Litigating Cancellation of Indebtedness Income
Weiderman v. Comm’r, T.C. Memo. 2020-109 | July 15, 2020 | Ashford, J. | Dkt. No. 14432-14
Short Summary: Mrs. Weiderman accepted an executive marketing position with K-Swiss in 2006. Under the terms of her employment offer, K-Swiss agreed to assist the Wediermans in their relocation to California, providing them with a $500,000 interest-free loan to help finance the purchase of a new residence. K-Swiss and Mrs. Weiderman later executed a promissory note, dated February 15, 2007, which discussed the terms and conditions of the loan including that the loan was due and payable in full in one lump-sum payment on the earlier of February 15, 2017, or the effective date of her termination (whether voluntary or non-voluntary). After the loan disbursement, the Weidermans used the loan proceeds to purchase a residence in California.
But on December 1, 2008, K-Swiss terminated Mrs. Weiderman’s employment. Accordingly, K-Swiss demanded full payment of the $500,000 loan. Ultimately, Mrs. Weiderman and K-Swiss agreed (through various settlement negotiations) that K-Swiss would cancel $285,000 of the loan with proceeds from the sale of the California residence satisfying the remaining loan balance.
In 2009 and 2010, Mr. and Mrs. Weiderman also claimed various business deductions on Schedules C.
Key Issue: Whether the taxpayers: (1) must include in gross income COD income of $255,000 and $30,000 for 2009 and 2010, respectively; (2) are entitled to deduct certain expenses they reported on their 2009 and 2010 Schedules C, Profit or Loss From Business; and (3) are liable for accuracy-related penalties.
- The taxpayers (1) must include in gross income COD income of $255,000 and $30,000 for 2009 and 2010 because the COD income was not excludible under Section 108(e)(1)(A); (2) are not entitled to deductions on Schedule C because Mrs. Weiderman was not engaged in carrying on a separate trade or business for profit under Section 162 and, in any event, she did not provide substantiation for the expenses, and the Schedule C deductions claimed with respect to Mr. Weiderman’s business were deemed conceded during trial; and (3) are liable for the accuracy-related penalty because they did not satisfy all of the factors under Neonatology Assocs. in asserting that they relied on the professional tax advice of a tax preparer.
Key Points of Law:
- Generally, the Commissioner’s determinations set forth in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving otherwise. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933). In the Ninth Circuit, and with respect to unreported income cases, the Commissioner must provide some reasonable foundation connecting the taxpayer with the income-producing activity, see Weimerskirch v. Comm’r, 596 F.2d 358, 360-61 (9th 1979), rev’g 67 T.C. 672 (1977), or demonstrate that the taxpayer received unreported income, see Hardy v. Comm’r, 181 F.3d 1002, 1004 (9th Cir. 1999), aff’g T.C. Memo. 1997-97. Once the Commissioner has done this, the burden of proof shifts to the taxpayer to prove by a preponderance of the evidence that the Commissioner’s determinations are arbitrary and capricious. Helvering v. Taylor, 293 U.S. 507, 515 (1935). Similarly, under section 6201(d), if a taxpayer in any court proceeding asserts a reasonable dispute with respect to any item of income reported on an information return, the Commissioner shall have the burden of producing reasonable and probative information concerning such deficiency, in addition to such information return.
- Tax deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any deduction claimed. Rule 142(a); INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992); Segel v. Comm’r, 89 T.C. 816, 842 (1987). This burden generally requires the taxpayer to demonstrate that the claimed deductions are allowable pursuant to some statutory provision and to substantiate the expenses giving rise to the claimed deductions by maintaining and producing adequate records that enable the Commissioner to determine the taxpayer’s correct liability. 6001; Higbee v. Comm’r, 116 T.C. 438, 440 (2001).
- The Commissioner bears the burden of production with respect to accuracy-related penalties under section 6662(a), see 7491(c), but the taxpayer bears the burden of proving that the Commissioner’s determinations with respect to the accuracy-related penalties are incorrect, see Rule 142(a); Welch v. Helvering, 290 U.S. at 115; Higbee v. Comm’r, 116 T.C. at 447.
- A taxpayer’s gross income includes “all income from whatever source derived,” including COD income. 61(a)(12). “The underlying rationale for the inclusion of canceled debt as income is that the release from a debt obligation the taxpayer would otherwise have to pay frees up assets previously offset by the obligation and acts as an accession to wealth—i.e., income.” Bui v. Comm’r, T.C. Memo. 2019-54 (citing U.S. v. Kirby Lumber Co., 284 U.S. 1, 2 (1931)).
- Generally, the amount of COD income that is includible in a taxpayer’s gross income is equal to the face value of the canceled debt minus any amount paid in satisfaction of the debt. Rios v. Comm’r, T.C. Memo. 2012-128, aff’d, 586 F. App’x 268 (9th 2014). The income is recognized for the year in which the debt is canceled, Bui v. Comm’r, T.C. Memo. 2019-54, and is taxed at ordinary rates, Callahan v. Comm’r, T.C. Memo. 2013-131.
- “[C]ertain accessions to wealth that would ordinarily constitute income may be excluded by statute or other operation of law.” Comm’r v. Dunkin, 500 F.3d 1065, 1069 (9th 2007). But “given the clear Congressional intent to exert the full measure of its taxing power, exclusions from gross income are construed narrowly in favor of taxation.” Id. (quoting Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955).
