But It Isn’t Where Your Tax Home Is

So learn Captain Jac Baker and Aircrew Cynthia Baker in JAC E. and CYNTHIA L. BAKER, 2011 T.C. Sum. Op. 95, filed 7/19/2011. Although this is another fact-specific “don’t quote me” Section 7463, the decision goes into the general rules for tax home, and is good CPE reading.

Captain Jac was tugmaster of the vessel Malulani and, for the years at issue, “began and ended each voyage in the Honolulu, Hawaii, port. Each tug voyage lasted approximately 3 days. On eight occasions during the years in issue, Mr. Baker either began or ended his voyage in a port other than Honolulu: five of these occasions were in neighboring islands in Hawaii and three were in the continental United States.” 2011 T.C. Sum. Op. 95, at p. 4. Captain Jac recorded his unreimbursed employment expenses in a calendar he kept.

Aircrew Cynthia flew for Delta for the years at issue, as cabin attendant, based out of JFK. She flew one to four times a month during the years in question, mostly to Europe, but kept no records of the destinations. She shared an apartment near JFK with nine other aircrew, but proffered no evidence of what she spent there.

Captain Jac and Aircrew Cynthia were married. They lived in Washington State, apparently because it was the most appealing dry land halfway between JFK and Honolulu. Each deducted their travel expenses from and to their Washington State home, claiming that was their tax home.

No, says Special Trial Judge Dean. Aircrew Cynthia’s tax home is JFK, and Captain Jac’s is Honolulu. Both were permanent employees, whose employment was of indefinite duration. Although each claimed unreimbursed employee expenses, neither filed Form 2106 for the years at issue, although they did reduce the expenses claimed by the 2% AGI “floor”.

Captain Jac and Aircrew Cynthia tried to shift burden of proof via Section 7491, but their recordkeeping doesn’t pass muster.

They based the deductions at issue on Section 162. Special Trial Judge Dean: “Section 162(a)(2) allows a taxpayer to deduct traveling expenses, including amounts expended for meals and lodging, if such expenses are: (1) Ordinary and necessary, (2) incurred while away from home, and (3) incurred in the pursuit of a trade or business. Commissioner v. Flowers, 326 U.S. 465, 470 (1946). ‘The exigencies of business rather than the personal conveniences and necessities of the traveler must be the motivating factors.’ Id. at 477.” 2011 T.C. Sum. Op. 95, at p. 10.

The fact that Captain Jac and Aircrew Cynthia are married doesn’t mean that each can’t have a tax home separate from the other. While they may be together till death do them part,  for tax purposes they can be spread across the world.

Captain Jac’s tugboating endeavors almost always started in Honolulu; only rarely did he ever start anywhere else. He had a permanent place of employment for tax purposes. Aircrew Cynthia likewise was home-ported, out of JFK, and rarely if ever flew from anywhere else.

Temporary employment (what I used to call TDY in an earlier incarnation), of limited duration and a sufficient distance from one’s tax home, might allow the deduction of unreimbursed employee expenses for travel. Not here. They were permanently based elsewhere than Washington State, and their personal preferences decided where they made their permanent residence.

However, Captain Jac and Aircrew Cynthia get a bye. They used the same CPA for all the years at issue, and for years before (I somehow doubt they will use him or her for subsequent years). Special Trial Judge Dean concluded: “…considering the totality of the facts and circumstances, we are satisfied that petitioners, who used the same C.P.A. for the years in issue that they had used for several prior years, acted in good faith and come within the reasonable cause exception of section 6664(c)(1). Accordingly, we hold that petitioners are not liable for the section 6662(a) accuracy-related penalties for the years in issue.” 2011 T.C. Sum Op. 95, at pp. 21-22.

But You’re Not a Pro If Gambling  Isn’t Your Full-Time Job

 So learns Randy L. Moore, in 2011 T.C. Mem. 173, filed 7/18/11. Randy delivered food and worked as a traveling x-ray technician. But he spent his every spare moment at the casino, working the slots. He claimed he was a professional gambler, filed Schedule C so claiming, but his expenses were $40K and his winnings only $25K. He claimed a $15K loss against his x-ray wages.

Everyone agrees that gambling losses can be offset against gambling winnings, but any other gambling expense can only be deducted by professional gamblers. Likewise, non-professionals offset their losses against winnings via the Other Income line on Form 1040 for winnings, and on Schedule A for losses. Schedule C is for pros only.

