The Tax Court in Brief – October 17th – October 21st, 2022
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Tax Litigation: The Week of October 17th, 2022, through October 21st, 2022
Yaguda v. Comm’r, T.C. Summary Opin. 2022-21 | October 20, 2022 | Panuthos, Special Trial J. | Dkt. No. 19113-19S
Summary: Pursuant to 26 U.S.C. § 7463(b), the decision to be entered on this opinion is not reviewable by any other court, and the opinion shall not be treated as precedent for any other case. The case regards a deficiency determination and a 26 U.S.C. § 6662(a) accuracy-related penalty.
Estate Financial, Inc. (EFI), a loan service provider, was incorporated in 1991 and made a valid election to be treated as an S corporation. Petitioners, Joshua Yaguda and Joeli Yaguda (Petitioners), held a 10% shareholder interest in EFI. Petitioners’ daughter, Isabella Yaguda, held a 5% shareholder interest. In 2008, a creditor filed an involuntary bankruptcy petition against EFI. The case was converted to a voluntary chapter 11 bankruptcy. As directed by the bankruptcy trustee, EFI engaged in business activity, including liquidating certain assets. Pursuant to EFI’s election as an S corporation, and for the 2015 tax year, EFI filed with the IRS several Schedules K–1, Shareholder’s Share of Income, Deductions, Credits, etc., for shareholders, which included petitioners and their daughter. In 2007 “petitioner” (the opinion does not identify which Yaguda) was charged with counts of securities fraud. In 2008, a Notice of Pendency of Action (Lis Pendens) was filed in the criminal proceeding, listing petitioner’s shares in EFI to be preserved from any transfer. Petitioner entered a plea agreement in 2009, in which he relinquished and forfeited assets. In sentencing, Petitioner’s interest in EFI was assigned to the District Attorney’s Office to oversee for the benefit of the victims of the securities fraud. In 2010, the court appointed a receiver for liquidating assets and paying restitution to victims. Petitioner remained incarcerated until 2012. Petitioners timely filed Form 1040 for tax year 2015. It was prepared by a certified public accountant (CPA). Petitioners’ return did not include amounts reported on EFI’s Schedules K–1 filed with the IRS. Examination of Petitioners’ 2015 return began in 2017. The IRS determined that Petitioners had failed to include in income amounts attributable to their interest in EFI and that Petitioners should have included in income the unearned income of their daughter, pursuant to 26 U.S.C. § 1(g). On December 6, 2018, a Form 300, Civil Penalty Approval Form, was approved by the examiner’s manager on the basis of Petitioner’s failure to report the flowthrough income. A notice of deficiency was issued and the IRS adjusted Petitioners’ income accordingly.
Key Issues:
(1) Whether the amounts in taxable interest of EFI was includible in Petitioners’ income?
(2) Whether a distributive share of income of EFI is includible in Petitioners’ income?
(3) Whether Petitioners are liable for a section 6662(a) accuracy-related penalty?
Primary Holdings:
Yes. Yes. No.
The IRS proved, and Petitioners failed to present evidence otherwise, that the interest in EFI was includable. As their daughter’s unearned income, 26 U.S.C. § 1(g) provides that certain unearned income of children is taxed as the parent’s income if the child is under the age of 18 at the close of the taxable year, which was the case here. But, Petitioners made a reasonable, good faith effort to correctly assess their tax liability, so the accuracy-related penalty was not sustained.
Key Points of Law:
Burdens and Presumptions. Generally, the IRS’s determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving that those determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). In order for the presumption of correctness to attach to the deficiency determination in unreported income cases, the IRS must establish “some evidentiary foundation” connecting the taxpayer with the income-producing activity or demonstrate that the taxpayer received unreported income. Weimerskirch v. Commissioner, 596 F.2d 358, 361–62 (9th Cir. 1979), rev’g 67 T.C. 672 (1977). Once the IRS introduces such evidence, the burden shifts to the taxpayer to show by a preponderance of the evidence that the determination was arbitrary or erroneous. Klootwyk v. Commissioner, T.C. Memo. 2006-130, slip op. at 4–5.
