nonresident alien will be subject to the graduated tax rates applicable to U.S. residents. In the case of U.S.- source income that is not effectively connected with a U.S. trade or business and consists of rents, dividends, royalties or other fixed or determinable annual or periodic income, the nonresident-alien will be subject to a flat 30-percent withholding tax.” 136 T.C. 27, at pp. 32-33.

Any money related to Goose’s participation in golf tournaments is effectively connected. But off-course, where there was no contractual obligation for Goose to show up, play or do anything, is not effectively connected.

Goose claimed the 12/31/1975 US-UK tax treaty, preventing uncoordinated or double taxation of the contracting parties’ nationals protects whatever part of his US-taxed income was received (and presumably taxed) in the UK. But Goose didn’t prove what was actually received in the UK, because his Liechtenstein and Channel Islands fronts got the money, and what they sent to the UK wasn’t categorized as royalty, personal services, or anything else. So Goose bogeyed that hole.

Takeaway- Facts-and-circumstances prevail again. Goose’s witnesses helped his cause. And Tax Court again plays strict rules of golf.

I may be showing my age, but I remember the Natalie Wood, Steve McQueen and Edie Adams 1963 movie so entitled.  The “proper stranger” problem arose for Seven W. Enterprises, Inc., 136 T.C. 26, filed 6/7/11, when they rehired their former Vice-President for Taxation after he had resigned and freelanced while attending law school.

The VP had been a CPA with Deloitte. Seven W. hired him and made him VP for Taxation, in which capacity he served for ten years, until he went back to school full-time, at which point he consulted with Seven W.  per separate agreement but was no longer on the payroll.

While freelancing, VP prepared one year’s returns for Seven W. Thereafter, he came back to Seven W. as VP for Taxation and prepared the next several years’ returns, signing each of them on behalf of Seven W. as VP of Taxation.

But for several years, both when freelance and in-house, VP erroneously concluded that interest on a $4 million-plus promissory note came from within Seven W.’s group of companies, and wasn’t taxable as personal holding company income. Wrong, says IRS and Tax Court; it was from a proper stranger and thus taxable as personal holding company income, so deficiency, interest and accuracy (substantial understatement) penalties rained down on Seven W.

Seeking to duck the Section 6662 understatement penalties, Seven W. raises the standard Section 6664(c)(1) flag: “We relied on our expert preparer.”

OK, says Judge Foley, but only for the freelance year,  not for the years that VP was back in the fold as VP for Taxation. He begins with the basics:  “The determination of whether a taxpayer acted with reasonable cause and in good faith depends upon the facts and circumstances, including the taxpayer’s efforts to assess his or her proper tax liability; experience, knowledge, and education; and reliance on the advice of a professional tax advisor. Sec. 1.6664-4(b)(1), Income Tax Regs.” 136 T.C. 26, at pp. 7-8.

IRS  initially claims the freelance year wasn’t truly freelance, because VP did the same work whether in-house or out-of-house. Wrong, says Judge Foley; there was a real consulting agreement, VP had resigned, the consulting agreement provided that Seven W. did not supervise VP, and Seven W. relied in good faith, so no penalty for the freelance year.

Not so for the in-house years. Aside from what Judge Foley described as Seven W.’s “myriad of mistakes… the result of confusion, inattention to detail, or pure laziness, but we are convinced that petitioners and [VP] failed to exercise the requisite due care.” 136 T.C. 26, at p. 9, VP wasn’t independent.

VP was no longer an independent freelancer, so Seven W.’s case runs hard aground on Reg. 1.6664-4(c)(2): “advice” is “any communication… setting forth the analysis or conclusion of a person, other than the taxpayer”. (Emphasis added.). VP wasn’t a person other than the taxpayer. Corporations can only act through their officers, VP was an officer, and he signed the returns he prepared during the in-house years as VP for Taxation.

Seven W.’s reliance on the foundation excise tax regulations and the REIT regulations to bring VP into the ambit of the house counsel’s opinions exceptions doesn’t fly, because those regulations deal with willful conduct, and also require a “reasoned written opinion”, which VP never supplied.