IRS first raised the issue of Randy’s pro status at the answer stage of the proceedings, so IRS had Rule 142(a)(1) burden of proof. IRS claimed that Randy never replied to the answer, so their allegation of his non-professionalism must be deemed admitted under Rule 37.

No need to go there, says Judge Morrison; the trial record is sufficient to show that Randy is an amateur without any deemed admissions. Even though having the burden of proof, IRS discharges it easily.

Randy kept no records. His winnings were established by W-2Gs from two casinos.  Judge Morrison said: “Moore said that he called the IRS in 2004 to ask how to keep track of his gambling losses and that the IRS told him he could use bank statements. Moore claimed to have kept bank statements as records of his gambling transactions, but he did not present any bank statements as evidence.” 2011 T.C. Mem. 173, footnote 3, at pp. 3-4.

Judge Morrison went on: “Other documents from the two casinos purportedly have more data on Moore’s gambling activities, but we do not find the documents comprehensible or reliable.” 2011 T.C. Mem. 173, footnote 4, at p. 4.

Randy never studied gambling in a systematic way (he said he “read a couple books” about gambling, but aside from showing ignorance of the partitive genitive, that was insufficient to show professionalism). He never made a profit gambling, and his gambling certainly afforded him personal pleasure. The greatest part of his income came from his work as a rambling x-ray technician. In fact, he adjusted his gambling time around his x-raying gigs.

Randy apparently (because he never cited it by name) relied on “Commissioner v. Groetzinger, 480 U.S. 23 (1987), which he said supported the notion that he was a professional gambler because he gambled ‘full time’. But Moore’s situation differs from that of the taxpayer in Groetzinger…. The taxpayer in Groetzinger gambled 60 to 80 hours a week for 48 weeks during the year at issue and had no other employment.” 2011 T.C. Mem. 173, at p. 12. Randy was rambling around x-raying 40 hours per week during the year at issue.

So Randy falls foul of Regulation Section 1.6662-4(d)(3)(ii), which provides that an authority is not relevant if materially distinguishable on its facts. Randy was negligent, and if the Rule 155 recomputation shows substantial underpayment, Randy gets the 20% penalty. PS- Randy also left out almost $8900 of wages on his return.

So Randy may have been a rambler, but he wasn’t enough of a gambler to qualify as a pro.

Or, Drafting the Credit Shelter Trust

 Hints for drafters of credit shelter trusts (those designed to remove all non-taxable assets from an estate and pass them on to the heirs) are always useful, and some good ones can be found in Estate of Ann R. Chancellor, 2011 T.C. Mem. 172, filed 7/14/11.

Ann’s husband Lester predeceased her, creating through his will a trust wherein he placed all non-taxable assets, to the maximum amount permitted by law (the so-called unified credit). Judge Thornton takes up the story: “Under the terms of the trust as stated in the will, during decedent’s lifetime the cotrustees were authorized to apportion trust income among decedent, Mr. Chancellor’s children, and Mr. Chancellor’s grandchildren (the beneficiaries) ‘in accordance with their respective needs.’ The cotrustees were also given the right and power to invade the corpus of the trust and to use such part thereof and if necessary, all of it, for the necessary maintenance, education, health care, sustenance, welfare or other appropriate expenditures needed by * * * [Mr. Chancellor’s] wife and the other beneficiaries of this trust taking into consideration the standard of living to which they are accustomed and any income available to them from other sources.’” 2011 T.C. Mem. 172, at p. 2.

Ann’s 706 didn’t mention the trust assets. IRS said she had a general power of appointment over the trust corpus, so they should have been included, and assessed a deficiency.

No question that this is a power of appointment, as Ann could have directed the trust corpus to herself or the kids and grandkids. But the Section 2041(b)(1)(A) exception saves a general power if it is “limited by an ascertainable standard relating to the health, education, support, or maintenance of the decedent”.

So we have a two-part test:  “ascertainable standard”,  and “relating to health, education, support or maintenance”.

Lester’s estate plan passes both tests. First, IRS concedes that the “taking into consideration the standard of living to which * * * [the will beneficiaries] are accustomed” satisfies the ascertainable standard test. “Accustomed standard of living” has gotten around the Section 2041(b) slalom for years.

Now for the “relating to the health, education, support, or maintenance” test. IRS says the “welfare or other appropriate expenditures” language flunks the test–too broad. Not so, says Judge Thornton: “maintenance and sustenance” are not restricted to the bare necessities of life. And the “welfare or other appropriate expenditures” language is limited by “taking into consideration the standard of living to which they are accustomed”.

