The Tax Court in Brief November 29 – December 3, 2021
Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.
Tax Litigation: The Week of November 29 – December 3, 2021
U.S. Tax Court Summaries
- Plateau Holdings, LLC, Waterfall Development Manager, LLC, TMP v. Comm’r (Plateau II), T.C. Memo. 2021-133 | November 30, 2021 | Lauber, J. | Dkt. No. 12519-16
- FAB Holdings, LLC v. Comm’r; Berritto v. Comm’r; T.C. Memo. 2021-135 | November 30, 2021 Copeland, J. | Docket Nos. 21971-17 22152-17
- Hong Jun Chan v. Comm’r, No. 21904-19, T.C. Memo. 2021-136 | December 1, 2021 | Lauber |
- Soni v. Comm’r; T.C. Memo. 2021-137 | December 1, 2021 Lauber, J. | Dkt. No. 15328-15
Plateau Holdings, LLC, Waterfall Development Manager, LLC, TMP v. Comm’r (Plateau II), T.C. Memo. 2021-133
November 30, 2021 | Lauber, J. | Dkt. No. 12519-16
Short Summary: Plateau Holdings, LLC (“Plateau”), a partnership for federal tax purposes, donated conservation easements related to two parcels of real property in Tennessee to Foothills Land Conservancy (“Conservancy”), a tax-exempt organization. However, eight days before Plateau made this donation, an investor acquired, in an arm’s length transaction, a 98.99% indirect ownership interest in Plateau for less than $6 million. On its 2012 federal income tax return (Form 1065), Plateau claimed a roughly $25.5 million charitable contribution deduction for the donation.
After an audit, the Internal Revenue Service (“IRS”) issued Plateau’s TMP a notice of final partnership administrative adjustment (FPAA) that disallowed the charitable contribution for a donation of real property and determined a 40% gross valuation misstatement penalty under Section 6662(e) and (h). The IRS also sought a 20% penalty for negligence or a substantial understatement of tax under Section 6662(a) and (b)(1) and (2).
On June 23, 2020, the Tax Court held that Plateau was not entitled to a charitable contribution deduction and liable for the gross valuation misstatement penalty. See Plateau Holdings, LLC v. Comm’r (Plateau I), T.C. Memo. 2020-93, 119 T.C.M. (CCH) 1619. Subsequently, the parties submitted supplemental briefs relate to the penalty under Section 6662(a) and (b)(1) and (2).
- (1) Whether Plateau is liable for the 20% penalty for negligence or a substantial understatement of tax under Section 6662(a) and (b)(1) and (2).
- (1) Plateau was not liable for the penalty under Section 6662(a) and (b)(1) and (2) because Plateau had reasonable cause and acted in good faith with respect to the claimed charitable contribution deduction corresponding to the correct value of the easements.
Key Points of Law:
- The Internal Revenue Service imposes an accuracy-related penalty for any portion of an underpayment that is attributable to negligence or disregard of rules or regulations or a substantial understatement of income tax. An understatement is substantial if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. See R.C. § 6662(a), (b)(1) and (2), and (d).
- Negligence is the failure to make a reasonable attempt to comply with the Code, and disregard includes carless, reckless, or intentional disregard. See R.C. § 6662(c).
- In the case of a partnership, a penalty under Section 6662 applies when the partnership takes a return position that is negligent or that might create a substantial understatement of tax at the partner level. See Oakbrook Land Holdings, LLC v. Comm’r, T.C. Memo. 2020-54, 119 T.C.M. (CCH) 1351, 1360.
- The Section 6662(a) penalty will not apply to any portion of an underpayment where the taxpayers establish that they acted with reasonable cause and in good faith with respect to that portion. See R.C. § 6664(c)(1).
Insight: Plateau (II) highlights that reasonable cause requires the Court to take into account all pertinent facts and circumstances. Notably, the Tax Court held that Plateau could reasonably rely on the easements drafted by Conservancy’s experienced attorney, even though he was not Plateau’s attorney. Further, the easement deeds’ inclusion of judicial extinguishment clauses was not problematic because (1) the validity of such clauses had not yet been tested at the time the 2012 tax return was filed, and (2) a 2008 PLR suggested that such clauses would not necessarily prevent the allowance of a charitable contribution deduction (even though there was no evidence in the record that Plateau relied on such PLR).