So Seven W. gets hit for the understatement penalties for the years that VP was under their roof. I have no idea whether VP will remain under their roof after this decision.

Takeaway–Love with the proper stranger. If you want to rely on an expert, find one from outside your shop.

Recordkeeping for Charitable Services

Tax Court carefully reviews the requirements for deducting the value of expenses incurred in rendering services to a Section 501(c)(3) charitable organization in Jan Elizabeth Van Dusen 136 T.C. 25, released 6/2/11. This is a useful review, well worth the time it takes to read the 42 pages of Judge Morrison’s opinion.

Jan was an attorney who took care of feral (that is, wild) cats. She worked with several California charities, principally Fix Our Ferals, which took in wild cats, neutered them, and released them back into the wild. This was a Publication 78 organization, and Judge Morrison took judicial notice of that fact.

The sole issue remaining from the deficiency was a $12K charitable deduction Jan took for her unreimbursed out-of-pocket expenses incidental to her rendering services. Some of these out-of-pockets were expenditures of less than $250, and some were $250 or greater. Of course, the value of her time and labor are not deductible.

As to Jan’s recordkeeping, Judge Morrison said: “Van Dusen introduced the following evidence as proof of her foster-cat expenses: check copies, bank account statements, credit card statements, a Thornhill Pet Hospital client account history, a Costco purchase history, Pacific Gas & Electric invoices, a Waste Management payment history (for garbage removal), and an East Bay Municipal Utility District billing history (for water). All the data in the documents was recorded contemporaneously….Van Dusen states that she initially had more substantial records of her foster-cat expenses, namely itemized receipts, but that her tax preparer, Cary Cheng, told her they were unnecessary for preparing her original return. Those records have since disappeared. Van Dusen compiled the documents she introduced at trial by searching through other records and requesting records from third parties. “ 136 T.C. 25, at p. 11 [footnote omitted].

The “check copies” referred to were photocopies of the carbon copies from Jan’s checkbook; apparently she used checks that made carbon copies as a check was written, and these were acceptable to Tax Court as substitutes for canceled checks or copies thereof.

IRS first contended that Jan was an independent cat rescuer and not affiliated with Fix Our Ferals, which itself was a loose organization of volunteers. Judge Morrison rejected IRS’ position, saying:  “In determining whether a taxpayer has provided services to a particular organization, courts consider the strength of the taxpayer’s affiliation with the organization, the organization’s ability to initiate or request services from the taxpayer, the organization’s supervision over the taxpayer’s work, and the taxpayer’s accountability to the organization.” 136 T.C. 25, at p. 15.  Jan passed the test.

To the extent any of Jan’s claimed deductible expenses served both charitable and personal functions, they were disallowed.

Because of the extensive services Jan rendered, Judge Morrison carefully examined the claimed expenses and apportioned them on a percentage basis between personal items and charitable items. Then Judge Morrison discusses the requisite substantiation requirements.

The money contribution regulations (1.170A-13(a)) apply to nonreimbursed out-of-pocket expenditures. The non-monetary contribution rules impose irrelevant requirements, and most unreimbursed expenses are paid with money. The regulations require that the taxpayer maintain, for monetary contributions less than $250, “(I)n the absence of a canceled check or receipt from the donee charitable organization, other reliable written records showing the name of the donee, the date of the contribution, and the amount of the contribution.” Regulation 1.170A-13(a)(1)(iii).

Tax Court found Jan substantially complied with the requirements, even though her compliance was not strict compliance. The key here is that strict compliance with the Regulation is not required. See Bond v. Commissioner, 100 T.C. 32 (1993).

However, because Jan didn’t get contemporaneous written acknowledgments from Fix Our Ferals when she incurred the $250 and over expenses, she gets none of those deductions.

Note for preparers-Save every receipt for unreimbursed charitable contributions.

