The Tax Court in Brief – February 20th – February 24th, 2023
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.
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Tax Litigation: The Week of February 20th, 2022, through February 24th, 2023
- Fairbank v. Comm’r, T.C. Memo. 2023-19| February 23, 2023 |Weiler, J. | Dkt. No. 13400-18
- Moore v. Comm’r, T.C. Memo. 2023-20| February 23, 2023 |Colvin, J. | Dkt. No. 18632-19
Avery v. Comm’r, T.C. Memo. 2023–18| February 21, 2023 | Lauber, J. | Dkt. No. 23237–18L (Collection Due Process and a Lawyer’s Race Car Business Expense Deductions)
Summary: Since 1982, James William Avery (Avery) was a practicing lawyer, specializing in personal injury law as a solo practitioner primarily in Denver, Colorado for the period 2008–2013 but also some in Indiana during 2008–2010. Avery became involved in car–racing activities in 2005 after he moved to Indiana. He began attending car shows, thinking this might be a way to meet potential clients. He purchased a race car and placed a decal for the Avery Law Firm, his “sponsor,” on the car. His website dedicated to racing activities linked to the Facebook page for his law firm, hoping to attract potential clients or referrals. But, after his marriage dissolved during the period 2011–2013, he all but quit racing, and the race car sat idle in a garage.
Avery failed to file returns for 2008 and 2009, and the IRS accordingly prepared substitutes for returns (SFRs). In 2011, Avery hired a new CPA. Some of Avery’s financial records remained in the possession of his wife, her father (Avery’s former CPA), or her divorce lawyer. On April 29, 2013, his new CPA filed delinquent returns for 2010 and 2011. Avery timely filed his return for tax year 2012, reporting zero tax due. Avery did not file a return for 2013, and the IRS prepared an SFR on the basis of third– party reports. On January 14, 2016, the IRS sent Avery a notice of deficiency for 2008, 2009, and 2013. The notice was based on the SFRs and determined deficiencies of $3,752, $242,788, and $141,754, respectively, plus additions to tax for failure to timely file, failure to timely pay, and (for 2009 and 2013) failure to pay estimated tax. The IRS examined Avery’s 2010–2012 returns. It disallowed for lack of substantiation all deductions claimed on his Schedules C, Profit or Loss From Business, and determined unreported gross receipts for 2011 and 2012. The IRS issued Avery a notice of deficiency for 2010–2012 that determined deficiencies for each year. The notice determined late–filing additions to tax for 2010 and 2011. Later in 2016, Avery prepared and submitted to the IRS delinquent returns for 2008, 2009, and 2013, and amended returns for 2010–2012. On his delinquent and amended returns Avery claimed in connection with his Schedule C business $355,000 of deductions for racing– related advertising expenses (contending the expenses promoted his litigation practice), all reported in round–dollar amounts of $50,000, $60,000, $65,000, or $70,000.
The IRS assessed the tax determined in the notices of deficiency after Avery failed to seek relief from the Tax Court within 90 days. When Avery did not pay the assessed liabilities on notice and demand, the IRS commenced collection action. The IRS issued a Letter 1058, Notice of Intent to Levy and Your Right to a Hearing, for 2008–2013, reflecting an aggregate liability of $986,794. The IRS later issued Avery a Letter 3172, Notice of Federal Tax Lien (NFTL) Filing and Your Right to a Hearing, for 2008, 2009, 2010, and 2013. Avery timely requested a CDP hearing for both notices, and he sought to challenge his underlying tax liabilities for all six years, contending that his correct liabilities were shown on the delinquent and amended returns he had submitted in 2016. The SOs verified that the notices of deficiency for 2008–2013 had been sent to Avery to his last known address. So, the SOs concluded that he was prohibited from disputing his underlying tax liabilities. See 26 U.S.C. § 6330(c)(2)(B). As a collection alternative Avery made an offer–in–compromise (OIC), proposing to compromise his outstanding liabilities for $4,277. He represented that he could afford no more than this, having lost his last three personal injury cases and having forfeited most of his assets to his ex– wife in the divorce. The SOs viewed his offer with disfavor and rejected it. The IRS issued Avery notices of determination sustaining the NFTL filings and proposed levies for 2008–2013. He timely petitioned the Tax Court.