November 30, 2021 Copeland, J. | Docket Nos. 21971-17 22152-17
In late 2009 or early 2010, Mr. and Mrs. Berrittos hired A.V. Arias & Co. to prepare an integrated tax plan (ITP). The ITP included the formation of two entities: a C corporation (FAB) and a partnership (Berritto Enterprises, LLC (Enterprises)). The Berrittos were the sole owners of both, each owning a 50% interest in each entity. During the years at issue Mr. Berritto was the managing member of Enterprises and the president of FAB, working roughly 600 hours a year for FAB. Mrs. Berritto worked about 40 per year for both FAB and Enterprises.
Enterprises’ income was largely interest, dividends, and capital gains from securities investments contributed by the Berrittos. FAB’s income was mostly payments from Enterprises. Enterprises paid FAB management fees and deducted those fees each year, which created nonpassive losses that flowed through the partnership and were reported on the Berrittos’ individual returns. FAB conversely reported the fees as income.
The issues in these consolidated cases are (1) whether the statutory notices of deficiency (SNODs) were timely sent, (2) whether there should be a correlative adjustment to the gross income of FAB, and (3) whether petitioner Frank Berritto received constructive dividends from FAB in tax years 2010, 2011, and 2012 and petitioners Frank Berritto and the Estate of Dana Berritto received constructive dividends from FAB in 2013.
Key Issues and Primary Holdings:
Limitations: The taxpayers’ first argument was limitations, contending that the SNODs were not timely. In support of this argument, they urged that Mr. Arias had a conflict of interest that made the Forms 872 that he signed for them invalid (and therefore did not extend the assessments limitations period). Specifically, they argued that Arias was a promoter because he advised them to implement the structure at issue and received payment for his advice and that his status as a promoter invalidated his authority to act on their behalf. The Court rejected this argument, easily distinguishing the cases petitioners relied upon (even dismissing one argument as “beyond the pale”). As the Court explained, the facts do not support the contention that Arias was a promoter:
Mr. Berritto hired Mr. Arias to structure the ITP to help him and Mrs. Berritto save on their taxes. Mr. Arias did not benefit from or have an interest in the transaction outside of fees generated from time spent setting up the transaction and providing accounting and tax preparation services. Furthermore, while Mr. Arias advised Mr. Berritto on the ITP, Mr. Berritto also participated in planning the structure. Petitioners have offered no evidence to show that Mr. Arias was offering multiple clients the same tax plan. … as any individual would go to an adviser for help in setting up a transaction, Mr. Berritto went to Mr. Arias for general tax planning advice. Mr. Arias helped the Berrittos with their ITP but was not a promoter with an inherent conflict of interest.
Id. at 7.
Correlative Adjustments: On the second issue, the Berrittos did not dispute the disallowed deductions (for management fees and performance bonuses claimed by Enterprises for payments to FAB, which in turn decreased the losses flowing through to the Berrittos’ returns). Instead, they argued that those adjustments required a correlative adjustment to FAB’s income that was not taken into account in the proposed adjustments outlined in FAB’s SNOD. They argued that the Commissioner was required to reduce FAB’s income in amounts corresponding to the amounts of Enterprises’ disallowed deductions for management fees and performance bonuses. They contend that without such adjustments to FAB’s income they would be unfairly “double taxed.”
The Court rejected this argument, again, readily distinguishing the authority that the petitioners relied upon. As the Court pointed out, “[t]he tax consequences of operating a business through a C corporation are different from those of a partnership. Pursuant to sections 701 and 702, partnerships are flow-through entities, which means that they do not pay tax at the partnership level. A corporation, on the other hand, is a separate taxable entity from its shareholders. Consequently, when it is operating as a C corporation, the income is taxed first at the corporate level. And then, upon distribution from the corporation to the shareholders, the shareholders also have tax consequences.” Id. at 9 (citations omitted). “The Berrittos chose to make FAB a C corporation and themselves shareholders of it. FAB received payments from Enterprises, which are taxable to FAB. Petitioners have not provided any cogent legal argument … that would allow such payments to be nontaxable. Likewise, this Court has not found any precedent indicating that respondent is required to oblige their request. Because FAB has not proven its entitlement to a reduction in income, the respondent is not required to reduce FAB’s income.” Id. at 10.