Note for volunteers- If you have a large unreimbursed expense, get a statement from the charity describing the services provided, whether or not the donee organization provides any goods or services in consideration, in whole or in part, for the unreimbursed expenditures; and a description and good faith estimate of the value of any goods or services provided by the donee organization.

Or, When is a Return Filed?

That’s what Tax Court had to determine in the case of Martin R. Dingman, 2011 T.C. Mem. 116, filed 6/1/11. Martin had plenty of problems. The C.I.D. nailed him for criminal non-filing, and he pled guilty.

But while the investigation was ongoing, Martin had his accountants prepare returns for the missing years, and Martin’s attorneys handed these returns to the CID. Somehow, never explained by IRS, IRS’ records show checks in the amounts Martin’s attorney tendered to C.I.D. received at a date which would prove Martin right and the statute expired by the date of the later assessment of the Section 6651(a) fraud penalty that IRS was belatedly trying to collect via this levy.

IRS claimed Martin had signed a statute of limitations extension agreement, but never produced it. Likewise, IRS admitted they never served notices of deficiency (90-day letters) (although IRS first claimed 90-day letters were sent). So Tax Court treats this CDP case as one where Martin had no opportunity to contest the assessment, and gives it de novo treatment.

The only question before Tax Court: did giving C.I.D. the returns (and checks in payment of at least some of the tax due) start the clock running on the three-year statute of limitations?

Judge Marvel wades through Regulations, General Counsel Advices, Notices and a bushel-basketful of cases for 37 pages to conclude that, because IRS’ records, incomplete and unexplained as some of them might be, indicate that the checks were paid and therefore the returns (erroneously styled “amended returns”) were in fact received by the critical date, handing them to C.I.D. did effect “filing.”

Burden of pleading and proof rest upon Martin. Even after IRS goes forward with contrary evidence, burden of persuasion still rests on Martin. Judge Marvel credits Martin’s testimony about delivery and expressly rejects IRS’ transcripts, which contain unexplained codes and remarks.

But Martin still faces the “meticulous compliance by the taxpayer with all named conditions,” hurdle from  Winnett v. Commissioner, 96 T.C. 802, 807-808 (1991) (quoting Lucas v. Pilliod Lumber Co., 281 U.S. 245, 249(1930)). In plain English, must apply strict rules of golf, no gimmes, no Mulligans.

Martin clears the hurdle, helped by the IRS Reorganization of 1998. The filing protocols had changed, but not Section 6091 (the filing section) or the Regulations, when Martin’s attorney gave C.I.D. the checks and returns. IRS had earlier issued a Notice trying to clarify the confused situation, but the Notice wasn’t effective as of the date Martin’s attorney handed C.I.D. the returns.

IRS issued Regulations embodying the Notice provisions the next year, and claimed they were mere clarifications and therefore were retroactive. Wrong, says Judge Marvel. There is nothing in the Regulations or anywhere else that say they are to be given retroactivity.

So Judge Marvel goes on to say: “The record does not establish exactly how or when petitioner’s counsel delivered the package of returns and checks to the CID. In the normal case, such a gap in the record would dictate that the taxpayer, who has the burden of proof on the limitations issue, must lose. This is not the normal case, however. [Editorial comment–Couldn’t agree more, Judge!]

“Although the record is not clear regarding the details of the delivery of the tax return package to the IRS, the record clearly establishes two important facts: (1) The tax return package was delivered to the IRS no later than February 19, 2003, and (2) the package was received by an IRS office that had the authority to process its contents. We know these facts because the income tax transcripts in the record confirm that the checks to pay petitioner’s 1996 and 1997 tax liabilities as reported on petitioner’s 1996 and 1997 returns were processed, deposited, and ultimately credited to petitioner’s 1996 and 1997 accounts on February 19, 2003.” 2011 T.C. Mem. 116, at p. 26.