During trial preparation the IRS determined that Avery had not received the notices of deficiency, that he was entitled to challenge his underlying tax liabilities, and that the SOs had erred in declining to consider that challenge. The IRS concluded that Avery should not be allowed most of the Schedule C advertising expense deductions claimed on his delinquent and amended returns for 2008–2013. A trial in the following issues ensued:
Key Issues:
(1) Whether the IRS erred in declining to allow deductions for $303,366 of advertising expenses that Avery allegedly incurred during 2008–2013 in connection with his business as an attorney?
(2) Whether Avery is liable for additions to tax for failure to timely file, failure to timely pay, and failure to pay estimated tax?
(3) Whether the SOs abused their discretion in considering Avery’s offer of a collection alternative
Primary Holdings:
(1) No, Avery is not entitled to deduct the advertising costs in issue. The costs were unsubstantiated for the most part, and those that were substantiated were neither “necessary” nor “common” for
attorneys to incur in the ordinary course of business. “Even if petitioner had raced in the relevant market, we would not find his expenses to be legitimate advertising expenses.”
(2) Yes, Avery is liable for the late-filing addition to tax for all five years. His excuses for failing to file were not supported by fact or law. Avery failed to show undue hardship.
(3) Not decided. At the IRS’s request, the collection alternative matter will be remanded to the IRS Independent Office of Appeals for a supplemental hearing to consider offers of collection alternatives.
Key Points of Law:
Standard of Review. Where the validity of a taxpayer’s underlying liability is properly at issue, the Tax Court reviews the IRS determination de novo. Goza v. Commissioner, 114 T.C. 176, 181–82 (2000). Where the taxpayer’s underlying liability is not properly at issue, the Court reviews the IRS decision for abuse of discretion only. See id. at 182. Abuse of discretion exists when a determination is arbitrary, capricious, or without sound basis in fact or law. See Murphy v. Commissioner, 125 T.C. 301, 320 (2005), aff’d, 469 F.3d 27 (1st Cir. 2006). A taxpayer may challenge his underlying liability at a CDP hearing if he did not receive a statutory notice of deficiency or did not otherwise have a prior opportunity to dispute his liability. 26 U.S.C. § 6330(c)(2)(B).
Advertising Expense Deductions. Deductions are a matter of legislative grace, and taxpayers bear the burden of proving their entitlement to any deduction claimed. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). A taxpayer must show that he or she has met all requirements for each deduction and keep books or records that substantiate the expenses underlying it. 26 U.S.C. § 6001; Roberts v. Commissioner, 62 T.C. 834, 836 (1974). Failure to keep and present such records counts heavily against a taxpayer’s attempted proof. Rogers v. Commissioner, T.C. Memo. 2014-141, 108 T.C.M. (CCH) 39, 43.
Section 162(a). Section 162(a) allows the deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” A taxpayer must show, not only that the taxpayer incurred the item in question, but also that it was an ordinary and necessary expense of the particular business in which the taxpayer was engaged. Commissioner v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352 (1971). An expense is “ordinary” if “the transaction which gives rise to it [is] of common or frequent occurrence in the type of business involved.” Deputy v. du Pont, 308 U.S. 488, 495 (1940); Welch v. Helvering, 290 U.S. 111, 113–14 (1933). A necessary expense is one that is “appropriate and helpful” in carrying on the taxpayer’s profit-seeking activity. Welch v. Helvering, 290 U.S. at 113; Heineman v. Commissioner, 82 T.C. 538, 543 (1984). In determining whether an expense is “ordinary and necessary” within the meaning of section 162(a), the courts focus on the taxpayer’s primary motive for incurring the expense and on whether there is a reasonably proximate relationship between the expense and the taxpayer’s occupation. See, e.g., O’Connor v. Commissioner, 653 F. App’x 633, 638 (10th Cir. 2016), aff’g on this issue T.C. Memo. 2015-155. No deduction is allowed for personal expenses. See 26 U.S.C. § 262(a).
