Even though there are no novel principles of law discussed, I can’t resist the title of this decision, Richard A. Nixon, 2011 T.C. Mem.249, filed 10/25/11. Of course, this isn’t the Richard Nixon (to quote the immortal words of Surgeon Commander Leonard McCoy to Starship Captain James T. Kirk, “He’s dead, Jim”).

This Richard Nixon is Poor Richard,  just a hard-working Dad, who’s entitled to some of the tax breaks for supporting his two kids by his now-divorced spouse, Lowdown Leslie, by virtue of a parenting plan and order of child support entered in Superior Court in Clark County, Washington State.

Unfortunately, though Poor Richard signed a Form 8832, Lowdown Leslie refused to sign, and grabbed for herself the exemptions and credits Poor Richard was supposed to get per plan and order, even though Poor Richard dutifully paid all that the plan and order required. IRS assessed tax by disallowing Poor Richard’s dependency exemptions and child credits.

Poor Richard can’t prove he provided half the children’s support. They lived more than half the year with Lowdown Leslie, and the Form 8832 that Lowdown Leslie refused to sign isn’t worth the paper it’s written on. Besides, the kids were the qualifying children of Lowdown Leslie, under the strict terms of Section 152(d)(1).

Although Poor Richard attached to his return letters concerning the plan and order and Lowdown Leslie’s disreputable tactics, they don’t satisfy the Section 152(e) reasonable equivalency to a Form 8832 test, because Lowdown Leslie didn’t sign them.

So Poor Richard loses.

Judge Vasquez tosses in the boilerplate “tough turkey” language we often see in these cases (see my blogpost “Supported Child, Unsupported Exemption” , 7/11/11): “We are not unsympathetic to petitioner’s position. We also realize that the statutory requirements may seem to work harsh results on taxpayers, such as petitioner, who are current in their child support obligations and who are entitled to claim the dependency exemption deductions or child tax credits under the terms of a child support order. However, we are bound by the statute as written and the accompanying regulations when consistent therewith. Michaels v. Commissioner, 87 T.C. 1412, 1417 (1986); Brissett v. Commissioner, T.C. Memo. 2003-310.” 2011 T.C. Mem. 249, at p. 7.

Maybe Poor Richard would feel Judge Vasquez’s sympathy more if the Judge didn’t use the same boilerplate phraseology as appears in all these cases. Anyway, sympathy or no, IRS and Lowdown Leslie still have Dick Nixon to kick around.

Back in 1962, a young novelist named Robert Gover wrote the cult classic “The $100 Misunderstanding”. The phrase has entered the common lectionary, and I, even I, used it for my blogpost “The $250 Misunderstanding”, 6/3/2011.

Now Congress has added the $500 misunderstanding, via Public Law 112-41, the United States-Korea Free Trade Agreement Implementation Act, which, besides implementing free trade, raises the Section 6695(g) $100 preparer penalty to $500 for each due diligence failure by a preparer on an EITC claim.

In short, one wrong answer out of the two dozen or so required on the Form 8867 due diligence checklist, which now must accompany the return as well as being retained by the RTP, is worth $500 out of the preparer’s pocket. This was touted as an offset to the revenue to be lost by freely trading with Korea. So IRS will be enforcing this, to make sure that those who trade with the Land of the Morning Calm will not unduly deplete our national treasury.

Now how much does the average RTP charge to prepare an EITC return? And who is eligible to request an EITC? Clearly neither preparer nor requester is one of the 1% who feels the ire of the Wall Street Occupiers. And I’ll wager a large sum that no one who requests an EITC is a major trading partner with Korea, or anywhere else.

Now this is a non-partisan blog. I grind no axes here. But who is kidding whom? What level of IRS resources will be deployed to crack down on the $50 per return solo preparer? And when they are driven out of business by the first two penalties (and there is no maximum penalty per preparer or per return under Section 6695(g)), who will prepare the returns? True, the statute makes the RTP’s employer liable, so maybe IRS will concentrate on the franchise operations, which may be good news for the solos. One can but wait and see. I do not even want to contemplate the impact on VITA and other not-for-profit volunteer preparers and their organizations.

We all know that IRS reckons somewhere between 23% and 28% of all EITC filings are improper. But when Congress decrees a 17-part test, accompanied by a mandatory cross-examination worthy of Clarence Darrow in his prime, to provide what is claimed to be tax relief for, but is really welfare to, (presumably) the poorest in our society, what did Congress expect?

In any case, there’s nothing like slipping a Draconian penalty, that hits the bottom of the food chain the hardest, into Section 501 of a massive trade bill. You have to admire a Congress capable of this sort of thing.