Constructive Dividends: “A constructive dividend arises where a corporation confers an economic benefit on a shareholder without the expectation of repayment, even though neither the corporation nor the shareholder intended a dividend. Sections 301 and 316 govern the characterization of a corporate distribution of property to a shareholder. If the distributing corporation has sufficient earnings and profits, then the distribution is a dividend which is included in the shareholder’s gross income. If the distribution exceeds the corporation’s earnings and profits, the excess is first a return of capital, and any remaining is taxed as a capital gain. The taxpayer bears the burden of proving that the corporation lacks sufficient earnings and profits to support dividend treatment.” Id. at 11 (citations, internal quotation marks, and modifications omitted).
The Berrittos’ SNOD also proposed adjustments to their income in the form of constructive dividends. With one exception, the Court rejected Petitioners’ argument that there were no constructive dividends. Petitioners’ argument regarding the treatment of the distribution rested on their assertion that FAB was entitled to a correlative adjustment. Reducing FAB’s income would reduce its earnings and profits. If FAB’s income had been reduced, the Berrittos could have recovered some of their basis in FAB stock before recognizing gain, thereby reducing their income tax liabilities. Because no correlative adjustment was required, FAB’s income remained unadjusted, and accordingly, its earnings and profits remained unchanged. Thus, petitioners failed to show that FAB lacks sufficient earnings and profits to pay a taxable dividend. Accordingly, the Court sustained the Commissioner’s determination regarding the constructive dividends – with one exception.
The Berrittos included the director’s fees in their income for tax years 2012 and 2013. While the Berrittos did receive an economic benefit from such payments, they already paid tax on this benefit because it was included as income on their individual returns. Treating the director’s fees are a constructive dividend would result in the Berrittos having to pay tax on the same income twice: once as director’s fees and once as constructive dividends.
Insight: As the Court observed several times, the Berrittos chose to structure their business as they did (as a C corporation and a partnership) and they must accept the liabilities, as well as the benefits, of their chosen arrangement.
December 1, 2021 | Lauber |
Short Summary: This case involves taxpayers who ran a restaurant under an entity that validly elected to be an S Corporation. However, the taxpayers, shareholders of that S corporation, failed to report tax for the business. After assessment, the taxpayers claimed that the entity was a C corporation based on the alleged filing of Forms 1120.
- Whether the taxpayers’ business was operated as, and therefore should report tax as, an S corporation.
- Whether summary judgment was appropriate on the entire case.
Facts and Primary Holdings:
- Petitioners operated a restaurant in California, which was incorporated in 2010.
- In 2011, Petitioner husband filed a Form 2553 on behalf of the restaurant, by which it elected to be treated as an S corporation.
- Despite the requirements of subchapter S, Petitioners did not report results of the restaurant’s operations on their 2015 Federal income tax return, and they filed no return for 2016.
- On audit, the IRS determined substantial deficiencies for both years, determining the restaurant’s gross income by use of a bank deposits analysis but allowing no deductions for the costs of operating the restaurant. It also assessed accuracy-related penalties.
- The IRS moved for summary judgment on its entire case – both as to the filing status of Petitioners as well as to the amount of tax owed.
- The Tax Court granted summary judgment to the IRS as to the filing status of Petitioners – finding that, because the entity elected to be taxed as an S corporation, its income passed through to its shareholders and must be reported on their individual tax returns.
- The Tax Court, however, denied summary judgment on the remaining issues, including: (1) the gross income derived from the restaurant entity; (2) the Petitioners’ pro rata share of that income; (3) Deductions that are available to Petitioners; and (4) the Petitioners’ liability for accuracy-related penalties.
Key Points of Law:
- The IRS’s determinations in a notice of deficiency are generally presumed correct, and taxpayers bear the burden of proving them erroneous. See Rule 142(a).
- An S corporation is a “small business corporation for which an election under I.R.C. §1362(a) has been made. Sec. 1361(a)(1).
- S corporations are afforded special treatment under the Code. “One of the benefits of S corporation tax status is that income earned by the entity escapes corporate-level taxation.” Mourad v. Commissioner, 121 T.C. 1 , 3 (2003), aff’d, 387 F.3d 27 (1st Cir. 2004). “Thus, an S corporation’s income passes through the entity and is, generally, taxed only at the shareholder level on a pro rata basis.” ; see §§1363, 1366.
