The Tax Court in Brief – December 19th – December 23rd, 2022
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Tax Litigation: The Week of December 19th, 2022, through December 23rd, 2022
- Brooks v. Comm’r, T.C. Memo. 2022-122 | December 19, 2022 |Wells, J. |Docket No. 28206-15
- Ayria v Commissioner, T.C. Memo. 2022-123 | December 19, 2022 | Lauber, J.| Dkt. No. 13745-20
- Mamadou v. Comm’r, T.C. Memo. 2022-121 | December 20, 2022 | Lauber, J. | Dkt. No. 9759-21L
- Schwartz v. Comm’r, T.C. Memo. 2022-125| December 21, 2022 | Vasquez, J. | Dkt. No. 17291-14L
Starer v. Comm’r, T.C. Memo. 2022-124 | December 20, 2022 |Wells, J. |Docket No. 615-13
Summary: This 28-page opinion regards Petitioners Robert Lewis Starer and Merle Ann Starer (the “Starers”), controlling shareholders of the Bayview Corp. (Bayview), an S corporation. Bayview operated agriculture and horse-breeding businesses and served as a holding company for the Starers’ primary residence, a farm, and several unimproved subdivided properties initially marked for development. Ultimately, the Tax Court addressed six distinct issues (listed below) all stemming from the IRS’s deficiency notice issued to the Starers for tax years 2008, 2009, and 2010, which included determinations of deficiencies totaling over $1.3 million and penalties totaling over $250,000.
Boiled down in Tax Court in Brief style, the opinion regards the Starers’ tax liability arising from real property sales made by Bayview to family members and long-standing business acquaintances of the Starers (none of which appeared to have arm-length qualities in application) as well as transactions and inter-company transfers involving debt forgiveness among Bayview and two other of the Sharers’ closely held corporations, Village Builders, Inc. (Village Builders) and Historic Arms, Inc. (Historic Arms), and two later-formed grantor trusts, Old Plantation Trust and Family Plantation Trust. Village Builders operated a construction business that built modular homes. Historic Arms operated a firearms training and dealing business out of a residence in which Bayview owned but leased to the Sharers for no rent. The Starers and their related entities operated under the cash method of accounting. With regard to the real property transactions, Bayview and the Sharers (along with the purchasers) did not maintain arms-length relationships on the deals, especially in regard to Bayview’s contractual rights upon default by the purchasers, Bayview’s failure to exercise repurchase rights, and Bayview’s complete acquiescence to the substantial financial obligations owed by the defaulting purchasers. Some of the transfers appeared to be gratuitous, despite parcel valuations near $1 million.
Notice of Deficiency. The IRS conducted an examination of Bayview’s tax returns for taxable years 2008 through 2010, which led to adjustments of the Starers’ individual income tax for the same years. In the notice issued to petitioners, the IRS determined the deficiencies totaling over $1.3 million for the three-year period in issue and, pursuant to section 6662(a), penalties totaling over $250,000. The Starers timely petitioned the Tax Court for redetermination.
Key Issues and Short Answers:
(1) Whether any resulting tax liabilities from the transactions in issue should pass through to the Starers’ two grantor trusts as shareholders of record in Bayview or to Starers as reported on Bayview’s tax return?
Short Answer: No. The Sharers presented no evidence demonstrating, for these purposes, that they filed the required S Corp election or election statement as required by Treasury Regulation § 1.1361- 1(m)(2)(i) and (ii)(A).
(2) Whether the IRS’s determination that Bayview’s accounting of four transfers of property should be treated as sales rather than loans constitutes a change in Starers’ method of accounting, and if so, whether the IRS abused his discretion in making the determination?
Short Answer: The transactions in issue were sales because Bayview never intended to fulfill its repurchase obligations. And, the IRS did not abuse its discretion in making the changes to Bayview’s method of accounting.
(3) Whether two transfers of property constitute constructive distributions of appreciated property from Bayview to the Starers?
