The Tax Court in Brief – December 5th – December 9th, 2022
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.
For a link to our podcast covering the Tax Court in Brief, download here or check out other episodes of The Freeman Law Project.
Tax Litigation: The Week of December 5th, 2022, through December 9th, 2022
Hoakison v. Comm’r, T.C. Memo. 2022-117| December 5, 2022 | Paris, J. | Dkt. No. 16577-17
Short Summary: Mr. and Mrs. Hoakison (collectively, the “Hoakisons”) are long-time farmers. They own real estate used for farming and utilize various equipment to assist with their farming operations, including tractors and pickup trucks. In 2012, the Hoakisons also constructed a machine shed for a cost of $108,856, which was paid in cash.
The Hoakisons are not tax professionals and do not have advanced educations. Accordingly, for their 2013, 2014, and 2015 tax years, they relied on Mr. Powell, a farm management specialist with a master’s degree in agricultural education, to prepare their returns on their behalf.
The IRS selected the Hoakisons’ 2013, 2014, and 2015 tax returns for examination. The IRS disallowed many of the Schedule F, Profit or Loss from Farming (“Schedule F”), deductions they claimed related to their farming activities. The IRS also imposed accuracy-related penalties regarding the disallowed deductions and related underpayment of tax for 2013, 2014, and 2015.
Key Issues:
- Whether the Hoakisons are entitled to deduct depreciation claimed on Schedule F, Profit or Loss from Farming, beyond amounts conceded by the IRS.
- Whether the Hoakisons are entitled to deduct certain other expenses (g., gasoline, repairs and maintenance, etc.) on Schedule F beyond amounts conceded by the IRS.
- Whether the Hoakisons are liable for accuracy-related penalties.
Primary Holdings:
- To the extent the Hoakisons provided sufficient evidence regarding their cost and other bases in the various tractors, they are entitled to depreciation deductions on the tractors. Moreover, they are entitled to depreciation deductions related to the machine shed. Finally, with respect to the pickup trucks, the Hoakisons are entitled to depreciation deductions on the trucks to the extent they met the strict substantiation requirements of section 274(d). Otherwise, the Hoakisons are not entitled to the remaining depreciation deductions claimed for the tractors and the pickup trucks; moreover, to the extent the Hoakisons claimed additional deductions related to the farm equipment and vehicles and already claimed accelerated depreciation under section 179, those deductions will be disallowed.
- The Hoakisons are entitled to some of the claimed deductions (g., utility expenses, umbrella policy insurance, etc.) on Schedule F to the extent permissible under the Cohan doctrine and not otherwise disallowed under section 274(d). They are entitled to all of their claimed deductions for the insurance on the machine shed. They are not entitled to their claimed deductions for gasoline, fuel, and oil under section 274(d) except for small deductions related to propone which were used in the farming equipment. Moreover, they are entitled to additional repair and maintenance expenses to the extent they have substantiated such amounts.
- With respect to certain underpayments attributable to duplicate depreciation deductions claimed on the tax returns, the taxpayers are liable for accuracy-related penalties with respect to those underpayments. However, the taxpayers are not liable for the accuracy-related penalties regarding the other underpayments under Neonatology Assocs. PA v. Comm’r, 115 T.C. 43 (2000).
Key Points of Law:
- Generally, the IRS’s determinations set forth in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving error. Rule 142(a); Welch v. Helvering,, 290 U.S. 111, 115 (1933). Deductions are a matter of legislative grace, and taxpayers bear the burden of establishing entitlement to any claimed deductions. See INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992); Van Velzor v. Comm’r, T.C. Memo. 2014-71; Rule 142(a).
- Section 6001 requires every person subject to income tax to maintain books and records sufficient to establish the amount of gross income and deductions shown on its income tax return. Reg. § 1.6001-1(a).
- Section 274(d)(4) provides that no deduction shall be allowed “with respect to any listed property (as defined in section 280F(d)(4))” unless the taxpayer substantiates “by adequate records or by sufficient evidence corroborating the taxpayer’s own statement.” Listed property includes, among other things, passenger automobiles or any other property used as a means of transportation. 280F(d)(4)(A)(i) and (ii).