- Section 1362 specifies the procedure for electing S corporation status. If an entity qualifies as a “small business corporation”, it may make an election “on or before the 15th day of the third month of the taxable year.” Sec. 1362(b)(1)(B).
- To make an election the entity must file a completed Form 2553. Sec. 1.1362-6 (a)(2)(i), Income Tax Regs .
- Once an entity elects S corporation status, the election is effective “for all succeeding taxable years.” Sec. 1362(c).
Insight: This case highlights the perils of pro se representation in Tax Court. Taxpayers took a position that is plainly incorrect on the law. The filed an S election, but then failed report income on their personal tax returns and attempted to claim that the entity was, in fact, a C Corporation. Thankfully, although the IRS granted summary judgment as to the entity status of the taxpayer, it denied summary judgment on the substantive issues of the amount of tax liability and the availability of deductions.
December 1, 2021 Lauber, J. | Dkt. No. 15328-15
Short Summary: The court found that the Commissioner correctly determined a deficiency in Om and Anjali Soni’s 2004 joint return, additional tax for filing late, and an accuracy-related penalty. The issues were whether: (1) petitioners filed a valid joint return; (2) the period of limitations for assessment of tax under section 6501(a) and (c)(4) expired before the issuance of the notice of deficiency; (3) petitioners are liable for an addition to tax under section 6651(a)(1); and (4) petitioners are liable for the 20% accuracy-related penalty under section 6662(a). The Court decided these issues in favor of the Commissioner.
Om, an experienced businessman, handled all of the couple’s finances, including their tax returns, with the assistance of administrative staff and tax professionals. Anjali was not involved in any meaningful way in the preparation of the couple’s tax returns. Her husband or son signed tax documents for her. In their 2004 tax return, the Sonis claimed a $1,777,789 loss deduction from one of Om’s businesses (an S corporation). Their tax professional relied on Om’s representations that there was sufficient basis for that loss reduction but, in fact, Om did not keep reliable records for the basis.
The Commissioner issued the Sonis a SNOD on March 12, 2015. The only noncomputational deficiency adjustment made was the disallowance of a $1,777,789 flowthrough loss from S corporation deducted on their 2004 income tax return because the Sonis could not substantiate their basis in that entity. The Commissioner also determined an addition to tax for late filing under section 6651(a)(1) of $28,836.
Key Issues and Primary Holdings:
Joint Return and the Tacit Consent Rule: Much of the Court’s opinion (its recounting of the facts and analysis) is devoted to the first issue: whether the Sonis filed a valid joint return. This turned mainly on the “tacit consent rule.”
The Commissioner’s determination of a taxpayer’s liability is generally presumed correct, and the taxpayer bears the burden of proving that the determination is incorrect, but a spouse’s failure to sign the return removes the presumption of correctness ordinarily attaching to the Commissioner’s determination of jointness. Where a spouse does not sign a purported joint return, the Commissioner bears the burden of producing evidence that a joint return was intended.
Because Anjali did not sign, it was the Commission’s burden to show that the return was filed jointly. Whether an income tax return is a joint or separate return is a question of fact that depends on the intent of the parties. Married-filing-jointly status does not apply to a return unless both spouses intended to make a joint return.
The failure of one spouse to actually sign does not necessarily negate the intent to file a joint return by the nonsigning spouse. Intent can be inferred from the acquiescence or tacit approval from the nonsigning spouse (the “tacit consent rule”). The Court has considered a variety of factors in deciding the issue of tacit consent, including whether the nonsigning spouse filed a separate return, whether the nonsigning spouse objected to filing jointly, and whether the prior filing history indicates the intent to file jointly. Additionally, a pattern of relying on one’s spouse to handle the family’s financial matters, including preparation of tax returns, suggests that the spouse consented to the other spouse’s filing of the return.
Based on its fact-intensive analysis, the Court concluded that “Anjali approved or at least acquiesced in the joint filing of their 2004 return. Anjali did not discuss financial matters with her husband or her son. She was generally aware of the U.S. tax system but chose not to engage. Anjali relied on and continues to trust her husband and son to handle the tax matters, including their Federal income tax returns. Anjali was not interested in viewing the contents of the return; she viewed it as her husband’s responsibility for the family. Anjali had the opportunity to take affirmative steps upon receiving notices. However, she did not take any affirmative steps in attempting to file separately or object to the 2004 return. Overall, Anjali repeatedly reiterated that she fully trusted her husband and son to handle the financial issues for her. Anjali chose to let others handle all of her affairs for her. It was part of her arrangement with her husband that he handle all of their tax-related matters. Therefore, she tacitly consented to file the 2004 return jointly.” Id. at 7. (The court considered additional factors that also confirmed that Anjali tacitly consented to filing the 2004 return jointly.)