So Ann’s estate is off the hook. And drafters of credit shelter trusts have another phrase for their form files.

Or, If You Mail It, You Have to Nail It

The mailing dates, that is. Proving mailing dates is a critical matter for the IRS. Where most mailing requirements specify certified mail, this is (or should be) a non-issue, as the USPS issues date-stamped receipts and makes on-line tracking easily accessible.

But not in the Section 7623(b) “whistleblower” situation; Congress did not specify how IRS gives notice of determination of a whistleblower claim. This case comes from the time when IRS used ordinary mail. But there was no mailing log kept or PS3817 proof of mailing obtained in the case of Kenneth William Kasper, 137 T.C. 4, filed 7/12/2011.

Kenneth William caught a corporation and its CEO playing games with overtime and the payroll taxes arising therefrom. He filed Form 211, Application for Award for Original Information, a/k/a Whistleblower. Three months later, he got an acknowledgement letter from IRS, stating his claim was bifurcated, one claim being against the corporation, the other against the CEO. IRS claimed they denied both claims three months after that, with a boilerplate letter in each case, asserting that the real reason for denial was confidential under the tax laws, but giving the usual laundry list of possible bases for denial: “(1) The application provided insufficient information; (2) the information provided did not result in the recovery of taxes, penalties, or fines; or (3) the Internal Revenue Service (IRS) already had the information provided or such information was available in public records.” 137 T.C. 4 at p. 4.

In the words of the old song, “it was clear as mud but it covered the ground”.  Only Kenneth William claimed he never got either letter. Kenneth William wrote the IRS eleven months after the alleged denial letters had been mailed, stating the corporation had settled with IRS   and when was he getting his? Oh no, said IRS, we told you a year ago you were out of luck.

Kenneth William immediately petitioned Tax Court. IRS said no jurisdiction, you’re too late, and anyway we never made a determination within the meaning of Section 7623 (those letters aren’t a determination), so if you’re not too late you’re premature.

Wrong on both counts, says Judge Haines. First, the denial letters are determinations. See Cooper, 136 T.C. 30, filed 6/20/11, and see my blogpost “The Whistleblower Blows It”, 6/20/11. I’m following Cooper, says Judge Haines. IRS said “no” to Kenneth William; and that is a determination, at least as to his CEO claim.

Next, as to mailing of the determinations, Kenneth William’s petition is timely as to the CEO, and premature as to the corporation, as IRS can’t prove they mailed either the corporation or the CEO determination to Kenneth William at a time which would make his petition untimely. When Kenneth William wrote IRS asking for his share of the take from the corporation, his letter referenced the CEO claim number, and IRS sent him a copy of the CEO denial letter, not the corporation denial letter. He claims he never got the corporation denial letter.

Judge Haines now scrutinizes the IRS’ whistleblower notification procedures. “During the time relevant to this case, the standard practice within the Whistleblower Office was to prepare a denial letter and scan it into e-Trak, the Whistleblower Office’s computer database. Thereafter, history notes were written or typed, dated, and then entered into e-Trak as an investigation history report. A copy of the denial letter was placed in a paper file. “Standard mailing procedures for denial letters required that the original denial letter be placed by a clerk in an envelope addressed to the whistleblower claimant at his or her last known address and deposited in the Whistleblower Office’s outgoing mail. At the end of each day, a clerk took the outgoing mail to the facilities mailroom, where mail was picked up daily for delivery by the U.S. Postal Service. None of the letters were sent by certified or registered mail, and a mailing log was not kept. “The e-Trak system and the investigation history reports indicate that the Whistleblower Office’s standard procedures were followed in petitioner’s case. Moreover, the denial letters were addressed to petitioner at his last known address and were not returned to the Whistleblower Office by the U.S. Postal Service as undeliverable.” 137 T.C. 4, at pp. 5-6.

Unlike the lien and levy notice provision of Section 6330(d), with its certified mail language, Section 7623(b) doesn’t say how notice of determination must be given. The then current IRS manual was unclear, although the later version, inapplicable to Kenneth William, required certified mailing.