Short Answer: Yes. The transfers of two lots constituted constructive distributions of appreciated property to the Sharers as shareholders of Bayview followed by gifts or compensatory transfers to the purchasers (one a friend; the other a family member). The Starers and others in the transactions did not intend their relationship as a joint venture or partnership. And, the Sharers failed to demonstrate that Bayview’s gratuitous transfer of real property was made primarily for the benefit of Bayview.
(4) Whether the Starers’ rent-free use of their home in 2008, 2009, and 2010 constitutes a constructive dividend from Bayview to the Starers?
Short Answer: Yes, the Starers’ rent-free use of the home constituted a constructive dividend from Bayview to the Starers in the amount stipulated by them.
(5) Whether Bayview is entitled to a bad debt deduction for 2008?
Short Answer: No. The arrangement between Bayview and Village Builders lacked the objective formalities required of a bona fide debt. And, Village Builders failed to include cancellation of debt income on its 2008 Form 1120 as the 2008 Instructions for Form 1120 require. There was no indication that the corporations conducted themselves as if the transaction was a loan for which a bad debt deduction may be permitted.
(6) Whether the Starers are liable for section 6662(a) accuracy-related penalties for the years in issue?
Short Answer: No. The IRS failed to show supervisory approval for the penalties, which is a requirement for such liability pursuant to section 6751(b) of the Code. Therefore, the Sharers are not liable for accuracy-related penalties under section 6662.
Key Points of Law:
Burden of Proof. The IRS’s determinations in a notice of deficiency are generally presumed correct, and taxpayers bear the burden of proving them incorrect. See Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
S Corporation. In general, a corporation electing to be taxed as an S corporation does not pay tax at the corporate level. I.R.C. § 1363(a). Rather, an S corporation shareholder reports a pro rata share of the S corporation’s income, loss, and credit items on a per-share, per-day basis for the shareholder’s taxable year in which the S corporation’s taxable year ends. I.R.C. § 1366(a). An S corporation shareholder is required to recognize his or her percentage share of the S corporation’s items of income for any taxable year even if the shareholder does not receive a distribution from the S corporation for that year. Treas. Reg. § 1.1366- 1(a)(1); see also Jones v. Commissioner, T.C. Memo. 2010-112, 2010 WL 2011013, at *3.
Trusts as Shareholders of S Corporation. Certain trusts, such as a grantor trust, may be eligible shareholders of an S corporation under section 1361(c)(2). See I.R.C. § 1361(c)(2)(A)(i). Under section 671, the deemed owners of a grantor trust are taxable on the trust’s income attributable to them. See, e.g., Madorin v. Commissioner, 84 T.C. 667, 675 (1985). A trust may also be eligible to be a shareholder of an S corporation under section 1361(c)(2)(A)(v), which would treat current beneficiaries as the shareholders of the S corporation for tax purposes, or if no current beneficiaries, then the trust as the shareholder of the S corporation under section 1361(c)(2)(B)(v) (electing small business trust or ESBT). In order to qualify as an ESBT, the trust must elect to be taxed as such. This requires the filing of an ESBT election and an ESBT statement in accordance with the provisions of Treasury Regulation § 1.1361-1(m)(2)(i) and (ii)(A).
Section 481 Change in Method of Accounting Adjustment to Clearly Reflect Income. Section 446(a) sets forth the general rule that “[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” If a taxpayer’s method of accounting does not clearly reflect income, the IRS is authorized to impose a change on the taxpayer’s method of accounting that does clearly reflect income. See I.R.C. § 446(b); Treas. Reg. § 1.446-1(b)(1). The IRS has broad discretion in determining whether a taxpayer’s method of accounting clearly reflects income. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979); RCA Corp. v. United States, 664 F.2d 881 (2d Cir. 1981). Once the IRS determines that a taxpayer’s method of accounting does not clearly reflect income and thereafter uses that legal authority to select a method of accounting that does clearly reflect income, the IRS’s selection may be challenged successfully only upon a demonstration of an abuse of discretion. See Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 353 n.3 (1st Cir. 1970), aff’g T.C. Memo. 1969-79.