Additions to Tax. Section 6651(a)(1) provides for an addition to tax of 5% of the tax required to be shown on the return for each month or fraction thereof for which there is a failure to file the return, not to exceed 25% in total. An individual taxpayer is generally required to file a return for a given year by April 15 of the following year, see 26 U.S.C. § 6072(a), or by October 15 if an extension was secured, see id. at § 6081(a); id. § 7503 (extending the deadline until the following business day if the due date falls on a weekend or a legal holiday). The addition to tax for late filing does not apply if the taxpayer shows that the failure was “due to reasonable cause and not due to willful neglect.” 26 U.S.C. § 6651(a)(1). “If the taxpayer exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time, then the delay is due to a reasonable cause.” Treas. Reg. § 301.6651-1(c)(1). The taxpayer can show that he did not act with “willful neglect” if he can “prove that the late filing did not result from a ‘conscious, intentional failure or reckless indifference.’” Niedringhaus v. Commissioner, 99 T.C. 202, 221 (1992). Taxpayers have a personal, nondelegable duty to file tax returns on time. See United States v. Boyle, 469 U.S. 241, 249 (1985). A taxpayer cannot seek shelter in inattention or neglect on the part of a CPA. See id. at 252; Shaw v. Commissioner, T.C. Memo. 2013-170, 106 T.C.M. (CCH) 54, 59, aff’d, 623 F. App’x 467 (9th Cir. 2015). And, a taxpayer must file timely income tax returns on the basis of the best information available to them at the time, and then file an amended return if necessary. Estate of Vriniotis v. Commissioner, 79 T.C. 298, 311 (1982).
Failure to Timely Pay. Section 6651(a)(2) provides for an addition to tax when a taxpayer fails “to pay the amount shown as tax on any return . . . on or before the date prescribed for payment of such tax.” To meet his burden of production for this addition to tax, the IRS must establish that the unpaid amount was “shown as tax on [a] return.” 26 U.S.C. § 6651(a)(2). An SFR that meets the requirements of section 6020(b) may be treated as the “return” filed by the taxpayer for this purpose. See 26 U.S.C. § 6651(g)(2). The addition to tax for failure to pay does not apply if the taxpayer shows that the failure was “due to reasonable cause and not due to willful neglect.” 26 U.S.C. § 6651(a)(2). To prove reasonable cause the taxpayer must show that he or she exercised ordinary business care and prudence in providing for payment of the tax liability but nevertheless was either unable to pay the tax or would have suffered undue hardship if he had paid the tax on the due date. Treas. Reg. § 301.6651- 1(c)(1). To establish undue hardship, the taxpayer must show that making the tax payment on time would have created “the risk of a substantial financial loss.” Merriam v. Commissioner, T.C. Memo. 1995-432, 70 T.C.M. (CCH) 627, 636, aff’d without published opinion, 107 F.3d 877 (9th Cir. 1997).
Failure to Pay Estimated Tax. Section 6654(a) imposes an addition to tax on an individual who underpays his estimated tax. This addition to tax is calculated with reference to four required
installment payments of the taxpayer’s estimated tax liability. 26 U.S.C. § 6654(c) and (d). However, no addition to tax is imposed if the taxpayer is U.S. citizen who “did not have any liability for tax for the preceding [12-month] taxable year.” 26 U.S.C. § 6654(e)(2).
Abuse of Discretion. In deciding whether the IRS settlement officers (SOs) abused their discretion the courts consider whether they (1) properly verified that the requirements of applicable law or
administrative procedure were met, (2) considered relevant issues the taxpayer raised, and (3) considered “whether any proposed collection action balances the need for the efficient collection of taxes with the legitimate concern of [petitioner] that any collection action be no more intrusive than necessary.” See 26 U.S.C. §§ 6330(c)(3), 6320(c).
Insights: Expenses incurred by a lawyer in engaging in car-racing activities are not likely deductible as an “ordinary” and “necessary” expense that is “appropriate and helpful” in carrying on the lawyer’s profit-seeking activity of practicing law. At least in Avery’s case, the primary motive for incurring the expenses in issue was personal and, thus, not deductible under section 162(a). If an expenditure is primarily motivated by personal considerations, no deduction is allowed.