Judge Haines states the IRS argument: “The Government is generally entitled to a rebuttable presumption of delivery upon presentation of evidence of proper mailing. Although the Whistleblower Office did not have a certified mailing requirement at the time the denial letters were issued, respondent [IRS] argues there is a strong inference of delivery when it is shown that the Whistleblower Office complied with its internal procedures for mailing of the denial letters in the regular course of its operations.  A strong inference must arise from more than unsupported conclusory statements of an individual based on his assumption of how mail was handled in the normal course of business in his office. “Respondent argues that the standard operating procedures within the Whistleblower Office were followed to prove that the denial letters were mailed. The Whistleblower Office’s e-trak (sic) system was described. The e-Trak system is a computer record which indicates that a denial letter was sent but does not confirm where it was sent, to whom it was sent, or whether it was a part of the Whistleblower Office’s outgoing mail. Nor was there a mailing log.” 137 T.C. 4, at pp. 12-13. (Citations omitted).

These “unsupported conclusory statements” came from the declaration of one Bradley DeBerg, at the time the chief of the IRS whistleblower office in Ogden, UT, in support of IRS’ motion to dismiss.

Judge Haines gives Mr. DeBerg and IRS short shrift. “Although evidence of standard practice will be afforded appropriate weight as the circumstances of each case require, we cannot find that compliance with standard practices within the Whistleblower Office, standing alone,  permits a finding that the denial letters in question were mailed to petitioner…. The date a determination is mailed is of critical importance to establish our jurisdiction to review a taxpayer’s case. We will hold we do not have jurisdiction when a taxpayer does not meet the 30-day requirement. And as we have emphasized in cases involving our jurisdiction: ‘In this setting, we must require * * * [the Commissioner] to prove by direct evidence the date and fact of mailing the notice to a taxpayer.’ Magazine v. Commissioner, 89 T.C. 321, 326 (1987).” 137 T.C. 4, at p. 14.

So sorry, IRS, Kenneth William’s CEO petition is timely, because you never provided direct evidence that you denied anything until you replied to his inquiry as to the CEO claim and he promptly petitioned. And as to his corporation claim, you still haven’t told him anything, so he can’t petition until you do.

Takeaway- If taxpayers need good records, so does IRS.

Or, You Must Follow the Form

This lesson comes the hard way for Mickel and Mary Briscoe, in 2011 T.C. Mem. 165, filed 7/11/11. Mickel and ex-wife Nedra had a son, J.B., then they divorced. The divorce decree gave Nedra sole custody of J.B., but awarded her child support. Mickel paid; Nedra asked for more. The Louisiana Court gave it to her, but decreed that Mickel would get the dependency exemption. Mickel paid the increased amount.

Mickel and current wife Mary filed their 1040 for the year in issue and attached the second decree, which Nedra had signed but which did not contain Nedra’s SSAN or specify for what years Mickel would get the exemption.  Mickel and Mary claimed J.B. as a dependent, but so did Nedra, who either forgot about the decree or didn’t care. Neither Nedra nor Mickel and Mary attached Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, to their respective returns.

To be a dependent, one must be a qualifying child or qualifying relative. J.B. isn’t Mickel’s qualifying child because he didn’t live more than half the year with Mickel. Nor he is Mickel’s qualifying relative. See Section 152(d)(1)(A)- (D). Judge Vasquez said: “The two pertinent requirements are that the taxpayer must provide over one-half of the individual’s support for the taxable year and the individual must not be a qualifying child of the taxpayer or of any other taxpayer for the taxable year. Sec. 152(d)(1)(C) and (D).

“Mr. Briscoe did not substantiate the amount of J.B.’s support from all sources…. Mr. Briscoe also did not establish that J.B. was not a qualifying child of any other taxpayer….” 2011 T.C. Mem. 165, at pp. 3-4.

However, there is a savings clause,  Section 152(e)(1) and (2). Judge Vasquez unpacks the clause: “A child will be treated as the noncustodial parent’s qualifying child or qualifying relative if five requirements are met. See sec. 152(e)(1) and (2). The relevant requirements here are that the custodial parent sign a written declaration, in such manner and form as the Secretary may prescribe, that the custodial parent will not claim the child as a dependent and that the noncustodial parent attach that declaration to the noncustodial parent’s return for the taxable year. Sec. 152(e)(2)(A) and (B).

