Tax Court in Brief | Patacsil v. Comm’r | Insolvency to Avoid Recognition of Cancellation-of-Indebtedness income; Net Operating Loss; Reliance on Tax Professional

The Tax Court in Brief – January 16th – January 20th, 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.

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 January 16th, 2022, through January 20th, 2023

• Lucas v. Comm’r, T.C. Memo. 2023-9| January 17, 2023 | Urda, J. | Dkt. No. 2808-20

Patacsil v. Comm’r, T.C. Memo. 2023-8| January 17, 2023 |Holmes, J. | Dkt. No. 21902-19

Summary: Ernesto Patacsil and Marilyn Patacsil (“Taxpayers”) owned a business that ran group homes for consumers with intellectual or physical maladies in California, being an expensive yet statutorily encouraged social-service endeavor. See Disability and Aging Community Living Advisory Committee, Cal. Health & Hum. Servs. Agency. Their business was always in danger of toppling financially, and Mrs. Patacsil did not help the situation by her gambling proclivities. Taxpayers used a system of envelopes for maintaining records of expenses and receipts. Taxpayers used accountants to prepare their returns for the years in issue, being 2015, 2016, and 2017. For 2015, Taxpayers claimed near $500,000 of “other expenses.” For the 2016 and 2017 returns, Taxpayers provided their preparer near 6,000 files from the envelopes.

The preparer completed Forms 4797, Sales of Business Property, for both 2016 and 2017 relating to the sale of group homes known as Knickerbocker and Hildreth. They bought Hildreth in 2005 for $622,263; claimed a basis built up to $921,450; a gross sale price of $416,000; and a canceled loan of $391,080. They also claimed to have no allowable depreciation even though the property was used in their business. These numbers led them to claim a loss of $505,450. For Knickerbocker, they reported that in 2017 they sold the property for nothing but that they did receive $365,000 of loan forgiveness upon the sale. Taxpayers reported having a total accumulated basis of $125,587 in the property from which they had taken $101,361 of depreciation deductions. This left them with a basis of $24,226 in the property at the time of the sale. Ignoring the cancellation of debt, Taxpayers reported the $24,226 claimed basis as a loss on their return. Testimony at trial in the Tax Court indicated this reporting was in error.

Their preparer advised them to exclude any cancellation-of-indebtedness income on the ground that they were insolvent for tax year 2016, based on personal property valuations, loans and liabilities, and real property value estimates and resulting in about $3 million in assets against $3.9 in liabilities. But, they did not update the figures for 2017. On their 2017 return, they carried forward about $450,000 as a net operating loss from the 2016 return, calculated by adding Taxpayers’ business income on Line 12 with the other gains or losses on Line 14 and business-rental loss from Line 17 of the 2016 return. They offset the net operating loss in part with Mrs. Patacsil’s gambling income but then reported a deduction in the full amount of that income as a miscellaneous deduction on Schedule A.

According to the Tax Court, the IRS’s “computer whirred and spotted” the “anomalies” in Taxpayers’ reporting. There was an audit, followed by a notice of deficiency for all three years.

Key Issues:

1. Should Taxpayers have reported cancellation-of-indebtedness income for 2015 and 2016?
2. Are Taxpayers entitled to additional Schedule C expenses for 2015, 2016, and 2017?
3. Did Taxpayers overstate their losses from the sales of the Hildreth and Knickerbocker properties?
4. Did they incur a net operating loss of $450,000 in 2016 that they are entitled to carry forward to 2017?
5. Do Taxpayers owe any penalties?