- However, section 274(d) excludes from the strict substantiation requirements any “qualified nonpersonal use vehicle.” For these purposes, a “qualified nonpersonal use vehicle” means “any vehicle which, by reason of its nature, is not likely to be used more than a de minimis amount for personal purposes. 274(i). The strict substantiation requirements of section 274(d) generally apply to any pickup truck or van “unless the truck or van has been specially modified with the result that it is not likely to be used more than a de minimis amount for personal purposes.” Treas. Reg. § 1.274-5(k)(7). Other qualified nonpersonal use vehicles not subject to the strict substantiation requirements of section 274(d) include any vehicle designed to carry cargo with a loaded gross vehicle weight over 14,000 pounds, combines, flatbed trucks, and tractors and other special purpose farm vehicles. Treas. Reg. § 1.274-5(k)(2)(ii)(C), (F), (J), (Q).
- Section 167(a) allows as a depreciation deduction a reasonable allowance for exhaustion and wear and tear (including a reasonable allowance for obsolescence) of property used in a trade or business or held for the production of income.
- Section 168(a) specifies that the amount allowed as a depreciation deduction under section 167(a) is determined by using the applicable depreciation method, the applicable recovery period, and the applicable convention. The basis on which exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property is the adjusted basis as provided in section 1011. 167(c).
- A taxpayer may elect to deduct as a current expense the cost of section 179 property acquired and used in the active conduct of a trade or business and placed in service during the year. 179(a), (b), (d)(1); Treas. Reg. § 1.179-4(a). Section 179 property includes tangible property (to which section 168 applies) that is section 1245 property which is acquired by purchase for use in the active conduct of a trade or business. § 179(d)(1). The deduction under section 179 is allowable for the tax year in which the qualifying property is placed in service.
- When applying sections 167 and 179 in the context of particular items of property, the initial question is whether ownership and maintenance of the property are related primarily to business or personal purposes. Int’l Artists, Ltd. v. Comm’r, 55 T.C. 94, 104 (1970); Deihl v. Comm’r, T.C. Memo. 2005-287. If acquisition and maintenance of the property are associated primarily with profit-motivated purposes and any personal use is distinctly secondary and incidental, expenses and depreciation are deductible. Deihl v. Comm’r, supra. If, however, acquisition and maintenance is motivated primarily by personal considerations, deductions are disallowed. Where substantial business and personal motives exist, allocation becomes necessary. Id.
- Section 168 does not suggestion or require that the availability of the depreciation deduction is dependent on the ordinary, necessary, and reasonable requirements of section 162. Noyce v. Comm’r, 97 T.C. 670, 689-90 (1991). The only requirement is that the depreciable property be used in the taxpayer’s trader or business. at 690.
- Although the Tax Court may generally estimate the amount of a deductible expense when the taxpayer shows that a deductible expense was incurred but is unable to substantiate the amount, see Cohan v. Comm’r, 39 F.2d 540, 543-44 (2d Cir. 1930), the Court may not use the Cohan doctrine to estimate expenses covered by section 274(d), Sanford v. Comm’r, 50 T.C. 823, 827-28 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969).
- Section 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. An ordinary and necessary expense is one which is appropriate and helpful to the taxpayer’s business and results from an activity that is common and accepted practice in the business. Amdahl Corp. v. Comm’r, 108 T.C. 507, 523 (1997). Whether a payment qualifies as a deduction under section 162(a) is a factual issue which must be decided on the basis of all relevant facts and circumstances. Comm’r v. Heininger, 320 U.S. 467, 475 (1943). To prove entitlement to deduct an expense, the taxpayer must prove not only the fact of the expenditure but also the business purpose (or other deductible character) of the expense. “Business expenses deductible from gross income include ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business . . .” Reg. § 1.162-1(a). The taxpayer must show that a reported business expense was incurred primarily for business rather than personal reasons and that there was a proximate relationship between the expense and the business. Walliser v. Comm’r, 72 T.C. 433, 437 (1979).
- Section 274(d) disallows any deduction for any listed property, including automobile expenses, unless the taxpayer substantiates by adequate records or sufficient evidence corroborating the taxpayer’s own statement the amount, time, place, and business purpose of the expense. No deduction is allowed for personal, living, or family expenses. 262(a).