“The Internal Revenue Service issued Form 8332 in order to standardize the written declaration required by section 152(e). See, e.g., Chamberlain v. Commissioner, T.C. Memo. 2007-178. Form 8332 requires a taxpayer to furnish: (1) The name of the child; (2) the name and Social Security number of the noncustodial parent claiming the dependency exemption deduction; (3) the Social Security number of the custodial parent; (4) the signature of the custodial parent; (5) the date of the custodial parent’s signature; and (6) the year(s) for which the claims were released. See Miller v. Commissioner, 114 T.C. 184, 190 (2000), affd. on another ground sub nom. Lovejoy v. Commissioner, 293 F.3d 1208 (10th Cir. 2002). Although taxpayers are not required to use Form 8332, any other written declaration executed by the custodial parent must conform to the substance of Form 8332. See id. at 189. The general instructions for Form 8332 state that a divorce decree may be attached to the Form 1040 instead of Form 8332 if the decree states all of the items listed above, specifically the years for which the claim is released and the custodial parent’s Social Security number. Section 152(e) allows a noncustodial parent to claim the dependency exemption deduction only when that parent attaches a valid Form 8332 or its equivalent to a Federal income tax return for the taxable year for which he or she claims the dependency exemption deduction. See Paulson v. Commissioner, T.C. Memo. 1996-560.” [Footnotes omitted.]  2011 T.C. Mem. 165, at pp. 5-6.

Mickel attached the divorce decree, but it didn’t specify the years for which Mickel was to utilize the exemption, nor did it state Nedra’s SSAN.  So no exemption, and no Child Tax Credit, even though Mickel did support J.B.

Judge Vasquez sees how hard this hits Mickel and Mary: “We are not unsympathetic to petitioners’ position. We also realize that the statutory requirements may seem to work harsh results to taxpayers, such as Mr. Briscoe, 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.” [Citations omitted.] 2011 T.C. Mem. 165, at pp. 7-8.

Takeaway for family lawyers: make sure your decrees allocate exemptions and credits specifically, and follow the Form 8332 six-part release tests. Judge Vasquez said five, but I count six.

To Get your Section 475 Trader Benefits

That’s the story in Richard Kay, Jr., 2011 T.C. Mem. 159, filed 7/6/11. Richard owned and operated a ball bearing business, but he claimed as well to be a day trader. So he took the mark-to-market year-end Section 475(f) election for all years at issue. That means he could take losses based on last-day-of-year prices even if he didn’t dispose of the stock.  And traders can take paper losses against ordinary income without limit, unlike investors who are limited to the $3000 capital loss limitations.

But Judge Cohen disposes of Richard’s trader status thus: one who buys and sells securities is either a dealer, a trader, or an investor. No one says Richard is a dealer. Richard says “trader”, IRS says “investor”.

A trader is one who buys and sells for his/her own account as a trade or business; an investor likewise buys and sells for his/her own account, but is not engaged in a trade or business. So the question is the one Tosca asked Scarpia: “Quando?” “How much?”

How much trading activity did Richard actually engage in, while also running the ball bearing business?

Not enough, says Judge Cohen: “In determining whether a taxpayer is a trader, nonexclusive factors to consider are: (1) The taxpayer’s intent, (2) the nature of the income to be derived from the activity, and (3) the frequency, extent, and regularity of the taxpayer’s securities transactions. Purvis v. Commissioner, 530 F.2d 1332, 1334 (9th Cir. 1976), affg. T.C. Memo. 1974-164. For a taxpayer to be a trader, the trading activity must be substantial, which means “‘frequent, regular, and continuous enough to constitute a trade or business’”. Ball v. Commissioner, T.C. Memo. 2000-245 (quoting Hart v. Commissioner, T.C. Memo. 1997-11). A taxpayer’s activities constitute a trade or business where both of the following requirements are met: (1) The taxpayer’s trading is substantial, and (2) the taxpayer seeks to catch the swings in the daily market movements and to profit from these short-term changes rather than to profit from the long-term holding of investments. King v. Commissioner, supra at 458-459; Mayer v. Commissioner, T.C. Memo. 1994-209.” 2011 T.C. Mem, 159, at pp. 7-8.

Over the three years at issue, Richard made fewer than a thousand trades. While he traded in big numbers, the amount of money involved is not dispositive. Richard actually traded on just 29 percent, 7 percent, and 8 percent, respectively, of the possible trading days in each year at issue. Moreover, his trading wasn’t in-and-out, the kind of quick-flip of a trader looking to make profits on a series of trades. He held most stocks for more than a day, unlike the trader who does not let the sun set on his/her portfolio.

And most of Richard’s income came from, and most of his time was spent on, the ball bearings, not the stock market.

In short,  Richard is an investor, not a trader.

Takeaway- As the lottery slogan says, “ya gotta be in it to win it.”

 No, Not a Misprint – The Day of the IRA

Judge Wherry pitches a double-header today, coming off the July 4 layoff, with Ronald V. and Donna-Kay Swanson, 2011 T.C. Mem. 156, filed 7/5/11, and Robert K. and Joan L. Paschall, 2011 T.C. 2, also filed 7/5/11.