Abandonment of Ownership Interests. A partner can abandon his or her partnership interest for federal tax purposes. See Citron v. Commissioner, 97 T.C. 200, 213 (1991). In such a case, an affirmative act to abandon must be ascertained from all the facts and surrounding circumstances. Intention alone is not sufficient to accomplish abandonment but must be accompanied by an affirmative act of abandonment. See Beus v. Commissioner, 261 F.2d 176, 180 (9th Cir. 1958), aff’g 28 T.C. 1133 (1957); United Cal. Bank v. Commissioner, 41 T.C. 437, 451 (1964), aff’d per curiam, 340 F.2d 320 (9th Cir. 1965).
S Corp and Corporate Income. An S corporation is generally not subject to federal income tax at the entity level. See 26 U.S.C. § 1363(a). Instead, the corporation’s income, losses, deductions, and credits are passed through to the shareholders as their pro rata shares. Id. at § 1366(a). The S corporation’s income is taxable to the shareholder regardless of whether any income is distributed. Treas. Reg. § 1.1366-1(a)(1). Once an entity elects S corporation status, the election is effective for all succeeding taxable years until terminated. 26 U.S.C. § 1362(c). The election will be terminated if and only if (1) the shareholders make an affirmative revocation, (2) the entity ceases to be a “small business corporation,” or (3) the entity’s passive investment income exceeds 25% of its total gross receipts for the previous three years. See id. at § 1362(d). The filing of a petition in bankruptcy court generally creates a bankruptcy estate, which is a separate entity for bankruptcy purposes and a separate taxpayer for federal income tax purposes. See id. at § 1398. Section 1398 does not apply to corporations. See id. at § 1399. In an S corporation, shareholders remain liable for any income that is taxable and generated after the bankruptcy is filed, even when no benefit is received. See Mourad v. Commissioner, 121 T.C. 1, 6 (2003), aff’d, 387 F.3d 27 (1st Cir. 2004).
Unearned Income of Children. 26 U.S.C. § 1(g) provides that certain unearned income of children is taxed as the parent’s income if the child is under the age of 18 at the close of the taxable year.
Section 6662(a) Accuracy-Related Penalty. Section 6662(a) and (b)(1) and (2) imposes an accuracy-related penalty of 20% on any portion of an underpayment of federal income tax attributable to the taxpayer’s “[n]egligence or disregard of rules or regulations” or “substantial understatement of income tax.” An understatement of federal income tax is substantial if the amount of the understatement for the taxable year exceeds the greater of 10% of the tax required to be shown on the return or $5,000. 26 U.S.C. § 6662(d)(1)(A).
Negligence for Accuracy-Related Penalty. “Negligence” includes any failure to make a reasonable attempt to comply with the Code and any failure to keep adequate books and records or to substantiate items properly. Id. at § 6662(c); Treas. Reg. § 1.6662-3(b). Negligence has also been defined as the failure to exercise due care or the failure to do what a reasonable person would do under the circumstances. See Allen v. Commissioner, 92 T.C. 1, 12 (1989), aff’d, 925 F.2d 348 (9th Cir. 1991).
Burdens for Accuracy-Related Penalty. The IRS bears the burden of production with respect to a section 6662 penalty. 26 U.S.C. § 7491(c). Once the IRS has met the burden, the taxpayer may avoid a section 6662(a) accuracy-related penalty to the extent that he or she can demonstrate (1) reasonable cause for the underpayment and (2) that he or she acted in good faith with respect to the amount paid. Id. at § 6664(c)(1). The decision as to whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances, including: (1) the taxpayer’s efforts to assess the proper tax liability, (2) the knowledge and experience of the taxpayer, and (3) reliance on the advice of a tax professional. Treas. Reg. § 1.6664-4(b)(1). An honest misunderstanding of the law that is reasonable in the light of the facts and circumstances may support a conclusion that a taxpayer acted with reasonable cause and in good faith with respect to a reported position. Id.; see also Higbee, 116 T.C. at 448–49. Generally, the most important factor is the extent of the taxpayer’s efforts to assess his or her proper tax liability. Treas. Reg. § 1.6664-4(b)(1). Statutory complexity alone does not constitute reasonable cause. Barnes v. Commissioner, T.C. Memo. 2012-80, aff’d, 712 F.3d 581 (D.C. Cir. 2013).
Insight: To abandon an interest in an S corporation, the shareholder must make an affirmative act to abandon. Otherwise, the corporate income of the S corporation will likely remain attributable to the shareholder. Another unique tax issue addressed in this opinion is the application of 26 U.S.C. § 1(g), which provides that certain unearned income of children is taxed as the parent’s income if the child is under the age of 18 at the close of the taxable year.