A “method of accounting” includes not only the taxpayer’s overall plan of accounting for gross income or deductions but also the taxpayer’s accounting treatment for any “material item” within the overall plan. Treas. Reg. §§ 1.481-1(a)(1), 1.446-1(e)(2)(ii). A material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. Treas. Reg. § 1.446-1(e)(2)(ii)(a). “[A] change in method of accounting does not include adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction.” Treas. Reg. § 1.446- 1(e)(2)(ii)(b). Where a taxpayer’s accounting practice permanently avoids reporting of income and accordingly distorts its lifetime income, the practice is not a method of accounting and section 481(a) is inapplicable to a change of the accounting practice. Schuster’s Express, Inc. v. Commissioner, 66 T.C. 588 (1976), aff’d without published opinion, 562 F.2d 39 (2d Cir. 1977). When an accounting practice merely postpones the reporting of income, rather than permanently avoiding the reporting of income over the taxpayer’s lifetime, it involves the proper time for reporting income. See Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 510 (1989).
Constructive Transfers. Generally, unless otherwise provided, gross income under section 61 includes all accessions to wealth from whatever source derived. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). “[G]ain . . . constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it. That occurs when [property] . . . is delivered by its owner to the taxpayer in a manner which allows the recipient freedom to dispose of it at will . . . .” Rogers v. Commissioner, T.C. Memo. 2011-277, 2011 WL 5885083, at *2 (quoting Rutkin v. United States, 343 U.S. 130, 137 (1952)), aff’d, 728 F.3d 673 (7th Cir. 2013).
The economic benefit is the controlling factor in determining whether gain is income. Rutkin, 343 U.S. at 137. When a corporation confers an economic benefit upon a shareholder without expectation of reimbursement, that economic benefit becomes a constructive distribution and is taxable as such. See Loftin & Woodward, Inc. v. United States, 577 F.2d 1206, 1214 (5th Cir. 1978). A distribution need not be formally declared or even intended by a corporation but can be constructive. Noble v. Commissioner, 368 F.2d 439, 442–43 (9th Cir. 1966), aff’g T.C. Memo. 1965-84. Whether a distribution is a constructive distribution depends on whether it was made primarily for the benefit of the shareholder. See Hood v. Commissioner, 115 T.C. 172, 179–80 (2000). To avoid having a distribution treated as a constructive distribution, the taxpayer must show that the corporation primarily benefited from the distribution. See id. at 181. The main focus of whether there is a constructive distribution is that the corporation has conferred a benefit on the shareholder to distribute available earnings and profits without the expectation of repayment. CTM Constr., Inc. v. Commissioner, T.C. Memo. 1988-590, 1988 Tax Ct. Memo LEXIS 619, at *11.
Petitioners maintain that they never received any ownership interest in Lot 2 in their individual names and therefore they did not receive any personal benefit or accession to wealth or derive any readily realizable economic value as a consequence of Bayview’s transfer of Lot 2 to Ravenna.
Joint Ventures – Partnerships. Joint ventures are the equivalent to partnerships for federal tax purposes. See I.R.C. § 7701(a)(2). “A partnership is generally said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses.” Commissioner v. Tower, 327 U.S. 280, 286 (1946). A partnership is an organization for the production of income to which each partner contributes one or both of the ingredients of income—capital or services. Commissioner v. Culbertson, 337 U.S. 733, 740 (1949). To decide whether a partnership exists, a court must also analyze various factors, including: (1) the contributions made by both parties to the venture; (2) the parties’ control over capital and income and the right of each party to make withdrawals; (3) whether each party shared a mutual proprietary interest in the net profits and had an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; and (4) whether the parties exercised mutual control and assumed mutual responsibilities of the venture.
Constructive Dividend. A shareholder’s use of corporate property can result in a constructive dividend to the shareholder measured by the fair market rental value of the property. Nicholls, North, Buse Co. v. Commissioner, 56 T.C. 1225, 1240–42 (1971). The amount of the constructive dividend and Rule 91(e) requires that the Tax Court bind a taxpayer to any stipulation made with respect to the dividend amount, absent clearly contrary evidence. See Jasionowski v. Commissioner, 66 T.C. 312, 318 (1976).