- Generally, premiums paid on insurance policies are deductible if the insurance coverage is ordinary and necessary for the taxpayer’s trade or business. Reg. § 1.162-1(a). However, no deduction is allowed for insurance with respect to property that is not used in a trade or business. Rogers, T.C. Memo. 2014-141.
- Section 6662(a) and (b)(2) imposes a 20% accuracy-related penalty on any portion of an underpayment of tax required to be shown on a return if the underpayment is attributable to a substantial understatement of income tax. An understatement of income tax is a “substantial understatement” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. 6662(d)(1)(A). Taxpayers may avoid a section 6662(a) penalty if they can show that they had reasonable cause for the underpayments and acted in good faith. § 6664(c)(1).
- The IRS bears the burden of production with respect to an individual taxpayer’s liability for any penalty, requiring the IRS to come forward with sufficient evidence indicating that the imposition of the penalty is appropriate. See 7491(c); Higbee, 116 T.C. at 446-47. As part of that burden, the IRS must produce evidence that it complied with the procedural requirements of section 6751(b)(1). Graev v. Comm’r, 149 T.C. 485, 492-93 (2017), supplementing and overruling in part 147 T.C. 460 (2016). Section 6751(b)(1) requires the initial determination of certain penalties to be “personally approved (in writing ) by the immediate supervisor of the individual making such determination.” Graev, 149 T.C. at 492-93; see also Clay v. Comm’r, 152 T.C. 223, 248 (2019). The supervisory approval must be secured no later than (1) the date on which the IRS issues the notice of deficiency; or (2) the date, if earlier, on which the IRS formally communicates to the taxpayer the Examination Division’s determination to assert a penalty. Belair Wood, LLC v. Comm’r, 154 T.C. 1, 15 (2020).
- The Tax Court has previously found that a supervisor’s signature on a cover letter sent to a taxpayer along with an examination report is sufficient to satisfy the written supervisory approval requirement. See, e.g., PBBM-Rose Hill, Ltd. v. Comm’r, 900 F.3d 193, 213 (5th 2018); Flume v. Comm’r, T.C. Memo. 2020-80.
- Section 6664(c)(1) provides that the accuracy-related penalty shall not be imposed with respect to any portion of an underpayment “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith” with respect to it. The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, considering all pertinent facts and circumstances. See Reg. § 1.6664-4(b)(1). Generally, the most important factor in determining the existence of reasonable cause is the taxpayer’s effort to ascertain his or her correct tax liability. Id. Circumstances that may signal reasonable cause and good faith “include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer.” Id.
- Good-faith reliance on the advice on an independent, competent professional as to the tax treatment of an item may meet reasonable cause. Reg. § 1.6664-4(b)(1). A taxpayer acts in good faith when he or she acts upon honest belief and with intent to perform all lawful obligations. See Rutter v. Comm’r, T.C. Memo. 2017-174.
- A taxpayer alleging reasonable, good-faith reliance on the advice of an independent, competent professional must show that (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (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., PA , 115 T.C. at 99. A taxpayer’s unconditional reliance on an otherwise qualified professional does not constitute reasonable reliance in good faith for purposes of section 6664(c)(1). See Stough v. Comm’r, 144 T.C. 306, 323 (2015).
- There is no precise threshold of competence that a tax adviser must have to justify a taxpayer’s reliance. Rather, the Court looks for expertise in the context of the facts of each case. CNT Invs., LLC v. Comm’r, 144 T.C. 161, 224 (2015).
- Good faith, or lack thereof, is determined by looking at all of the facts and circumstances in the case, including the taxpayers’ “experience, knowledge, and education.” Reg. § 1.6664-4(b)(1).
Insight: The Hoakison case demonstrates many of the substantiation cases that come before the Tax Court. As the fact-finder, the Tax Court is often required to review the documents and testimony to determine the amounts, if any, that are permitted under the Code, Treasury Regulations, and existing court authority. As Hoakison shows, the Tax Court often splits the differences amongst the parties when the case proceeds to trial.