Primary Holdings (Split Results):

1. No and Yes. For 2015, they failed to submit proper evidence of total assets and liabilities. Thus, Taxpayers did not met their burden of proving the existence and extent of their insolvency, and they must recognize the entire amount shown on their Form 1099–C as cancellation-of-indebtedness income for 2015. For 2016, the IRS’s evidence proved Taxpayer’s insolvency.
2. No. Taxpayers failed to submit proper receipts or documentation to enable the Tax Court to find that they are entitled to deductions over and above what the IRS already allowed.
3. No. For Hildreth, Taxpayers introduced no evidence to substantiate the claimed basis, and they did not include any allowed or allowable depreciation in their calculation of the loss. For Knickerbocker, they failed to provide any records of their basis in the property, any allowable depreciation, or even its sale price. Thus, Taxpayers failed to substantiate any loss on its sale.
4. No. Taxpayers needed to file with their tax return a concise statement stating the amount of the NOL deduction claimed and all material and pertinent facts, including a detailed schedule that showed how they computed their NOL deductions. See Treas. Reg. § 1.172-1(c). They failed to do so.
5. Yes and No. The IRS showed compliance with section 6751 and that the tax Taxpayers should have shown on their returns for each of the three years at issue compared to what they did show revealed understatements of more than the 10% of the tax due or $5,000 that the section requires. And, Taxpayers’ recordkeeping—boxes of folders with envelopes stuffed with receipts—did not show the exercise of ordinary business care and prudence. The preparer gave no advice about the deductibility or amounts of their claimed expenses, and Taxpayers’ recordkeeping system would not have given the preparer necessary and accurate information about those expenses. But, Taxpayers were reasonable in relying on the preparer’s advice with respect to the 2017 understatement attributable to the NOL.

Key Points of Law:

Cancellation-of-Indebtedness Income. Section 61(a) defines income to include any income from the discharge of indebtedness. 26 U.S.C. § 61(a)(12). To the extent a taxpayer is released from indebtedness, the taxpayer has realized an accession to income because the cancellation effects a freeing of assets previously offset by the liability arising from such indebtedness. Cozzi v. Commissioner, 88 T.C. 435, 445 (1987). Canceled debt creates income that is usually equal to the face value of that debt minus any amount paid to satisfy it. Rios v. Commissioner, 103 T.C.M. (CCH) 1713, 1716 (2012), aff’d, 586 F. App’x 268 (9th Cir. 2014). A taxpayer has to recognize the income in the year the debt is canceled. Montgomery v. Commissioner, 65 T.C. 511, 520 (1975).

Exceptions to Cancellation-of-Indebtedness Income. The Code provides an exception for those debtors who are insolvent when their debts are forgiven. Section 108(a) limits this exclusion to the amount of the insolvency, 26 U.S.C. § 108(a)(1)(B), (3), and defines an insolvent taxpayer as one who has an “excess of liabilities over the fair market value of assets.” Id. at § 108(d)(3). The Tax Court’s focus is on the day the debt is canceled: The decisive moment is immediately before that cancellation. Id.  The taxpayer bears the burden to prove that they were insolvent. See Rule 142(a); see also Newman v. Commissioner, 111 T.C.M. (CCH) 1599, 1600 (2016).

Schedule C Expenses. Section 162 allows a deduction for ordinary and necessary business expenses, but taxpayers have the burden of proving what they spent. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). A taxpayer usually must keep sufficient records to substantiate them. 26 U.S.C. § 6001; Treas. Reg. § 1.6001-1(a). When a taxpayer fails to substantiate deductions, the Tax Court may estimate, but only if the taxpayer provides at least some evidence to support an estimate and the Court is convinced they were incurred. Finney v. Commissioner, 27 T.C.M. (CCH) 1510, 1516 (1968); see also Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957); Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir. 1930). Materials and supplies that a business uses during a tax year, for example, are generally deductible. See 26 U.S.C. § 162(a); Treas. Reg. § 1.162-3.

Loss from Sales of Business Property. Section 61(a)(3) includes in gross income gain derived from the sale of real property. Someone who sells property is taxed on the gain, not on the sale price. See 26 U.S.C. §§ 1001(a), 1011. The seller gets “basis” for the amount paid for the property, and the basis is then adjusted according to the rules in section 1016. See 26 U.S.C. § 1012. Adjusted basis is typically what a property owner paid for the property plus what the owner later spent to improve it, minus allowed or allowable depreciation. Id. at §§ 1011(a), 1012(a), 1016. Gain is the amount the seller receives reduced by the seller’s adjusted basis in the property. See id. at § 1011.