Or, Withholding Without Paying Isn’t Withholding

So Mark W. May learns, in Mark W. May and Cynthia R. May, 137 T. C. 11, filed 10/24/11. Mark W. and Cynthia R., supra, gets consolidated for trial with Cynthia R. May, Petitioner, and Mark W. May, Intervenor, but Cynthia gets let out after trial on Section 6015(b) grounds, so Mark W. is the last man standing, except he’s in jail for tax fraud when the petition is filed.

Mark W. owned a 100-employee financial services firm, that he ran with an iron hand and an outstretched arm. He personally controlled all bank accounts, although he signed all checks by electronic facsimile. Anyway, Judge Goeke finds Mark W. was an officer, director, shareholder and financial czar of the firm.

Payroll checks and paystubs were generated by Paychex, an independent data processing firm and payroll preparer. Nevertheless, no matter what Paychex put on the paychecks or paystubs, Mark W. signed the checks (including his own $260,000 annual salary checks). And no matter what the withholding (FICA, Medicare, FUTA, Federal, State or municipal income taxes or whatever) was supposed to be paid, Mark W. never paid any of them. He used the money to run the business.

The forces of righteousness caught up with Mark W., and he was sent to a Federal installation in Kentucky to worthily lament his sins; the record does not state whether Mark W. actually did so.

Mark W. defends against the deficiencies in his income taxes caused by the non-remittance of the required withholding of his own salary on the grounds that Tax Court has no jurisdiction over a deficiency caused by penalties for fraud. This Judge Goeke disposes of via Rice, 1999 T.C. Mem. 65: “Section 6665 provides that ‘additions to the tax, additional amounts, and penalties * * * shall be paid upon notice and demand and shall be assessed, collected, and paid in the same manner as taxes’. A deficiency in tax is assessed, collected, and paid only after respondent makes a determination and sends a notice of that determination in accordance with section 6213, which provides for the jurisdiction of this Court. Eck v. Commissioner, 16 T.C. 511, 515 (1951), affd. per curiam 202 F.2d 750 (2d Cir. 1953). Thus, respondent, in sending a notice determining petitioner was liable for a section 6663 penalty, was complying with the law that requires him to proceed in the same manner as if there were a deficiency. ‘The statute was intended to mean * * * that where such a notice was sent, the Tax Court has jurisdiction.’ Accordingly, a statutory notice from respondent, in which no deficiency is determined, advising the taxpayer that a penalty for fraud is due, is a valid basis for jurisdiction to this Court.” 137 T.C. 11, at pp. 7-8 (emphasis by the Court). Here there is a deficiency and there is fraud, so Mark W. loses that one.

Not to be so easily squelched, Mark W. argues that the amount of withholding of the taxes due, whether or not remitted to the Treasury, is properly to be credited to the taxpayer, namely him. How’s that for chutzpah? “In support of their position, petitioners cite section 1.31-1(a), Income Tax Regs., which states in part that ‘If the tax has actually been withheld at the source, credit or refund shall be made to the recipient of the income even though such tax has not been paid over to the Government by the employer.’” 137 T. C. 11, at p. 10.

In short, having diverted the trust funds, Mark W. wants credit for the funds he stole. Ol’ Mark W. is quite a lad, but Judge Goeke isn’t buying it. “In United States v. Blanchard, 618 F.3d 562, 576 (6th Cir. 2010), the defendant owned and operated his business and withheld taxes from his own paychecks but failed to remit those withholdings to the Government. In affirming the defendant’s conviction under 18 U.S.C. sec. 287 for making a false claim for a tax refund with regard to his personal taxes, the court stated: ‘Rather than creating an overly formalistic division between the personal and official capacities of an individual operating as both employer and employee, which would permit the corporate form to serve as a shield to individual liability, we find it more consonant with the purposes of §287 to conduct a functional inquiry into whether funds due the government left the defendant’s control and so may be deemed ‘actually withheld’ from his wages. * * *” 137 T.C. 11, at pp. 10-11.

So, being functional, Judge Goeke simply reviews the facts. Mark W. ran the show, owned the corporation, signed all the checks, was the responsible person for the withholding payments, was the only person who could make the payments but didn’t, and used the diverted trust funds to run the company (and incidentally pay himself). Though technically subject to withholding, what he really did was generate a phony W-2 for himself.

At the end of the day, Mark W. has fraud penalties, but is allowed a $772 deduction for local income taxes he paid the City of Xenia, Ohio, because he had a canceled personal check.

Takeaway- Withhold means withhold and pay.

Or, Research Is Scientific

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

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

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

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

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

No, said IRS.

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

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

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

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

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

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

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

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

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

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

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

Nothing new here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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