The facts in the two cases scarcely differ in any material respect. Both Messrs. Paschall and Swanson are high-priced engineers with major corporations, at or near retirement. Both had traditional IRAs, either self-started or rollovers from 401(k)s. Both faced heavy-duty income taxes on MRDs or earlier withdrawals, and both had heard about converting to Roths. The bad news, even if one could meet the $100K or less MAGI and could convert without limit at that time, was that one would have to pay income tax on whatever portion of the IRA being converted exceeded one’s basis (and basis was basically contributed post-tax dollars; but one couldn’t contribute post-tax dollars if one was a participant in a qualified plan, and both were). What to do?

Enter Jim Patton, financial adviser. He counseled both Messrs. Paschall and Swanson to talk to A. Blair (“Smokey”) Stover, then a partner at Grant Thornton, at the time the fifth largest accounting firm in the country. Smokey had the sorcerer’s stone for converting taxable IRAs into non-taxable Roths, without paying income tax in between. For a mere $120K, payable out of one’s IRA, Smokey would work his magic, and Grant Thornton would defend and indemnify Messrs. Swanson and Paschall from and against interest and penalties.

Sounds too good to be true? It was. Smokey bit the dust in US v. Stover, 731 F. Supp. 2nd 887 (USDC W. Dist. Mo., St. Joseph Div., 2010), wherein the IRS got a permanent injunction against Smokey’s shennanigans. And Judge Wherry takes judicial notice of Smokey’s crash-and-burn.

What Smokey did was create a pair of shell corporations for each taxpayer, rolled their traditional IRAs into new IRAs in each shell, paid the traditionals into new Roths, merged the shells, and gave taxpayers a “tax-free” distribution out of the “new” Roths. There was no business purpose for the three-card monte game.

Judge Wherry unpacks the transaction, and then disposes of Paschalls’ statute of limitations argument. Paschall filed their 1040s timely, but never filed Form 5329 for any year at issue, and argued that the 5329 was just an addition to the 1040. To demolish this argument, Judge Wherry cites US Supreme Court learning in Com’r v. Lane-Wells Co., 321 U.S. 219, at pp. 223-224 (1944): “[A] taxpayer does not start the statute of limitations running by filing one return when a different return is required if the return filed is insufficient to advise the Commissioner that any liability exists for the tax that should have been disclosed on the other return * * * the relevant inquiry is whether the return filed sets forth the facts establishing liability. * * *”2011 T.C. 2, at pp. 13-1

Paschall’s 1040s made no mention of Smokey’s smoke-and-mirrors IRA game, so no statute of limitations applies. Said Judge Wherry: “Upon review of Mr. Paschall’s Forms 1040, respondent was not reasonably able to discern that Mr. Paschall was potentially liable for a section 4973 excise tax. While a line on each Form 1040, i.e., line 54 for 2000, line 55 for 2001, line 58 for 2002, line 57 for 2003, line 59 for 2004, and line 60 for 2005 and 2006, states “Tax on qualified plans, including IRAs, and other tax-favored accounts. Attach 5329 if required”, Mr. Paschall left these lines blank, giving respondent no indication of his excess contribution.” 2011 T.C. 2, at p. 14.

Swanson did file 5329s, and of course was audited.

Both Swanson and Paschall, seeking to avoid penalties, claimed they relied on Smokey and Grant Thornton. But that avails them nothing, as Smokey and Grant Thornton were promoters of their tax dodge. Reliance on a promoter is not justifiable reliance.

Quoting a favorite of mine, Judge Wherry states: “Courts have repeatedly held that it is unreasonable for a taxpayer to rely on a tax adviser actively involved in planning the transaction and tainted by an inherent conflict of interest. Canal Corp. v. Commissioner, 135 T.C. 199, 218 (2010)….” 2011 T.C. 2, at pp. 23-24.

See also my posting “A Piece of the Action”, 1/9/2011. As I said then: “There are certain pressures against which the better angels of our nature often strive in vain: high on that list is the pecuniary interest of the pressured one.

“In short, tax professional: don’t do it.”

The Gift Must Be Complete

Unlike Sam Goldwyn, who invented the “definite maybe”, Tax Court is unimpressed by uncompleted gifts. And Judge Laro waves the play “incomplete” in E. Bruce and Denise A. Agness Didonato, 2011 T.C. Mem. 153, filed 6/29/11.