IRS called no witnesses and produced no evidence except the discredited transcripts. IRS only argued a long line of cases holding delivery to a Revenue Agent is not filing within Section 6091. Judge Marvel disposes of this argument summarily: “None of the cases respondent cites involved an attempt by the taxpayer to file executed original returns with payments, and none of the cases involved evidence that the payments made with the returns were actually processed by the IRS and credited to the taxpayer’s account.” 2011 T.C. Memo. 116, at p. 30 [emphasis added].

Finally, and most importantly, in the words of Tax Court: “Moreover, we have held that if a taxpayer submits a return to a person who is not authorized to accept the return for filing and the return is then forwarded to the correct IRS office, the period of limitations commences when the office designated to receive the return actually receives it. See Winnett v.Commissioner, 96 T.C. at 808 (holding that for purposes of determining the beginning of the period of limitations a return is deemed filed when it is received by the ‘revenue office designated to receive such return’); Allnutt v. Commissioner, T.C. Memo. 2002-311 (returns deemed filed when the District Director’s office stamped them received).” 2011 T.C. Mem. 116, at page 35.

Martin wins, statute of limitations expired, no Section 6651 penalty.

Takeaway? Make sure you file per Regulations and Instructions for the form in question, get receipts, and save all copies and canceled checks.

Or, Frivolity Isn’t Free

 So learns Scott F. Wnuck, in 136 T.C. 24, filed 5/31/11.  Scott moved for reconsideration of his frivolous arguments after his petition was dismissed from the bench and he was hit with a Section 6673(a) penalty of $1000.

Moving to the next plateau, Judge Gustafson writes a 27-page opinion deconstructing Scott’s ludicrous arguments, affirms the deficiency theretofore assessed, and ups the frivolity penalty to $5000, warning Scott that any more gaming will result in a higher penalty.

Said Judge Gustafson, “Mr. Wnuck advanced frivolous arguments, as we have shown. Both during Mr. Wnuck’s trial and in the bench opinion served several days later, the Court clearly stated to Mr. Wnuck that it found his positions not just unavailing but frivolous. For that reason the Court, in its original decision, imposed on Mr. Wnuck a $1,000 penalty pursuant to section 6673(a); and the Court warned him of steeper penalties to follow if he persisted.

“Mr. Wnuck disregarded that explicit warning when he filed his subsequent motion for reconsideration. That motion made clear that Mr. Wnuck did not have new points to make; he simply repeated the arguments that had already been ruled frivolous and suggested that the Court should have addressed those arguments in more detail in an opinion. He had to know that his motion was foredoomed, but there was a reason (i.e., an improper reason) for him to file the motion nonetheless.” 136 T.C. 24, at pp. 25-26.

Tax Court upbraids Scott for using the automatic stay on filing a motion for reconsideration to delay the proper assessment and collection of tax. Then Judge Gustafson takes aim at the real harm frivolous behavior causes.

He puts it this way: “Moreover, not only the authoring Judge’s time is involved in producing an opinion. To prepare a Tax Court opinion for public release requires substantial work by law clerks, clerical staff, and the Office of the Reporter of Decisions, as well as other Judges.[Footnote Omitted] A Tax Court opinion is thus the product of considerable institutional effort.

“The substantial effort expended to produce a Tax Court opinion is well spent, even in a small case and even where the outcome is clear, if the contentions being adjudicated are made seriously and in good faith. Taxpayers with disputes both large and small need to know that their good-faith disagreements with the tax collector will get serious attention from this Court. However, the peddlers of frivolous anti-tax positions and their clients who file petitions advancing those positions should not be allowed to divert and drain away resources that ought to be devoted to bona fide disputes. If frivolous positions were to bog down the operations of this Court, the resulting disadvantage would accrue not mainly to the Court itself but rather to litigants with legitimate issues and to the public generally. To responsibly manage its resources, the Court should therefore not address every frivolous argument.”[emphasis in original], 136 T.C. 24, at pp. 20-21.

So peddlers and frivoloteers beware. Frivolity isn’t free.

Practitioners, take a look at the law review article by Chief Judge Cohen, cited in Footnote 11 at page 21 of the Wnuck opinion. It’s an excellent overview of Tax Court Operations.