Recourse Debt. When there is debt, “the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition.” Treas. Reg. § 1.1001-2(a)(1). The amount that a taxpayer realizes from a transfer of property in exchange for discharge or reduction of debt depends on whether the debt is recourse or nonrecourse. See Frazier v. Commissioner, 111 T.C. 243, 245 (1998). “Indebtedness is generally characterized as ‘nonrecourse’ if the creditor’s remedies are limited to particular collateral for the debt and as ‘recourse’ if the creditor’s remedies extend to all the debtor’s assets.” Simonsen v. Commissioner, 150 T.C. 201, 213 (2018). The amount realized from the disposition of property secured by recourse debt is the fair market value of the property. See Bialock v. Commissioner, 35 T.C. 649, 660–61 (1961). Foreclosure of property secured by recourse debt does not trigger recognition of any cancellation-of-indebtedness income, unless and to the extent that the amount of the recourse debt discharged exceeds the fair market value of the property. Treas. Reg. § 1.1001-2(a)(2).

Non-Recourse Debt. For nonrecourse debt, the amount realized upon foreclosure of a property secured by nonrecourse debt includes the full amount of that debt. See Commissioner v. Tufts, 461 U.S. 300, 313 (1983). The general rule is that a disposition of property encumbered with nonrecourse debt triggers inclusion of the discharged debt only in the amount realized and not in a taxpayer’s gross income. See, e.g., Est. of Delman v. Commissioner, 73 T.C. 15, 31–33 (1979); Treas. Reg. § 1.1001-2(a)(1). But see, e.g., Gershkowitz v. Commissioner, 88 T.C. 984, 1011 (1987) (cancellation of nonrecourse debt without surrender of secured property results in COI income to extent canceled debt exceeds cash payment).

Net Operating Loss. Section 172(a) allows a deduction for an NOL for any tax year in an amount equal to the sum of (1) the NOL carryovers to such year and (2) the NOL carrybacks to such year. The Code defines an NOL as the excess of deductions allowed by chapter 1 of the Code over the gross income, subject to certain modifications. See 26 U.S.C. § 172(c). A taxpayer must generally carry back any NOL to each of the two tax years before the year of the loss, and then carry it forward to each of the twenty tax years after the year of the loss. See id. at § 172(b)(1)(A), (2). Taxpayers can elect to forgo a carryback, but without a timely election they must carry NOLs back before they can carry them forward. Id. at § 172(b)(2), (3). They also have to make an election to waive a carryback by the due date of their return “for the taxable year of the net operating loss for which the election is to be in effect.” Id. at § 172(b)(3).

Accuracy Related Penalty. The IRS has both a burden of proof and a burden of production. The IRS must show compliance with section 6751. If proven, the taxpayer may show that the penalties are nonetheless not assessable due to reasonable reliance on the advice of a tax professional.

Reliance on Tax Professional. There is a difference between tax preparation and tax advice. A tax preparer is “any person who prepares [the return] for compensation.” 26 U.S.C. § 7701(a)(36)(A). A tax adviser is a person who analyzes an issue and communicates his conclusions to the taxpayer. See Treas. Reg. § 1.6664-4(c)(2). Factors to decide whether the defense exists: (1) Was the adviser a competent professional who had sufficient expertise to justify reliance? (2) Did the taxpayer provide necessary and accurate information to the adviser? (3) Did the taxpayer actually rely in good faith on the adviser’s judgment? Whether a taxpayer relied on advice and whether his reliance was reasonable hinge on the facts and circumstances of the case. See Treas. Reg. § 1.6664-4(c)(1).

Insights: A key and low-hanging-fruit takeaway from Patacsil is this: Don’t maintain a record system consisting of boxes of folders with envelopes stuffed with thousands of receipts and expect to be able to rely on the “reliance on tax professional” defense to accuracy-related penalties based on errors made by the tax preparer in reporting the tax liability with respect to those records. See above for other key takeaways.