E. Bruce and Denise A. gave the New Jersey Green Acres Fund of Mercer County what they claimed was a $1,870,000 green acres easement, divesting themselves of development rights on property adjacent to a public park. To prove the gift, E. Bruce and Denise A. introduced a settlement agreement from a State-court lawsuit they brought against the County and the New Jersey Department of Environmental Protection (NJDEP) over an easement on the parkland, as proof of the donation, claiming it satisfied the contemporaneous acknowledgment of receipt requirements of Section 170(f)(8).

Judge Laro says it didn’t.  The effectiveness of the settlement agreement was contingent upon public hearings before the NJDEP, and various other acts, which weren’t finally completed until two years after E. Bruce and Denise A. supposedly made the gift.

E. Bruce and Denise A. then proffered a letter from the County thanking them for the donation, but it was dated two years after the tax year in which E. Bruce and Denise A. claimed they made the gift, and didn’t estimate the value of the donation.

E. Bruce and Denise A. filed a Form 8283 with their 1040, but the 8283 wasn’t signed by the appraiser whose report accompanied their 1040. Although IRS said nothing about the appraisal, Judge Laro found plenty of fault with the appraisal:  “Although respondent does not allege any defect in the appraisal…, we express concern over the validity and credibility of that appraisal. First, we observe that the appraisal includes in the value of the donated property the development rights on three parcels of property when the deed of restriction concerned development rights on only the two parcels making up the [donated] parcel.  Second, the appraisal uses market value and not fair market value as a standard of value. In that regard, the definition of market value in the appraisal embodies selective elements of fair market value but does not encompass the definition of fair market value required by sec.20.2031-1(b), Estate Tax Regs.” [citations omitted], 2011 T.C. Mem. 153, footnote 8, at p. 10. Appraisers beware!

So the letter acknowledgment, if acknowledgment it was, was not contemporaneous. And the settlement agreement could not be an acknowledgment, as there was no completed gift when the settlement agreement was signed, the contingencies enumerated therein not having yet been satisfied.

And of course neither the settlement agreement nor the letter stated that E. Bruce and Denise A. didn’t receive anything of value from the County.

Takeaway- A gift must be completed–no loose ends. And the tests of Section 170(f)(8) must be met contemporaneously with delivery of gift: description of gift and good faith estimate of value, and statement that nothing of value was paid to donor.

Or, If It Doesn’t Look Like a Loan, It Isn’t

The takeaway from John C. and Margaret T. Ramig, 2011 T.C. Mem. 147, filed 6/27/11, is that, if you make a loan to a business in which you have an ownership interest, the more it looks like a loan, the better chance you have for a business bad debt deduction.

John was a lawyer turned shoe salesman. He started an on-line C Corporation shoe store in the early dot.com days, but it soon lost its footing and never made money. John made four purported loans, the remaining unpaid balance of which aggregated $29,600, to the business, none of which was ever repaid. What sinks John’s business bad debt deduction is that John never treated the loans as loans, even paying business creditors before taking any payment on the loans.

Judge Morrison lists the factors Ninth Circuit (where an appeal would lie) would consider in determining that the monies paid, 2011 T.C. Mem. 147, at p. 18. These are (i) the labels on the documents evidencing the (supposed) indebtedness, (ii) the presence or absence of a maturity date, (iii) the source of payment, (iv) the right of the (supposed) lender to enforce payment, (v) the lender’s right to participate in management, (vi) the lender’s right to collect compared to the regular corporate creditors, (vii) the parties’ intent, (viii) the adequacy of the (supposed) borrower’s capitalization, (ix) whether stockholders’ advances to the corporation are in the same proportion as their equity ownership in the corporation, (x) the payment of interest out of only “dividend money”, and (xi) the borrower’s ability to obtain loans from outside lenders.

Though there were notes from the C Corp to John, John signed only one of the four both as lender and as officer of the borrower. The other three were unsigned. Though there were maturity dates stated in the notes, the parties ignored them. Interest was never paid, and John testified he expected to be repaid if the C Corp could raise further capital from investors (which it never did). John clearly paid trade creditors ahead of the noteholder (himself).

Thin capitalization is neutral, as neither John nor IRS introduced evidence on that point.  But the outside financing availability factor weighs against John, as the C Corp clearly was unable to generate sufficient revenue to pay an arms’-length lender, and John never introduced evidence to show the C Corp could borrow from other sources. Although John’s advances were not proportional to his ownership interest, Judge Morrison gives this little weight, as he does whether John increased his right to participate in management, as no evidence was introduced on that point.