I see from the Wall Street Journal that the Internal Revenue Service is subpoenaing land records information from the State of California (numerous other States having voluntarily complied), to ascertain who has either failed to pay gift tax or failed to file Form 709 even where no tax was due.

Back to basics: the annual exclusion is still $13,000 per donee; interspousals in any amounts are exempt; and all gifts must be present interests. Likewise, direct payment of medicals and educationals (see my post for 12/31/10, “Economic Substance – A Taxpayer Win”), and payments to charitables and politicals, are all exempt. If all these obtain, no 709 is due. If there are non-exempt transfers or tax is due, a 709 must be filed per taxpayer per year, and must list all gifts not exempt. Tax is due once the lifetime exclusion ($5 million) is reached. Of course, GST is a factor, but I’ll leave that to the side for now.

So suppose tax is due and unpaid. If the donee sold the property to a bona fide purchaser before IRS filed its lien, the BFP is safe, absent guilty knowledge on their part. If not, the donee had better start looking for the donor, or considering transferee liability (see my post for 3/15/11, “A Good Day for Taxpayers”). And remember, if no filing, no statute of limitations protection, so IRS could go back for years to assess and collect tax plus interest and penalties.

But what if no tax is due (probably the majority of cases)? Yes, there’s the minimum $135 Section 6651 non-filing penalty where there is a non-exempt transfer but no tax is due. But is IRS going to file liens all over California for $135 a throw?

I started with Abraham Lincoln. He is reputed to have written the following: “Who can be more nearly a fiend than he who habitually overhauls the register of deeds in search of defects in titles, whereon to stir up strife, and put money in his pocket?” Some things never change.

Not Exactly

So holds Special Trial Judge Dean in Michael Rosenfeld, 2011 T.C. Mem. 110, filed 5/23/11.

Mike was a self-employed public relations consultant, when he pitched the UK Consulate in Los Angeles for work. The Deputy Consul was so impressed he hired Mike for a three-year hitch as a full-time Trade Officer Grade US8. Mike’s engagement letter specified Mike “was required to work 40 hours per week and was not permitted to have outside business interests that could be furthered by virtue of his employment.” 2011 T.C.Mem 110, at p. 10.

The kicker is the engagement letter. That stated that Mike was “self-employed for tax purposes.” Mike took that to mean that his engagement with the Consulate was like any engagement with any client, so he wrote off his business expenses against his pay, and contributed to his SEP based on his business earnings from the Consulate.

STJ Dean goes through the eight factors for common-law employment vs. independent contractor status, and finds for IRS. The Consulate had enough command-and-control, on a fair preponderance of the evidence, to find for IRS, so denies both Mike’s attempts to introduce the UK Consulate Handbook as evidence, and to shift the burden of proof per Section 7491(a). The evidentiary points are of interest to trial counsel, but I leave it to them to parse these directly from the text of the decision.

Two main points: the engagement letter speaks louder than Mike’s uncontested but uncorroborated testimony. “Although petitioner alleged that he was not subject to the BCG’s direction and control, petitioner admitted that the head of the consulate could ask him to prepare or stop assignments and to attend conferences and meetings. His letter of appointment also specified that increases in his annual salary would be awarded only upon satisfactory service. Furthermore, contrary to petitioner’s assertions, the BCG did have the right to modify his employment arrangement. His letter of appointment explicitly stated that the BCG reserved the right to alter his conditions of service at any time.” [footnote omitted; emphasis added]. 2011 T.C. Mem. 110, at p. 9.

Although STJ Dean spends much time on the other seven factors, the letter of engagement is the key. And the Consulate reserves enough command-and-control to scuttle Mike’s ingenious but ultimately self-serving independent-contractor testimony.

What about the “self-employed for tax purposes” language in the letter of engagement? Oh, says Tax Court, that’s to do with payroll taxes; see Section 3121(b) and the Regulations. Employment by a foreign government is not “employment” for FICA and Medicare tax purposes, because IRS cannot levy on a foreign sovereign for its share of those taxes, so their US employees must file Form 1040-SE and pay those taxes. But the self-employment characterization is limited to FICA and Medicare, not income tax.

