Tax Court in Brief | Palmarini Inc. v. Commissioner, Palmarini v. Commissioner | Recordkeeping and Constructive Dividends

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The Tax Court in Brief – December 12th – December 16th, 2022

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Tax Litigation:  The Week of December 12th, 2022, through December 16th, 2022

Palmarini Inc. v. Comm’r, Palmarini v. Comm’r, T.C. Memo. 2022-119 | December 7, 2022 | Gustafson, J. | Dkt. Nos. 1719-17, 1723-17


Short Summary: During tax years 2013 and 2014 (the “Tax Years”), petitioners husband and wife filed joint Forms 1040, U.S. Individual Income Tax Returns. Petitioner wife worked as a procurement analyst for the U.S. Department of Defense. Petitioner husband worked as a cement contractor for petitioner corporation.

Petitioner husband owned an approximately 33% interest in petitioner corporation, with the remaining interests being owned by his brothers.  Petitioner husband also was the sole member of a limited liability company (“LLC”) that was engaged in the business of affiliated online marketing. Petitioner husband viewed all accounts of petitioner corporation and LLC as his own and used them for both business and personal purposes. Petitioner husband also owned various residential properties and hired professional real estate management companies to manage the renting of the properties to tenants.

While petitioner corporation in prior years had been primarily operated as a cement construction business, it did not receive any revenues from cement construction work or own any rental property as part its business activity during the Tax Years. Instead, all revenues from petitioner husband’s affiliated online marketing business were deposited into petitioner corporation’s corporate bank accounts and associated advertising expenses were paid from its corporate bank accounts.

Petitioner corporation did not keep books or records, a general ledger, or profit and loss statement, and did not engage the services of an accountant or bookkeeper for the Tax Years. In preparing petitioner corporation’s returns for the Tax Years, petitioner husband would review the corporation’s bank and credit card statements to identify business expenses versus personal expenses.

Petitioner corporation timely filed its Forms 1120, U.S. Corporation Income Tax Returns, for each the Tax Years. Starting shortly after filing the original return for the 2014 tax year, petitioner corporation filed multiple amended returns for both years. On its original returns for the Tax Years, petitioner corporation listed its business activity as “affiliate marketing,” although on the last amended return that petitioner corporation filed for its 2014 tax year, this was changed to “affiliate marketing (mainly) & cement work.” Petitioner corporation also indicated on its original returns for the Tax Years that it was on the cash method of accounting, although on some amended returns for these years it claimed to be on the accrual method.

On its returns for the Tax Years, petitioner corporation claimed deductions for officer compensation and wages but did not report to the IRS any wages paid to anyone on a Form W-2, Wage and Tax Statement, did not file a Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, or Form 941, Employer’s QUARTERLY Federal Tax Return, and did not pay any employment taxes. Petitioner corporation claimed a deduction for repairs and maintenance of residential properties owned by petitioner husband relating to petitioner corporation’s use of such properties for storage of machinery and equipment used in its inactive construction business. Petitioner corporation claimed bad deductions based on allegedly unpaid balance owed by a customer for affiliated online advertising services. Petitioner corporation deducted rent paid to petitioner husband’s brother for use of a garage as its principal place of business. Petitioner corporation claimed a depreciation deduction based on for a truck that was used in its cement construction business but that was owned by petitioner husband. Petitioner corporation also claimed a deduction for advertising expenses as well as various “other” deductions.

Petitioners husband and wife also timely filed their federal income tax returns for the Tax Years. On these returns, petitioners husband and wife claimed a casualty deduction on the basis of a decrease in the fair market value of their home after a series of severe storms caused trees at their residence to fall on their fence, destroying approximately twenty feet of the fence. On their Schedule C, Profit or Loss From Business, petitioners husband and wife reported only gross receipts and advertising expenses from LLC, reflecting a net loss. Petitioners husband and wife also included a Schedule E, Supplemental Income and Loss, with their 2013 federal income tax return relating to various rental properties.

The IRS examined petitioner corporation’s returns for the Tax Years. Because petitioner corporation did not provide any books or records reflecting its calculations of gross income for the Tax Years, the revenue performed a bank deposit analysis whereby the IRS issued summonses to all banks at which petitioner corporation held accounts and sent letters to third parties to verify the type of income reflected in the deposits. The revenue agent then performed a disbursement analysis using petitioner corporation’s bank and credit card statements, during the course of which a line-by-line survey was performed to distinguish business expenses from personal expenses. As a result of the examination, the IRS determined to increase petitioner corporation’s income for unreported gross income and disallowed deductions. The revenue agent also determined a constructive dividend to petitioner husband that that petitioner corporation was liable for accuracy related penalties.

The IRS also examined petitioners husband’s and wife’s returns for the Tax Years. Petitioners husband and wife did not provide any original books or records showing how they calculated LLC’s gross receipts for the Tax Years. As a result, the revenue agent performed a bank deposits analysis on petitioners husband and wife individually. The revenue agent increased petitioners husband’s and wife’s qualified dividends for the Tax Years because of her determination that petitioner husband had received constructive dividends from petitioner corporations during those years. The revenue agent disallowed deductions reported on the Schedule C for the LLC, because the expenses were paid from petitioner corporation’s bank accounts. Regarding petitioners husband’s and wife’s Schedule E, the revenue agent disallowed all deductions claimed for the Tax Years.

The IRS issued notices of deficiency to petitioner corporation and petitioners husband and wife for the Tax Years determining federal income tax deficiencies and accuracy-related penalties. Attached to each notice of deficiency were Letters 950 signed by the revenue agent’s group manager. Petitioner corporation and petitioners husband and wife timely filed petitions with the Tax Court.

Key Issues:

Primary Holdings:

Key Points of Law

Insight: This case demonstrates the importance for taxpayers to maintain records relating to income and expenses reported on their income tax returns. Additionally, this case shows the perils that taxpayers who own corporations may face if they ignore corporate formalities.