As for enforceability, it is questionable whether one can enforce an unsigned promissory note.

Bottom line–John was an equity investor, not a creditor.

My footnote-  Judge Morrison noted that John raised no other possible tax treatment with respect to the unpaid advances. How about capital loss, long or short term as the case might have been? John never asked, so Judge Morrison did not tell.

 Or, A Credible Appraisal Saves the Day

Fans of Sherlock Holmes will recognize his encomium to his nemesis, Prof. Moriarity: “Is he not the celebrated author of The Dynamics of an Asteroid, a book which ascends to such rarefied heights of pure mathematics that it is said that there was no man in the scientific press capable of criticizing it?”

I could say the same about Judge Morrison’s decision in Estate of Natale B. Giustina, Deceased, Laraway Michael Giustina, Executor, 2011 T.C. Memo. 141, filed 6/22/11. But here the object of the rarefied heights of pure mathematics is not found in outer space, but rather in a forest in Oregon. The late Nat, through a revocable trust everyone agrees should be disregarded for estate tax purposes, owned a 41.128% interest in a limited partnership; the partnership’s business was lumbering over 47,000 acres of Oregon timberland. The issue was valuing Nat’s interest at date of death. Laraway was the executor, and claimed around $12 million; IRS said $33 million.

Judge Morrison carefully unpacks the trust instrument and the limited partnership agreement. Who can break up the property, how can they break it up, and if they break it up what would a sale yield? Judge Morrison finds a sale would yield more present value dollars than continuing lumbering operations, finding the probability of the sale sufficiently high to justify a valuation taking that probability into account.

Judge Morrison also evaluates the expert appraisers’ testimony, both IRS’ and Laraway’s, and mixes and matches their methodologies and results to come in at $27 million, apparently discounting IRS’ expert’s value by 20%, and increasing Laraway’s expert’s value by 56%, ascending to the “rarefied heights of pure mathematics” that inspired Sherlock’s breathless praise.

Unhappily for Laraway, the estate is therefore in the Section 6662 substantial-understatement-because-of-estate-tax-undervaluation 20% penalty zone, as his number is more than 50% below what Judge Morrison finds.

Judge Morrison does admit that all the mathematical juggling, impressive as it is, still has a basic flaw. He quotes Repetti: “The entire valuation process is a boundless subjective inquiry: To value an asset the court has to make guesses or assumptions about the future. These inquiries require speculation about the composition of management * * *

Repetti, “Minority Discounts: The Alchemy in Estate and Gift Taxation”, 50 Tax L. Rev. 415, 445 (1995).” 2011 T.C. Memo. 141, at p. 21.

The difficulty does not deter Judge Morrison.

Now Laraway is looking at $2 million plus of penalty on top of a $15 million deficiency. But help is on the way. Says Judge Morrison: “However, no penalty is imposed with respect to an underpayment if there was reasonable cause for the underpayment and the taxpayer acted in good faith. Sec. 6664(c)(1). Whether an underpayment of tax is made in good faith and due to reasonable cause will depend upon the facts and circumstances of each case. Sec. 1.6664-4(b)(1), Income Tax Regs. In determining whether a taxpayer acted reasonably and in good faith with regard to the valuation of property, factors to be considered include: (1) the methodology and assumptions underlying the appraisal; (2) the appraised value; (3) the circumstances under which the appraisal was obtained; and (4) the appraiser’s relationship to the taxpayer. Id. Although the IRS bears the burden of production under section 7491(c) that the section 6662 penalty is appropriate, the taxpayer bears the burden of proof in demonstrating reasonable cause. See Higbee v. Commissioner, 116 T.C. 438, 446-448 (2001).” 2011 T.C. Memo. 141, at p. 29.

To prepare the Form 706, Laraway hired a lawyer, who hired an asset appraisal company, which produced an appraisal. Rather than unpacking yet another appraisal, Judge Morrison finds that, although he does not agree with the appraisal company’s results and finds their methodology deficient, their methodology and result were sufficiently credible to let Laraway rely in good faith on their number. So no penalty.

Takeaway for fiduciaries- Have a third party professional choose an appraiser with decent credentials, and rely in good faith.

To my readers–I was down in Virginia at the National Society of Tax Professionals’ summer school, so I missed a day or two of postings. I’m catching up. And for any who didn’t get the word, the new Registered Preparers Office at IRS is taking over the examination functions formerly carried on by OPR at Treasury. OPR will be strictly rulemaking and enforcement. A more energetic enforcement is coming: beware!