Mike also gets hit with the 6% excise for excessive contribution to his SEP. His Consulate earnings don’t count. Tax Court does an extensive analysis of Sections 401, 404 and 4979, which I leave to the specialists to decipher.

However, Mike does get a bye. Because for 25 years he had been self-employed, and used the same tax preparer, and because of the complex interface between the engagement letter, Section 3121(b), the Section 404 ramifications, and Mike’s ongoing work for other clients, STJ Dean finds for Mike on the Section 6662(a) accuracy-negligence-disregard penalty.

Takeaway? If you want independent contractor status, review your engagement letter very carefully.

Or, Payback of Loan Principal is Not Income

 Judge Paris so holds in Rick Fishman, T. C. Mem. 2011-102, filed 5/18/11.

Rick ran what amounted to a multi-level insurance sales operation. He first sold policies and recruited subordinates to sell insurance policies; later, as the business grew, he recruited subordinate managers who sold and recruited and managed other salespeople. Every link in the chain was an independent contractor, and IRS doesn’t dispute that.

Because everyone was paid on commission, and because the premium dollars to fund the commissions came in monthly, Rick would advance six months’ worth of commission to each salesperson for each policy sold. If six months’ worth of premium was eventually paid, the salesperson was compensated and owed nothing. But if the premiums remained unpaid for any portion of the six months, the salesperson owed the advanced premium to Rick, with interest.

Likewise Rick would advance certain business expenses to salespeople. He kept what Tax Court called “rudimentary” records, showing advances and repayment to his subordinate managers (called “district leaders”).

There was a written business plan that said all this, and the IRS was given a copy (twice), but the IRS agent never mentioned it in her report.

Now let’s see what Judge Paris said: “Respondent determined deficiencies based solely on the following two-pronged argument: (1) Petitioner paid expenses on behalf of the district leaders and deducted the expenses on his Schedules C; [footnote omitted](2) the district leaders eventually reimbursed petitioner for these expenses, and the reimbursements constituted gross income to petitioner, which he omitted from his return. To establish an underpayment based on this position, respondent must produce clear and convincing evidence that the reimbursements were properly characterized as gross income.” 2011 T.C. Mem. 102, at pp. 16-17.

This IRS could not do. All IRS could show was a stipulation that Rick paid for certain of the salespeoples’ business expenses and that he was reimbursed. But the salespeople were independent contractors and were obligated to repay Rick the sums he advanced.

Tax Court said:  “Simply put, respondent has not produced clear and convincing evidence that the reimbursements constitute gross income.[footnote omitted]. Rather, petitioner’s receipt of the reimbursements gave rise to nothing more than a loan repayment. Because receiving repayment of a loan does not give rise to gross income, respondent has not met his initial burden. Thus, petitioner need not produce evidence of offsetting expenses. Therefore, the Court holds that respondent has not proven that petitioner underpaid the Federal income tax required to be shown on his returns for the tax years at issue. Because respondent did not prove that petitioner underpaid his Federal income tax during the tax years at issue, the Court need not discuss whether petitioner acted with fraudulent intent.” 2011 T.C. Mem. 102, at pp. 21-22.

Moreover, since IRS conceded that, if IRS could not prove fraud, the statute of limitations would bar assessment of deficiencies for the years at issue, Rick walks.

Takeaway: Rudimentary records plus a written and adhered-to business plan are indispensable aids to a winning case.

Sorting through much financial maneuvering, the details of which I’ll spare you,  Judge Marvel gives us a roadmap to business activities that permit a controlled entity to be considered a separate entity for tax purposes, even when there is no substantial business purpose, in Weekend Warrior Trailers, Inc., T.C. Mem 2011-105, released 5/19/11.

Weekend Warrior (“WW”) created a management services C Corp called Leading Edge (“LE”). IRS contended LE was formed with no legitimate business purpose or economic substance, and should be disregarded as a sham. 2011 T.C. Mem. 105, at p. 44.