Uncorroborated Testimony. The Tax Court has no obligation to accept uncorroborated self-serving testimony. Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).
Bad Debt Deduction. Section 166(a)(1) allows a deduction for any debt that becomes wholly worthless within a taxable year. To deduct a business bad debt, the taxpayer must show that the debt was created or acquired in connection with a trade or business and must also establish the amount of the debt, the worthlessness of the debt, and the year that the debt became worthless. Davis v. Commissioner, 88 T.C. 122, 142 (1987), aff’d, 866 F.2d 852 (6th Cir. 1989). An intent to establish a debtor-creditor relationship exists if, when the transfers were made, the debtor intended to repay the funds and the creditor intended to enforce repayment. See, e.g., Beaver, 55 T.C. at 91; Fisher v. Commissioner, 54 T.C. 905, 909–10 (1970). This is a question of fact. Haber v. Commissioner, 52 T.C. 255, 266 (1969), aff’d, 422 F.2d 198 (5th Cir. 1970). Factors include: (1) whether the promise to repay is evidenced by a note or other instrument that evidences indebtedness; (2) whether interest was charged or paid; (3) whether a fixed schedule for repayment and a fixed maturity date were established; (4) whether collateral was given to secure payment; (5) whether repayments were made; (6) what the source of any payments was; (7) whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan; and (8) whether the parties conducted themselves as if the transaction was a loan. Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980); see also Welch v. Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000), aff’g T.C. Memo. 1998-121; Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972); Knutsen-Rowell, Inc. v. Commissioner, T.C. Memo. 2011-65.
Penalties. Section 6662(a) and (b)(1) and (2) imposes a 20% penalty on any portion of an underpayment of tax required to be shown on a return that is attributable to negligence or disregard of rules or regulations or a substantial understatement of income tax. “Negligence” includes any failure to make a reasonable attempt to comply with the internal revenue laws or to exercise reasonable care in the preparation of a tax return. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). “Disregard” includes any careless, reckless, or intentional disregard of the Code, regulations, or certain IRS administrative guidance. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(2). 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 the taxable year or $5,000. I.R.C. § 6662(d)(1)(A).
Penalties – Burdens and Procedure. Under section 7491(c), the IRS bears the burden of production regarding penalties and must come forward with sufficient evidence indicating that it is appropriate to impose penalties. Higbee v. Commissioner, 116 T.C. 438, 446–47 (2001). The IRS can meet that burden of production with regard to section 6662 by showing that the deficiencies exceed the greater of 10% of the tax required to be shown on the return or at least $5,000 for each year the penalty has been determined following a Rule 155 computation. However, part of the IRS’s burden of production in this setting includes demonstrating compliance with section 6751(b). Section 6751(b)(1) provides that “[n]o penalty . . . shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.” The IRS’s burden of production under section 7491(c) includes establishing compliance with the written supervisory approval requirement of section 6751(b). Graev v. Commissioner, 149 T.C. 485 (2017), supplementing and overruling in part 147 T.C. 460 (2016).
Insights: This Starers opinion illustrates that the IRS can and will use a taxpayer’s failure to exercise contractual rights as indicia of a taxable arrangement not indicated in the actual contracts. The Sharers (and Bayview) did not treat the real property transfers as arms-length transactions. Bayview and the related companies engaged in inter-company transfers that were not properly documented as loans, although the taxpayers’ reported them as such to the IRS. The Sharers failed to document significant financial transactions, and they failed to create, for example, temporal corporate minutes to substantiate Bayview’s business decisions that, at the time, may have been (arguably) reasonable. When the Tax Court ultimately evaluated those past business decisions, the Court, having only the Sharers’ uncorroborated testimony, basically concluded that no reasonable business person would have conducted themselves as such; thus, leaving the Tax Court wide latitude to evaluate the IRS’s deficiency determinations under the abuse of discretion standard. The only silver lining for the Starers is that the IRS, for whatever reason, failed to show procedural compliance for the accuracy-related penalties.