Implied Authority and Ratification: The Sonis argued that the three-year limitations period had expired before the IRS mailed the SNOD, based on the theory that they did not authorize Forms 872 (by which they waived limitations) submitted by a tax professional, Mr. Grossman. Similar to its facts-intensive analysis of the “implied consent rule,” the Court analyzed their eight Forms 872 and a Form 2848. The Court rejected Om’s attempts to argue that the forms were signed without his authorization. Furthermore, the Court determined that through their actions, both Om and Anjali ratified Grossman’s representation of them.
The Court recounted Grossman’s lengthy representation (Om had repeatedly indicated to the IRS that he wanted Grossman to handle the S corporation’s loss deduction and neither Om nor Anjali ever questioned his activities on their behalf) and concluded, “[t]o only now state that he was not their representative is beyond the pale.” The Court’s application of the “implied consent rule” may have sufficed to show that this Grossman also represented Anjali but her actions also ratified his representation: “She too remained silent and allowed the IRS the rightful perception that Mr. Grossman was an authorized representative of the Sonis acting on both their behalves.” Similarly, Anjali gave her husband implied authority to act on her behalf in signing these forms (appointing Grossman, whom they relied on throughout the appeal and litigation) who signed the extension.
Anjali relied on her husband to handle financial and tax matters. Om then gave authority to Grossman to act as the representative for him and Anjali. Neither of the Sonis challenged Grossman’s authority until almost a decade after they were aware that he acting on their behalf. The eight executed Forms 872 properly extended the period of limitations for assessment and therefore the period of limitations did not expire before the issuance of the SNOD.
Section 6651(a)(1) Addition to Tax: The Sonis argued that they should not be liable for the addition to tax under section 6651(a)(1) because they thought they did not owe any tax. The Sonis filed after their extended deadline, so the burden was on them to prove that an applicable exception to the section 6651(a)(1) addition to tax.
The application of the section 6651(a)(1) addition to tax may be avoided if the taxpayer shows that the failure to timely file was due to reasonable cause and not due to willful neglect. Reasonable cause exists if the taxpayer exercised ordinary business care and prudence but nevertheless could not file.
“Reasonable cause for delay is established where a taxpayer is unable to file despite the exercise of ordinary business care and prudence. ‘Willful neglect’ has been defined as a ‘conscious, intentional failure or reckless indifference. Whether a failure to file timely is due to reasonable cause and not willful neglect is a question of fact.’” Id. at 13 (citations omitted).
The Court concluded that “[t]he Sonis did not have a reasonable explanation for filing late. They thought no harm no foul because they would have zero tax due, but this is not a reasonable cause for the delay. Consequently, no reasonable cause exists.” Therefore, they the addition to tax under section 6651(a)(1) was properly assessed.
Section 6662(a) Accuracy-Related Penalty: Section 6662(a) imposes an accuracy-related penalty equal to 20% of the portion of an underpayment of tax required to be shown on a return that is attributable to either negligence or disregard of the rules or regulations under section 6662(b)(1) or a substantial understatement of income tax under section 6662(b)(2). The penalty was warranted on either basis because the Sonis did not keep adequate records and their tax understatement was substantial. Section 6662(c) defines “negligence” to include any failure to make a reasonable attempt to comply with tax laws, and section 1.6662-3(b)(1), Income Tax Regs., includes any failure to keep adequate books and records or to substantiate items properly. An understatement of income tax is substantial if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. Sec. 6662(d)(1)(A).
Insight: As the Court observed at the start of its lengthy opinion: “[T]his case [is] analogous to the phrase ignorance is bliss, except when it is not.” Id. at 1. Anjali can hardly be blamed for relying on her husband; nor he for relying on his several tax professionals and others. Their tax professionals, however, relied on Om’s representations in preparing the 2004 return. Those representations were unreliable due to Om’s poor record keeping.