- Section 108(a)(1)(E) provides that gross income does not include amounts which would be includible as COD income if “the indebtedness discharged is qualified principal residence indebtedness.” The term “qualified principal residence indebtedness” is defined as acquisition indebtedness with respect to the taxpayer’s principal residence. 108(h)(2), (5). Section 168(h)(3)(B)(i) provides that acquisition indebtedness is any indebtedness which is: (1) incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and (2) secured by that residence. For these purposes, secured debt is any debt that is on the security of an instrument (such as a mortgage, deed of trust, or land contract) that makes the debtor’s interest in the qualified residence specific security for the payment of the debt (1) under which, in the event of default, the residence could be subjected to the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated and (2) is recorded or otherwise perfected in accordance with the applicable State law. Temp. Treas. Reg. § 1.163-10T(o)(1).
- Section 162 allows a taxpayer to deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. 162(a); Treas. Reg. § 1.162-1(a). An expense is “ordinary” if it is “normal, usual, or customary” in the taxpayer’s trade or business or arises from a transaction “of common or frequent occurrence in the type of business involved.” Deputy v. du Pont, 308 U.S. 488, 495 (1940). An expense is “necessary” if it is “appropriate and helpful” to the taxpayer’s business, but it need not be absolutely essential. Comm’r v. Tellier, 383 U.S. 687, 689 (1966). Additionally, a taxpayer may not deduct a personal, living, or family expense unless the Code expressly provides otherwise. Sec. 262(a). The determination of whether an expense satisfies the requirements of section 162 is a question of fact. Cloud v. Comm’r, 97 T.C. 613, 618 (1991).
- Whether a taxpayer is engaged in a trade or business is a question of fact to be decided on the basis of all the relevant facts and circumstances. Stanton v. Comm’r, T.C. Memo. 1967-137, aff’d, 399 F.2d 326 (5th 1968). Applying this facts and circumstances test, courts have focused on the following three factors indicative of whether a trade or business exists: (1) whether the taxpayer’s primary purpose in undertaking the activity was for income or profit; (2) whether the taxpayer is regularly and actively involved in the activity; and (3) whether the taxpayer’s activity has actually commenced. Jafarpour v. Comm’r, T.C. Memo. 2012-165.
- Under the Cohan rule, if a taxpayer establishes that an expense is deductible but is unable to substantiate the precise amount, the Court may estimate the amount of the deductible expense, bearing heavily against the taxpayer whose inexactitude is of his or her own making. See Cohan v. Comm’r, 39 F.2d 540, 543-44 (2d Cir. 1930). In order for the Court to estimate the amount of a deductible expense, the taxpayer must establish some basis upon which an estimate may be made. Norgaard v. Comm’r, 939 F.2d 874, 879 (9th 1991). Otherwise an allowance would amount to “unguided largesse.” Norgaard v. Comm’r, 939 F.2d at 879.
- The Cohan rule, however, is superseded—that is, estimates are not permitted—for certain expenses specified in section 274; to wit, traveling expenses (including meals and lodging while away from home), entertainment expenses, and “listed property” (including passenger automobiles, computers, and, as relevant here, 2009 phone) expenses. 274(d); Sec. 280F(d)(4)(A); Temp. Treas. Reg. § 1.274-5T(a). Instead, these types of expenses are subject to strict substantiation rules. Sanford v. Comm’r, 50 T.C. 823, 827 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969). These strict substantiation rules generally require the taxpayer to substantiate with adequate records or by sufficient evidence corroborating the taxpayer’s own statement (1) the amount of the expense; (2) the time and place the expense was incurred; (3) the business purpose of the expense; and (4) in the case of entertainment expenses, the business relationship between the person entertained and the taxpayer. Balyan v. Comm’r, T.C. Memo. 2017-140.
- For “listed property” expenses, in addition to the time such expenses were incurred and their business purpose, the taxpayer must establish the amount of business use and the total use of such property. Balyan v. Comm’r, T.C. Memo. 2017-140. Generally, deductions for meals and entertainment expenses are subject to the 50% limitation imposed by section 274(n).
- Substantiation by adequate records requires the taxpayer to maintain (1) an account book, diary, log, statement of expense, trip sheets, or similar record prepared contemporaneously with the expenditure and (2) documentary evidence, such as receipts or paid bills, which together prove each element of an expenditure. Balyan v. Comm’r, T.C. Memo. 2017-140.
- Section 6662(a) imposes a 20% accuracy-related penalty on any portion of an underpayment of tax required to be shown on a return if, as provided by section 6662(b)(1) and (2), the underpayment is attributable to negligence or disregard of rules or regulations and/or a substantial understatement of income tax. For these purposes, negligence includes any failure to make a reasonable attempt to comply with the internal revenue laws, disregard includes any careless, reckless, or intentional disregard, and an understatement of income tax is substantial if it exceeds the greater of 10% of the tax required to be shown on the return for that tax year or $5,000. 6662(c) and (d)(1)(A).
- Reasonable cause may exist where the taxpayer relies on professional advice if the taxpayer proves by a preponderance of the evidence that: (1) the adviser was a competent professional who had sufficient expertise to justify the taxpayer’s reliance on him or her; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Neonatology Assocs., P.A. v. Comm’r, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
Insight: The Weiderman decision is a good illustration of the difficulties a taxpayer may face in attempting to fall within an exclusion to COD income under Section 108. Taxpayers should be aware that in many instances (as in this case), the lender will issue a Form 1099 alerting the IRS that the debt has been cancelled. In such a case, the IRS will often look to the debtor’s tax return to determine whether the COD income has been properly reported. In many cases, with proper tax planning, taxpayers can provide better arguments and documentary proof to meet an exception under Section 108.