Tax Court rejects IRS’ position, and expressly denies that it reaches its conclusion on Section 482 grounds.

Citing Moline Props., Inc. v. Commissioner, 319 U.S. 436 (1943), at pp. 438-439, Tax Court states: “Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator’s personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity. [Fn. refs. omitted.]”. 2011 T.C. Mem. 105, at p.45.

Now for the kicker. Moline sets out alternative methods of deciding the validity of a controlled entity. Substantial business purpose is one, and business activity is another; either will do to save the controlled entity. But how do you (or more to the point, how does Tax Court) define an “equivalent of a business activity”, absent a valid business purpose (and Tax Court found none here)?

Judge Marvel tells us, at least based on the facts of this case: “Even if a corporation was not formed for a valid business purpose, it nevertheless must be respected for tax purposes if it actually engaged in business activity. . . .

“Leading Edge provided personnel services to Weekend Warrior. It maintained an investment account and bank accounts. It paid its employees by check, adopted a retirement plan, which respondent does not timely argue was a sham, kept books and records, and engaged Mr. . . . to appraise its stock. Leading Edge invested excess funds and at least from August 2003 through December 2004 purchased and sold stocks and received dividends. Corporate formalities were followed. Leading Edge filed Federal income tax and employment tax returns. We conclude Leading Edge carried on sufficient business activity to be recognized for Federal income tax purposes. 2011 T.C. Mem 105, at pp.48-49.

So bank accounts and corporate books by themselves aren’t enough, it seems. The personnel services and employment tax filings, together with the financial activities, over a 15-month period, seem to save LE.

The takeaway? Even a little substance matters.

If You Rely On State Law, Especially If It’s Unclear

That’s the takeaway from Richard J. and Jacqueline Rocchio, 2011 T.C. Sum. Op. 58, released 5/11/11. It’s another 7463 with some good principles, so you can argue it even if you can’t cite it. Unclear State law could save the taxpayer.

Richard J. was a stockholder in the family Sub S along with his siblings, but the Sub S was run exclusively by Papa. When Mama died and Papa married Wife Number 2, Papa spent all the Sub S’s profits on Wife Number 2 and cut Richard J. and the siblings out. The Sub S was a New York corporation, so under New York law Richard J. and the siblings sued for dissolution of the Sub S.

New York law provides that where stockholders seek dissolution, the non-dissolvers can buy out the dissolvers’ shares at fair value. Papa bought out Richard J. and siblings, but between buy-out and pay-out, the Sub S had taxable income, for which the Sub S filed an 1120-S, and sent Richard J. a K-1. Richard J. did not report the K-1 income on his and Jacqueline’s 1040, claiming he had been bought out before the income was earned and never got any of the income.

IRS sought unpaid tax, interest and Section 6662(a) substantial understatement penalty.

No penalty, says Tax Court. While New York law says you value the stock as of the day before dissolution, New York law seems to be that the stockholder isn’t out until he’s out. There isn’t a totally clear answer from the New York State Court of Appeals, New York State’s highest court. Under New York State’s somewhat eccentric structure, the Court of Appeals is New York State’s highest court; paradoxically, the New York State Supreme Court is its lowest court of general jurisdiction. As they say in New York, go figure.

So while various New York trial courts and intermediate appellate courts say that the bought-out but not paid-out shareholder is entitled to dividends and other income, and perhaps other benefits and burdens of share ownership, given the complexities of Sub S taxation and no clear guidance from the New York Court of Appeals, Richard J. at least had the minimal reasonable basis and good faith excuse for not paying.

He does owe the tax and interest, of course. But Special Trial Judge Armen softens the blow at the very end of his decision: “Finally, we observe, without commenting on the validity of such, that petitioner may have a remedy pursuant to New York State law with respect to the undistributed earnings…reported on the Schedule K-1….” 2011 T.C. Sum. Op. 58, at p. 13.